Business Law: The Ethical, Global, and Digital Environment [18 ed.] 126073689X, 9781260736892

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Business Law

The Ethical, Global, and Digital Environment

18e

E I G H TE E N TH E DI TI O N

Jamie Darin Prenkert A. James Barnes Joshua E. Perry Todd Haugh Abbey R. Stemler all of Indiana University

Pixtal/AGE Fotostock

Final PDF to printer

BUSINESS LAW

Published by McGraw Hill LLC, 1325 Avenue of the Americas, New York, NY 10121. Copyright © 2022 by McGraw Hill LLC. All rights reserved. Printed in the United States of America. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw Hill LLC, including, but not limited to, in any network or other electronic  storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 LWI 24 23 22 21 ISBN 978-1-265-40639-4 MHID 1-265-40639-1

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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw Hill LLC, and McGraw Hill LLC does not guarantee the accuracy of the information presented at these sites.

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The Authors The Authors Jamie Darin Prenkert, Professor of Business Law and

the Charles M. Hewitt Professor, joined the faculty of Indiana University’s Kelley School of Business in 2002. He is the Associate Dean of Academics for the Kelley School. He served as chair of the Department of Business Law and Ethics from 2014 to 2016 and from 2019 to 2020, having served as an Associate Vice Provost for Faculty and Academic Affairs for the Indiana University–Bloomington campus from 2016 to 2019. Professor Prenkert is a former editor in chief of the American Business Law Journal and is a member of the executive committee of the Academy of Legal Studies in Business. His research focuses on issues of employment discrimination and the human rights obligations of transnational corporations. He has published articles in the American Business Law Journal, the North Carolina Law Review, the Berkeley Journal of Employment and Labor Law, and the University of Pennsylvania Journal of International Law, among others. He also coedited a volume titled Law, Business and Human Rights: Bridging the Gap. Professor Prenkert has taught undergraduate and graduate courses, both in-residence and online, focusing on the legal environment of business, employment law, law for entrepreneurs, business and human rights, and critical thinking. He is a recipient of the Harry C. Sauvain Undergraduate Teaching Award and the Kelley Innovative Teaching Award. Professor Prenkert earned a B.A. (summa cum laude) from Anderson University and a J.D. (magna cum laude) from Harvard Law School. Prior to joining the faculty of the Kelley School, he was a senior trial attorney for the U.S. Equal Employment Opportunity Commission.

A. James Barnes, Professor of Public and Environ-

mental Affairs and Professor of Law at Indiana University– Bloomington (IU), previously served as Dean of IU’s School of Public and Environmental Affairs and has taught business law at IU and Georgetown University. His teaching interests include commercial law, environmental law, alternative dispute resolution, law and public policy, and ethics and the public official. He is the co-author of several leading books on business law. From 1985 to 1988, Professor Barnes served as the deputy administrator of the U.S. Environmental Protection Agency (EPA). From 1983 to 1985, he was the EPA general counsel and in the early 1970s served as chief of staff to the first administrator of EPA. Professor Barnes also served as a trial attorney in the U.S. Department of Justice and as general counsel of the U.S. Department of Agriculture. From 1975 to 1981, he had a commercial and environmental law practice with the firm of Beveridge and Diamond in Washington, D.C. Professor Barnes is a Fellow of the National Academy of Public Administration, and a Fellow in the American College of Environmental Lawyers. He served as chair of the Environmental Protection Agency’s Environmental Finance Advisory Board and as a member of the U.S. Department of Energy’s Environmental Management Advisory Board. From 1992 to 1998,

he was a member of the Board of Directors of the Long Island Lighting Company (LILCO). Professor Barnes received his B.A. from Michigan State University and a J.D. (cum laude) from Harvard Law School.

Joshua E. Perry, Graf Family Professor and Associate

Professor of Business Law and Ethics, joined the faculty of Indiana University’s Kelley School of Business in 2009. He currently serves as chair of the Department of Business Law and Ethics, an appointment he has held since 2020. He was formerly the Faculty Chair for the Kelley School’s Undergraduate Program. A three-time winner of the IU Trustees’ Teaching Award and two-time winner of the Kelley Innovative Teaching Award, he teaches graduate and undergraduate courses on business ethics, critical thinking, and the legal environment of business. Professor Perry earned a B.A. (summa cum laude) from Lipscomb University, a Masters of Theological Studies from the Vanderbilt University Divinity School, and a J.D. from the Vanderbilt University Law School, where he was Senior Articles Editor on the Law Review. Prior to joining Kelley, he was on faculty at the Center for Biomedical Ethics and Society at Vanderbilt University Medical Center. In that role, he taught medical ethics in the School of Medicine and professional responsibility in the Law School, and served as a clinical ethicist in both the adult and children’s hospitals at Vanderbilt. Before entering academe, he practiced law in Nashville, Tennessee, at a boutique litigation firm, where he specialized in dispute resolution and risk mitigation for clients in the health care, intellectual property, and entertainment industries.   Professor Perry’s award-winning scholarship explores legal, ethical, and public policy issues in the life science, medical device, and health care industries, as well as in the business of medicine. He is the author of over 30 articles and essays that have appeared in a variety of journals, including the American Business Law Journal; the Georgia Law Review; the Notre Dame Journal of Law, Ethics, and Public Policy; the Journal of Law, Medicine and Ethics; and the University of Pennsylvania Journal of Law and Social Change, among others. His expertise has been featured in The New York Times, USA Today, Wired, Fast Company, Huffington Post, and Salon. Since 2015, he also has served on the editorial board for the Journal of Business Ethics as section editor for law, public policy, and ethics.

Todd Haugh, Associate Professor of Business Law and

Ethics and Weimer Faculty Fellow at Indiana University’s  Kelley School of Business. His scholarship focuses on whitecollar and corporate crime, business and behavioral ethics, and federal sentencing policy. His work has appeared in top law and business journals, including the Northwestern University Law Review, Notre Dame Law Review, Vanderbilt Law Review, and the MIT-Sloan Management Review. Prof. Haugh’s expertise relating to the burgeoning field of behavioral compliance has led to frequent speaking and consulting engagements with major U.S.

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The Authors

companies and ethics organizations. He is also regularly quoted in national news publications such as The New York Times, The Wall Street Journal, Forbes, Bloomberg News, and USA Today. A graduate of the University of Illinois College of Law and Brown University, Professor Haugh has extensive professional experience as a white-collar criminal defense attorney, a federal law clerk, and a member of the general counsel’s office of the U.S. Sentencing Commission. In 2011, he was chosen as one of four Supreme Court Fellows of the Supreme Court of the United States to study the administrative machinery of the federal judiciary. Prior to joining the Kelley School, where he teaches courses on business ethics, white-collar crime, and critical thinking, Professor Haugh taught at DePaul University College of Law and Chicago-Kent College of Law. He is a recipient of numerous teaching and scholarly awards, including a Trustees Teaching Award and multiple Innovative Teaching Awards, and a Jesse Fine Fellowship from the Poynter Center for the Study of Ethics and American Institutions, to which he now serves as a board member. In 2019 he was awarded the Distinguished Early Career Achievement Award by the Academy of Legal Studies in Business.

Abbey R. Stemler, Assistant Professor of Business Law and Ethics at Indiana University’s Kelley School of Business.

She is a leading scholar on the sharing economy, and her scholarship and teaching have garnered many university and national awards. She is frequently sought out for her expertise on platform-based technology companies, such as Facebook, Uber, and Google. Professor Stemler has published multiple articles in leading law journals such as the Iowa Law Review, Emory Law Journal, Maryland Law Review, Georgia Law Review, and Harvard Journal on Legislation. Her research explores the interesting spaces where law has yet to catch up with technology. In particular, her aim is to expose the evolving realities of Internet-based innovations and platforms and to find ways to effectively regulate them without hindering their beneficial uses. As she sees it, many modern firms inhabit a world that operates under alien physics—where free is often costly and “smart” is not always wise. She employs tools and insights from economics, behavioral science, regulatory theory, and rhetoric to understand how we, as a society, can better protect consumers, privacy, and democracy. Professor Stemler is also a faculty associate at the Berkman Klein Center for Internet & Society at Harvard University, practicing attorney, entrepreneur, and consultant for governments and multinational organizations such as the World Bank Group.

Preface Preface This is the 18th Edition (and the 24th overall edition) of a ­business law text that first appeared in 1935. Throughout its more than 80 years of existence, this book has been a leader and an innovator in the fields of business law and the legal ­environment of business. One reason for the book’s success is its clear and comprehensive treatment of the standard topics that form the traditional business law curriculum. Another reason is its responsiveness to changes in these traditional subjects and to new views about that curriculum. In 1976, this textbook was the first to inject regulatory materials into a business law textbook, defining the “legal environment” approach to business law. Over the years, this textbook has also pioneered by introducing ­materials on business ethics, corporate social responsibility, global legal issues, and the law of an increasingly digital world. The 18th Edition continues to emphasize change by integrating these four areas into its pedagogy.

Appendix B: The Uniform Commercial Code The Uniform Commercial Code, or UCC, was developed by the American Law Institute (ALI) and the National Conference of Commissioners on Uniform State Laws (NCCUSL) as a body of rules intended to make the application of law to commercial transactions consistent across fifty states. The UCC has been adopted in whole by all but one state legislature, Louisiana, which adopted only certain sections. Such widespread use of the UCC, even with the minor deviations some jurisdictions make from the official code, makes possible more efficient and more confident transactions across state lines. The UCC can be accessed here: www.law.cornell.edu/ucc.

Continuing Strengths The 18th Edition continues the basic features that have made its predecessors successful. They include: • Comprehensive coverage. We believe that the text continues to excel in both the number of topics it addresses and the depth of coverage within each topic. This is true not only of the basic business law subjects that form the core of the book, but also of the regulatory and other subjects that are said to constitute the “legal environment” curriculum. • Style and presentation. This text is written in a style that is direct, lucid, and organized, yet also relatively relaxed and conversational. For this reason, the text lends itself to the flipped classroom, allowing coverage of certain topics by assigning them as reading without lecturing on them. As always, key points and terms are emphasized; examples, charts, figures, and concept summaries are used liberally; and elements of a claim and lists of defenses are stated in numbered paragraphs. • Case selection. We try very hard to find cases that clearly illustrate important points made in the text, that should interest

students, and that are fun to teach. Except when older decisions are landmarks or continue to provide the best illustrations of particular concepts, we also try to select recent cases. Our collective in-class teaching experience with recent editions has helped us determine which of those cases best meet these criteria.

Important Changes in This Edition For this edition, we welcome Todd Haugh and Abbey Stemler, our Indiana University colleagues, to the author team. They bring new teaching, research, and legal practice experiences to our team that have helped shape our approach to the 18th Edition and will allow us to continue to deliver excellent coverage of the ever-changing legal environment of business. Our longtime co-author Arlen Langvardt decided to retire from authoring the textbook along with retiring from his faculty position at Indiana University. The author team wishes to express our gratitude for his leadership on the textbook for the past couple of editions and to thank him for the profound impact he has made on this text. In his place, Jamie Prenkert has moved into the lead author role. Co-author Jim Barnes remains our connection to the long and vital history of this textbook. With this edition, Jim will have been a co-author of this text for more than 50 years! In this edition, the combination of new and longstanding authors has led to a number of innovations, while maintaining the thorough yet accessible approach for which the book is well known. Along with a more explicit focus on compliance in addition to ethics (see Ethics and Compliance in Action features), the 18th Edition includes new cases, tracks recent developments in various substantive areas of law, and offers revisions to various textual material in our ongoing commitment to clarity and completeness. The book continues to include both hypothetical examples and real-life cases so that instructors can elucidate important concepts for students while also maintaining student interest and engagement. Key additions and revisions for the 18th Edition include the following: Chapter 1 • New problem case dealing with a spectator injured by a foul ball at a professional baseball game. The problem case can be used to enrich class discussion around case law reasoning, as illustrated in the Coomer case in the main text. • Introduction of the new Ethics and Compliance in Action feature, which is present throughout the book. Chapter 2 • New discussion of the Forced Arbitration Injustice Repeal Act (Fair Act). Chapter 3 • Incorporation in the text of several recent Supreme Court cases, including Trump v. Vance (separation of powers and v

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Supremacy Clause), Burwell v. Hobby Lobby Stores and Masterpiece Cakeshop, Ltd. v. Colorado Civil Rights Commission (First Amendment religion clause, as well as the federal Religious Freedom Restoration Act). • Reorganization of the Commerce Clause discussion and the addition of 2018 Supreme Court decision South Dakota v. ­Wayfair, Inc., which illustrates the standard for excessive burden on interstate commerce. • New figure describing the Food and Drug Administration’s tobacco regulations pursuant to the Family Smoking Prevention and Tobacco Control Act and related court challenges, with specific focus on First Amendment speech issues. • New discussion of the claims against Harvard College and the University of North Carolina related to their admissions practices.

Chapter 12 • New case, Mid-American Salt, LLC v. Morris County Cooperative Pricing Council, which illustrates that requirements contracts, though recognized under the UCC, must create some obligation in order to avoid being illusory. • Revision of the discussion of forbearance as a form of consideration for added clarity.

Chapter 4 • New discussion of the Business Roundtable’s 2019 statement regarding stakeholder theory.

Chapter 18 • New case, Macomb Mechanical, Inc. v. Lasalle Group Inc., which illustrates the operation of a “pay if paid” clause as a condition precedent.

Chapter 5 • New discussion of Fourth Amendment searches and the thirdparty doctrine. • New case note that highlights the importance of New York Central & Hudson River Railroad v. United States, which established the concept of corporate criminal liability. • Revision of discussion of criminal racketeering offenses. • New problem regarding whether a health care company and its senior executives had standing to challenge a warrant in a tax fraud case based on Fourth Amendment grounds. • New problem case on the Sixth Amendment’s reach in the context of corporate criminal fines based on the Apprendi line of Supreme Court cases. Chapter 7 • New case that provides a clear illustration of negligence elements in the context of an easily understood fact pattern. Chapter 8 • New case, ZUP, LLC v. Nash Manufacturing, Inc., which provides a relatable example of the patent requirement of nonobviousness. Chapter 9 • New case, Grimes v. Young Life, Inc., which deals with a hybrid contract and the application of the predominant factor test. • New case, PWS Environmental, Inc. v. All Clear Restoration and Remediation, LLC, which provides a straightforward application of quasi-contract. Chapter 10 • New Cyberlaw in Action feature dealing with Twitter and offer terms. • Replacement of the term “insanity” with the more modern concept of “mental incapacity.” Chapter 11 • General update of examples to ensure that concepts and technology references remain relevant.

Chapter 16 • Discussion of the 21st Century Integrated Digital Experience Act (IDEA). Chapter 17 • New Ethics and Compliance in Action feature, which explores the ethics of obligating a donee beneficiary to an arbitration clause.

Chapter 19 • New case, National Music Museum: America’s Shrine to Music v. Johnson, which deals with a contract for the sale of a guitar once owned by Elvis Presley and illustrates the rules concerning the passage of title. Chapter 20 • New introduction problem, which explores products liability and ethical issues involving JUUL e-cigarettes. • New Cyberlaw in Action feature that explores the question of whether Amazon, when it sells a defective product via a third-party seller, can be held liable. The box references and discusses recent litigation including Allstate New Jersey Insurance Co. v. Amazon.com; Eberhart v. Amazon.com; Oberdorf v. Amazon.com, Inc.; and Papataros v. Amazon.com. • Revision of discussion of punitive damages to include recent verdicts against Johnson & Johnson and Monsanto. Chapter 21 • New case, Hillerich & Bradsby v. Charles Products, which addresses whether a buyer timely notified the seller that products delivered to the buyer for sale to children in buyer’s Louisville Slugger Museum Store were defective (i.e., contained lead content in excess of limits prescribed under the Consumer Products Safety Improvement Act of 2008). Chapter 22 • New case, Beau Townsend Ford Lincoln v. Don Hinds Ford, which illustrates the principle that a buyer is liable for the purchase price of goods that have been received and accepted and that the buyer is not relieved of that obligation when deceived into making payment to someone other than the seller to whom the buyer is contractually obligated to pay. Chapter 23 • New problem case.

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Chapter 24 • Revision to Francini v. Goodspeed Airport, LLC to note that the Connecticut Supreme Court upheld the Connecticut Appellate Court’s decision (included in the text) in 2018. Chapter 25 • Revisions to text to clarify state and local variations in the law that have developed in recent years. • Revision and update to the discussion of a landlord’s duty to mitigate damages. Chapter 26 • Revision to the explanation of the formalities of a will for greater clarity. Chapter 27 • New Cyberlaw in Action feature discussing the burgeoning cyber insurance market. • Updates to the status of health care insurance under the Affordable Care Act. Chapter 28 • New case, Trump Endeavor 12 LLC v. Fernich, Inc. d/b/a The Paint Spot, involving a contractor who sued to enforce a lien on property on which it had provided materials but had not been paid by the owner of the property. Chapter 29 • New case, Hyman v. Capital One Auto Finance, where the court held that a debtor had stated a case for conversion and breach of the peace in the course of an attempted repossession of her automobile where the “repo man” involved the state police without judicial authorization. Chapter 30 • Revision of discussion of preferential liens. • New case, Rosenberg v. N.Y State Higher Education Services Corp., in which a bankruptcy court granted a discharge of student loans on the grounds their repayment would constitute an undue hardship. The court criticized previous bankruptcy court decisions that produced harsh results for students on the grounds that the courts did not properly apply prior case authority. • New text concerning the Small Business Organization Act of 2019 that provides a modified procedure to facilitate reorganization under Chapter 11 of small businesses in financial difficulty. Chapter 32 • New case, Triffin v. Sinha, which illustrates the operation of the shelter rule: The assignee of a check was held to be entitled to holder-in-due-course status because the entity that assigned the check to him was a holder in due course. Chapter 33 • Revision of the text for clarity and to reflect recent changes in the law. Chapter 34 • New case, Grodner & Associates v. Regions Bank, which involves a bookkeeper who defrauded the law firm for which she worked over a period of 15 months by writing checks utilizing

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facsimile signatures and initiating ACH transactions, which she was not authorized to perform. The bank refused to recredit the account on the grounds the law firm had not notified the bank of the fraud within a year after receiving a statement containing an unauthorized payment and the law firm was unable to show any deviation from the bank’s own procedures or local banking standards or from the terms of the parties’ deposit agreement. • Revision of discussion of Check 21, the electronic processing of checks, and Federal Reserve Board Regulations concerning wire transfers. Chapter 35 • New case, Krakauer v. Dish Network LLC, which illustrates the objective standard of manifested assent for agency formation. • New Cyberlaw in Action feature, which discusses California’s judicial and legislative responses to misclassification of gig workers as nonemployee agents in a variety of industries, specifically focusing on sharing-economy platform businesses like Uber and Lyft. Chapter 36 • New case, Synergies3 Tec Services, LLC v. Corvo, in which the court analyzes whether employees’ intentional tort was committed in the scope of their employment. Chapter 37 • Introduction of one of the newest business forms: the benefit corporation. Chapter 38 • New problem case, which deals with the possible creation of a partnership amid a pandemic. Chapter 39 • New case, Gelman v. Buehler, which demonstrates to students the importance of partnership agreements. Chapter 40 • New introduction problem, which examines the appropriateness for and tax implications of forming a limited liability company. • New in-depth discussion of the tax advantages of limited liability companies. • Removal of discussion of the now-outdated business form: the limited liability limited partnership. Chapter 41 • New text, which discusses benefit corporations and their growing importance, including a new chart comparing benefit corporations and certified “B corps.” • New case about scholarly critique of benefit corporations suggesting they may actually hurt socially conscious companies that are more traditionally organized. Chapter 42 • Revision of Ethics and Compliance in Action feature concerning offshore tax havens used by major U.S. companies.

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• New problem cases about the policy arguments for holding promoters liable for preincorporation contracts and the equity stakes taken in entrepreneurial ventures on the popular show Shark Tank. Chapter 43 • New text related to CEO compensation, including that of Tesla’s Elon Musk and Disney’s Bob Iger. • New text that highlights the duty-of-care obligations related to the oversight of legal compliance. • New case, In re Caremark Int’l Inc. Derivative Litig., which established the fiduciary obligation of board oversight of compliance and effectively created modern corporate compliance regimes. • Revised discussion of the foundations of corporate criminal liability and the costs of white-collar crime. • New problem case about a shareholder suit against Allergan, the company that makes Botox, and the theory of legal liability underlying fiduciary duty claims. Chapter 44 • New Ethics and Compliance in Action feature about the ethicality of share dissolution at Facebook. • New problem case regarding dividend distribution under the Model Business Corporation Act. Chapter 45 • New discussion of the Security and Exchange Commission’s powers, including implications of recent Supreme Court opinions Lucia v. SEC and Kokesh v. SEC. • New and revised text about Section 5 of the Securities Act of 1933, including Rules 163A, 135, 169, and the Jumpstart Our Business Startups (JOBS) Act. • Revision of the Concept Review concerning the communications issuers may provide to the public. • New text on “gun jumping” violations levied against Google and Salesforce. • Revisions to text on offering exemptions, including new text concerning Regulation A, Regulation Crowdfunding, and Rule 506, and deletion of text referring to the withdrawn Rule 595. • Revision of Ethics and Compliance in Action feature related to the trade-offs and criticisms of the JOBS Act. • Revision of the Concept Review regarding issuers’ exemptions from registration requirements. • New discussion of scienter and the Private Litigation Securities Reform Act. • Revision of text concerning insider trading, including a new discussion of classical and misappropriation theories, as well as tippee liability under Dirks v. SEC. • New case, SEC v. Dorozhko, which considered computer hacking as insider trading under the misappropriation theory. • New case note comparing United States v. Newman and United States v. Salman, which address the personal benefit test of tippee liability. • New problem case on whether Elon Musk violated securities laws based on his tweets.

• New problem case about insider trading prosecution of Mathew Martoma and SAC Capital Advisors. Chapter 46 • New discussion of Regulation Best Interest, including a summary chart of obligations of broker-dealers. • New case, United States v. Goyal, which concerned the evidence used to convict a former CFO for securities fraud violations under Section 10(b) of the 1934 Act. • New problem case about whether the suit against a seller of high-performance liquid chromatography systems met the pleading standards for scienter and materiality under the securities laws. Chapter 47 • Revision to discussion of Federal Communications Commission action about network neutrality regulation. Chapter 48 • Revision to discussion of the recent actions taken by the FTC to regulate deceptive practices. • Revision to discussion of the Truth in Lending Act. • New discussion of the Economic Growth, Regulatory Relief, and Consumer Protection Act (Economic Growth Act) and its impact on the Fair Credit Reporting Act. Chapter 49 • New case box about United States v. Apple, Inc., in which Apple was held responsible for violating the Sherman Act when it conspired among major book publishers to raise the retail prices of ebooks. • New Ethics and Compliance in Action feature that discusses how antitrust laws may hinder socially responsible business practices. Chapter 50 • New Ethics and Compliance in Action feature about consolidation among big tech firms such as Facebook and Instagram. Chapter 51 • New case concerning workers’ compensation, American Greetings Corp. v. Bunch, in which an employee is injured during a work-related event but not while performing day-to-day work responsibilities. • Added discussion of emergency medical and family leave provisions of the Families First Coronavirus Response Act. • Revised discussion of collective bargaining and unionization to reflect recent Supreme Court cases, including Janus v. AFSCME and Epic Systems Corp. v. Lewis. • New discussion of the Equal Pay Act that includes consideration of the U.S. Women’s National Soccer Team’s pay discrimination claim against U.S. Soccer. • New case, Bostock v. Clayton County, in which the U.S. Supreme Court held that Title VII of the 1964 Civil Rights Act prohibition against discrimination in employment because of sex includes discrimination on the basis of sexual orientation and gender identity.

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Chapter 52 • Revision of text to incorporate retrenchment by Trump administration of Environmental Protection Agency regulations to control greenhouse gasses associated with global climate change, including the Clean Power Plan and the automobile fuel economy standards adopted during the Obama administration.

Acknowledgments We would like to thank the many reviewers who have contributed their ideas and time to the development of this text. We express our sincere appreciation to the following: Wade Chumney, California State University–Northridge Amanda Foss, Modesto Junior College Richard Guertin, Orange County Community College Gwenda Bennett Hawk, Johnson County Community College Joseph Pugh, Immaculata University Kurt Saunders, California State University–Northridge Henry Lowenstein, Coastal Carolina University

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Dennis Wallace, University of New Mexico Melanie Stallings Williams, California State University–Northridge We also acknowledge the assistance and substantive c­ ontributions of Professor Sarah Jane Hughes of Indiana ­University’s Maurer School of Law and Professors Angela ­Aneiros (Chapter 25), Victor Bongard (Chapter 24), Shawna Eikenberry (Chapter 18), Goldburn Maynard (Chapter 26), and April Sellers (Chapters 3 and 51) of Indiana University’s Kelley School of Business. We further acknowledge the technical contributions of Elise Borouvka and the research assistance of Lin Ye, a student at the Maurer School. Jamie Darin Prenkert A. James Barnes Joshua E. Perry Todd Haugh Abbey R. Stemler

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A Guided Tour

A New Kind of Business Law The 18th Edition of Business Law continues to focus on global, ethical, and digital issues  affecting legal aspects of business. The new edition contains a number of new features as well as a revised supplements package. Please take a few moments to page through some of the highlights of this new edition.

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OPENING VIGNETTES Each chapter begins with an opening vignette that presents students with a mix of real-life and hypothetical situations and discussion questions. These stories provide a preview of issues addressed in the chapter and help to stimulate students’ interest in the chapter content.

CHAPTER 2

The Resolution of Private Disputes

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llnewsPublishingInc.,afirmwhoseprincipalofficesarelocatedinOrlando,Florida,ownsandpublishes 33 newspapers. These newspapers are published in 21 different states of the United States. Among the AllnewsnewspapersistheSnakebite Rattler,thelonenewspaperinthecityofSnakebite,NewMexico.The RattlerissoldinprintformonlyinNewMexico.However,manyofthearticlesinthenewspapercanbeviewedby anyonewithInternetaccess,regardlessofhisorhergeographiclocation,bygoingtotheAllnewswebsite. InarecentRattler edition,anarticleappearedbeneaththisheadline:“LocalBusinessExecutiveSuedforSexual Harassment.”Theaccompanyingarticle,writtenbyaRattlerreporter(anAllnewsemployee),statedthataperson namedPhilAndersonwasthedefendantinthesexualharassmentcase.Besidesbeingmarried,AndersonwasawellknownbusinesspersonintheSnakebitearea.HewasactiveinhischurchandincommunityaffairsinbothSnakebite (hiscityofprimaryhome)andPetoskey,Michigan(whereheandhiswifehaveasummerhome).Astockphotoof Anderson,whichhadbeenusedinconnectionwithpreviousRattlerstoriesmentioninghim,appearedalongsidethe storyaboutthesexualharassmentcase.Anderson,however,wasnotthedefendantinthatcase.Hewasnamedin theRattler storybecauseofanerrorbytheRattler reporter.Theactualdefendantinthesexualharassmentcasewas alocalbusinessexecutivewithasimilarname:PhilAnderer. AndersonplanstofileadefamationlawsuitagainstAllnewsbecauseoftheabove-describedfalsehoodintheRattler story.Heexpectstoseek$500,000indamagesforharmtohisreputationandforotherrelatedharms.InChapter6, youwilllearnaboutthesubstantivelegalissuesthatwillariseinAnderson’sdefamationcase.For now, however, the focus is on important legal matters of a procedural nature. ConsiderthefollowingquestionsregardingAnderson’scaseasyoureadthischapter: •Where,inageographicsense,mayAndersonproperlyfileandpursuehislawsuitagainstAllnews? •MustAndersonpursuehiscaseinastatecourt,ordoeshehavetheoptionoflitigatingitinfederalcourt? •AssumingthatAndersonfileshiscaseinastatecourt,whatstrategicoptionmayAllnewsexerciseifitacts promptly? •Intherun-uptoapossibletrialinthecase,whatlegalmechanismsmayAndersonutilizeinordertofindout,on apretrialbasis,whattheRattlerreporterandotherAllnewsemployeeswouldsayinpossibletestimonyattrial? IsAllnewsentitledtodothesamewithregardtoAnderson? •IfAnderson’scasegoestotrial,whattypesoftrialsarepossible? •Throughwhatlegalmechanismsmightacourtdecidethecasewithoutatrial? •Today,manylegaldisputesaredecidedthrougharbitrationratherthanthroughproceedingsincourt.Giventhe prevalenceofarbitrationthesedays,whyisn’tAnderson’scaseacandidateforarbitration?

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LO

Part One Foundations of American Law

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LEARNING OBJECTIVES After studying this chapter, you should be able to: 2-1

Describethebasicstructuresofstatecourt systemsandthefederalcourtsystem. 2-2 Explainthedifferencebetweensubject-matter jurisdictionandinpersonamjurisdiction. 2-3 Identifythemajorlegalissuescourtsmust resolvewhendecidingwhetherinpersonam jurisdictionexistswithregardtoadefendantina civilcase. 2-4 Explainwhatisnecessaryinorderforafederal courttohavesubject-matterjurisdictionovera civilcase.

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BUSINESS LAW COURSES examine many substantive legal rules that tell us how to behave in business and in society.Examplesincludetheprinciplesofcontract,tort, andagencylaw,aswellasthoseofmanyotherlegalareas addressedlaterinthistext.Mostoftheseprinciplesareappliedbycourtsastheydecidecivilcasesinvolvingprivate parties.Thischapterlaysafoundationforthetext’sdiscussionofsubstantivelegalrulesbyexaminingthecourtsystemsoftheUnitedStatesandbyoutlininghowcivilcases proceedfrombeginningtoend.Thechapteralsoexplores

2-5 Identifythemajorstepsinacivillawsuit’s progressionfrombeginningtoend. 2-6 Describethedifferentformsofdiscovery availabletopartiesincivilcases. 2-7 Explainthedifferencesamongthemajorforms ofalternativedisputeresolution.

these courts, procedures may be informal, and parties oftenarguetheirowncaseswithoutrepresentationbyattorneys.Courtsoflimitedjurisdictionoftenarenotcourts ofrecord—meaningthattheymaynotkeepatranscriptof theproceedingsconducted.Appealsfromtheirdecisions therefore require a new trial (a trial de novo) in a trial court.

Trial Courts Courts of limited jurisdiction find the relevantfacts,identifytheappropriaterule(s)oflaw,and

LEARNING OBJECTIVES 09/11/2009:15PM

Active Learning Objectives open each chapter. LOs inform you of specific outcomes you should have after finishing the chapter. Icons reference each LO’s reference within the chapter.

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A Guided Tour 2-16

Part One Foundations of American Law

CYBERLAW IN ACTION In recent years, the widespread uses of e-mail and information presented and stored in electronic form have raised questions about whether, in civil litigation, an opposing party’s e-mails and electronic information are discoverable to the same extent as conventional written or printed documents. With the Federal Rules of Civil Procedure and comparable discovery rules applicable in state courts having been devised prior to the explosion in e-mail use and online activities, the rules’ references to “documents” contemplated traditional on-paper items. Courts, however, frequently interpreted “documents” broadly, so as to include e-mails and certain electronic communications within the scope of discoverable items. Even so, greater clarity regarding discoverability seemed warranted—especially as to electronic material that might be less readily classifiable than e-mails as “documents.” Various states responded by updating their discovery rules to include electronic communications within the list of discoverable items. So did the Federal Judicial Conference. In Federal Rules of Civil Procedure amendments proposed by the Judicial Conference and ratified by Congress in 2006, “electronically stored information” became a separate category of discoverable material. The electronically stored information (ESI) category is broad enough to include e-mails and similar communications as well as electronic business records, web pages, dynamic databases, and a host of other material existing in electronic form. So-called e-discovery has become a standard feature of civil litigation because of the obvious value of having access to the opposing party’s e-mails and other electronic communications. Discovery regarding ESI occurs in largely the same manner as discovery regarding conventional documents. The party seeking discovery of ESI serves a specific request for production on the other. The served party must provide the requested ESI if it is relevant, is not protected by a legal privilege (e.g., the attorney–client privilege), and is reasonably accessible. Court involvement becomes necessary only if the party from whom discovery is sought fails to comply or objects on lack of relevance, privilege, or burdensomeness grounds. The Federal Rules allow the party seeking discovery of ESI to specify the form in which the requested copies should appear (e.g., hard copies, electronic files, searchable CD, direct access to database, etc.). The party from whom discovery is sought may object to the specified form, in which event the court may have to resolve the dispute. If the requesting party does not specify a form, the other party must provide the requested electronic material in a form that is reasonably usable. The Federal Rules provide that if the requested electronic material is “not reasonably accessible because of undue burden or cost,” the party from whom discovery is sought need not provide it. When an objection along those lines is filed, the court decides whether the

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CYBERLAW IN ACTION BOXES

objection is valid in light of the particular facts and circumstances. For instance, if requested e-mails appear only on backup tapes and searching those tapes would require the expenditures of significant time, money, and effort, are the requested e-mails “not reasonably accessible because of undue burden or costs”? Perhaps, but perhaps not. The court will rule, based on the relevant situation. The court may deny the discovery request, uphold it, or condition the upholding of it on the requesting party’s covering part or all of the costs incurred by the other party in retrieving the ESI and making it available. When a party fails or refuses to comply with a legitimate discovery request and the party seeking discovery of ESI has to secure a court order compelling the release of it, the court may order the noncompliant party to pay the attorney fees incurred by the requesting party in seeking the court order. If a recalcitrant party disregards a court order compelling discovery, the court may assess attorney fees against that party and/or impose evidentiary or procedural sanctions such as barring that party from using certain evidence or from raising certain claims or defenses at trial. The discussion suggests that discovery requests regarding ESI may be extensive and broad-ranging, with logistical issues often attending those requests. In recognition of these realities, the Federal Rules seek to head off disputes by requiring the parties to civil litigation to meet, at least through their attorneys, soon after the case is filed. The meeting’s goal is development of a discovery plan that outlines the parties’ intentions regarding ESI discovery and sets forth an agreement on such matters as the form in which the requested ESI will be provided. If the parties cannot agree on certain ESI discovery issues, the court will become involved to resolve the Confirming Pages disputes. The discoverability of ESI makes it incumbent upon businesses to retain and preserve such material not only when litigation to which the material may be related has already been instituted, but also when potential litigation might reasonably be anticipated. Failure to preserve the electronic communications could give rise to allegations 2-18 Part One Foundations of American Law of evidence destruction and, potentially, sanctions imposed by a court. (For further discussion of related legal and ethical issues, see this chapter’s Ethics and Compliance in Action box.) Finally, given the now-standard requests of plaintiffs and defendants that the opposing party provide access to relevant Thebroadscopeofdiscoveryrightsinacivilcase to impose appropriate sanctionson thedocument-destroying e-mails, one should not forget this important piece of advice: Do willoftenentitleapartytoseekandobtaincopies party.Thesesanctionsmayincludesuchremediesascourtorof e-mails, records, memos, and other documents ders prohibiting the document-destroyer from raising certain not say anything in an e-mail that you would not say in a formal andelectronicallystoredinformationfromtheopposingpar- claims or defenses in the lawsuit, instructions to the jury rewritten memo or in a conversation with someone. There is a tooty’sfiles.Inmanycases,someofthemostfavorableevidence gardingthewrongfuldestructionofthedocuments,andcourt frequent tendency to think that because e-mails often tend to be fortheplaintiffwillhavecomefromthedefendant’sfiles,and ordersthatthedocument-destroyerpaycertainattorneyfeesto informal in nature, one is somehow free to say things in an e-mail vice versa. If your firm is, or is likely to be, a party to civil theopposingparty. that he or she would not say in another setting. Many individuals litigationandyouknowthatthefirm’sfilescontainmaterials Whataboutthetemptationtorefusetocooperateregardand companies have learned the hard way that comments made thatmaybedamagingtothefirminthelitigation,youmaybe inganopposingparty’slawfulrequestfordiscoveryregarding in their e-mails or those of their employees proved to be damning faced with the temptation to alter or destroy the potentially material in one’s possession? Although a refusal to cooperevidence against them in litigation and thus helped the opposing damagingitems.Thistemptationposesseriousethicaldilem- ate seems less blameworthy than destruction or alteration parties win the cases. mas.Isitmorallydefensibletochangethecontentofrecords ofdocuments,extremeinstancesofrecalcitranceduringthe

In keeping with today’s technological world, these boxes describe and discuss actual instances of how the Internet is affecting business law today.

ETHICS AND COMPLIANCE IN ACTION BOXES

Ethics and Compliance in Action

These boxes appear throughout the chapters and offer critical thinking questions and situations that relate to ethical/public policy concerns.

ordocumentsonanafter-the-factbasis,inordertolessenthe adverseeffectonyourfirminpendingorprobablelitigation? Isdocumentdestructionore-maildeletionethicallyjustifiable whenyouseektoprotectyourfirm’sinterestsinalawsuit? If the ethical concerns are not sufficient by themselves to make you leery of involvement in document alteration or destruction, consider the potential legal consequences for yourConfirming Pages selfandyourfirm.Themuch-publicizedcollapseoftheEnron Corporationin2001ledtoconsiderablescrutinyoftheactions oftheArthurAndersenfirm,whichhadprovidedauditingand consultingservicestoEnron.AnAndersenpartner,DavidDuncan,pleadedguiltytoacriminalobstructionofjusticecharge pre3689X_ch02_001_032 2-16 09/11/2009:15PM thataccusedhimofhavingdestroyed,orhavinginstructedAndersenemployeestodestroy,certainEnron-relatedrecordsin 1-28 Part One Foundations of American Law ordertothwartaSecuritiesandExchangeCommission(SEC) investigation of Andersen. The U.S. Justice Department also between real parties with tangible opposing interests in eventhoughtheircontroversyhasnotadvancedtothelaunchedanobstructionofjusticeprosecutionagainstAnderthe lawsuit. Courts generally do not issue advisory opinpointwhereharmhasoccurredandlegalreliefmaybesen on the theory that the firm altered or destroyed records ions on abstract legal questions unrelated to a genuine necessary. This enables them to determine their legalpertaining to Enron in order to impede the SEC investigation. A jury found Andersen guilty of obstruction of justice. dispute,anddonotdecidefeigned controversiesthatparposition without taking action that could expose themAlthoughtheAndersenconvictionwaslateroverturnedbythe ties concoct to seek answers to such questions. Courts toliability.Forexample,ifDarlenebelievesthatsome- U.S.SupremeCourtbecausethetrialjudge’sinstructionstothe mayalsorefusetodecidecasesthatareinsufficientlyripe thingsheplanstodowouldnotviolateEarl’scopyrightjuryonrelevantprinciplesoflawhadbeenimpermissiblyvague to have matured into a genuine controversy, or that are onaworkofauthorshipbutsherecognizesthathemayregardingthecriticalissueofcriminalintent,adevastatingefmoot because there no longer is a real dispute between take a contrary view, she may seek a declaratory judg- fectonthefirmhadalreadytakenplace. the parties. Reflecting similar policies is the doctrine of ment on the question rather than risk Earl’s lawsuit Ofcourse,notallinstancesofdocumentalterationordestanding to sue,whichnormallyrequiresthattheplaintiff by proceeding to do what she had planned. Usually, astructionwillleadtocriminalprosecutionforobstructionof have some direct, tangible, and substantial stake in the declaratoryjudgmentisawardedonlywhentheparties’justice. Other consequences of a noncriminal but clearly severe nature may result, however, from document destruction outcomeofthelitigation. disputeissufficientlyadvancedtoconstitutearealcase thatinterfereswithlegitimatediscoveryrequestsinacivilcase. Stateandfederaldeclaratory judgmentstatutes,howorcontroversy. In such instances, courts have broad discretionary authority

ever, allow parties to determine their rights and duties

THE GLOBAL BUSINESS ENVIRONMENT BOXES

witnesses or to certain evidence that has been offered for admission.Thetrialjudgeutilizesthelegalrulesofevidence todeterminewhethertosustaintheobjection(meaningthat Just as statutes may require judicial interpreta- distress,whereuponhiswifeandadoctorwhowasonboardtheobjected-toquestioncannotbeansweredbythewitness tion when a dispute arises, so may treaties. The gave him shots of epinephrine from an emergency kit thatorthattheofferedevidencewillbedisallowed)or,instead,

The Global Business Environment

techniques that courts use in interpreting treaties correspond closely to the statutory interpretation techniques discussedinthischapter.Olympic Airways v. Husain,540U.S. 644(2004),furnishesausefulexample. In Olympic Airways, the U.S. Supreme Court was faced withaninterpretationquestionregardingatreaty,theWarsaw Convention,whichdealswithairlines’liabilityforpassenger deathsorinjuriesoninternationalflights.Numerousnations (including the United States) subscribe to the Warsaw Convention, a key provision of which provides that in regard to international flights, the airline “shall be liable for damages sustainedintheeventofthedeathorwoundingofapassengeroranyotherbodilyinjurysufferedbyapassenger,ifthe accidentwhichcausedthedamagesosustainedtookplaceon board the aircraft or in the course of any of the operations ofembarkingordisembarking.”Aseparateprovisionimposes limitsontheamountofmoneydamagestowhichaliableairlinemaybesubjected. The Olympic Airways case centered around the death of Dr. Abid Hanson, a severe asthmatic, on an international flight operated by Olympic. Smoking was permitted on the flight. Hanson was given a seat in the nonsmoking section, buthisseatwasonlythreerowsinfrontofthesmokingsection.BecauseHansonwasextremelysensitivetosecondhand smoke, he and his wife, Rubina Husain, requested various timesthathebeallowed,forhealthreasons,tomovetoaseat fartherawayfromthesmokingsection.Eachtime,therequest was denied by an Olympic flight attendant. When smoke from the smoking section began to give Hanson difficulty, he used a new inhaler and walked toward the front of the planetogetsomefresherair.Hansonwentintorespiratory

discovery process may cause a party to experience adverse consequences similar to those imposed on parties who destroy or alter documents. Litigation involving Ronald Perelman and the Morgan Stanley firm provides an illustration. Perelman had sued Morgan Stanley on the theory that the investmentbankparticipatedwithSunbeamCorp.inafraudulent scheme that supposedly induced him to sell Sunbeam hisstakeinanotherfirminreturnforSunbeamshareswhose value plummeted when Sunbeam collapsed. During the discovery phase of the case, Perelman had sought certain potentiallyrelevante-mailsfromMorganStanley’sfiles.Morgan Stanley repeatedly failed and refused to provide this discoverable material and, in the process, ignored court orders to providethee-mails. Eventually, a fed-up trial judge decided to impose sanctions for Morgan Stanley’s wrongful conduct during the discoveryprocess.ThejudgeorderedthatPerelman’scontentionswouldbepresumedtobecorrectandthattheburden of proof would be shifted to Morgan Stanley so that Morgan Stanley would have to disprove Perelman’s allegations. Inaddition,thetrialjudgeprohibitedMorganStanleyfrom contesting certain allegations made by Perelman. The jury laterreturnedaverdictinfavorofPerelmanandagainstMorganStanleyfor$604millionincompensatorydamagesand $850millioninpunitivedamages.ThecourtorderssanctioningMorganStanleyforitsdiscoverymisconductundoubtedly playedakeyroleinPerelman’svictory,effectivelyturninga case that was not a sure-fire winner for Perelman into just that.Thecaseillustratesthatapartytolitigationmaybeplayingwithfireifhe,she,oritinsistsonrefusingtocomplywith legitimatediscoveryrequests.

Hansoncarried.AlthoughthedoctoradministeredCPRand oxygen when Hanson collapsed, Hanson died. Husain, acting as personal representative of her late husband’s estate, suedOlympicinfederalcourtonthetheorythattheWarsaw Convention made Olympic liable for Hanson’s death. The federaldistrictcourtandthecourtofappealsruledinfavor ofHusain. InconsideringOlympic’sappeal,theU.S.SupremeCourt pre3689X_ch02_001_032 2-18 noted that the key issue was one of treaty interpretation: whethertheflightattendant’srefusalstoreseatHansonconstituted an “accident which caused” the death of Hanson. NotingthattheWarsawConventionitselfdidnotdefine“accident” and that different dictionary definitions of “accident” exist,theCourtlookedtoaprecedentcase,Air France v. Saks, 470 U.S. 392 (1985), for guidance. In the Air France case, theCourtheldthattheterm“accident”intheWarsawConventionmeans“anunexpectedorunusualeventorhappening thatisexternaltothepassenger.”Applyingthatdefinitionto the facts at hand, the Court concluded in Olympic Airways thattherepeatedrefusalstoreseatHansondespitehishealth concernsamountedtounexpectedandunusualbehaviorfora flightattendant.Althoughtherefusalswerenotthesolereason why Hanson died (the smoke itself being a key factor), therefusalswerenonethelessasignificantlinkinthecausation chain that led to Hanson’s death. Given the definition of “accident” in the Court’s earlier precedent, the phrasing, the Warsaw Convention, and the underlying public policies supportingit,theCourtconcludedthattherefusalstoreseat Hanson constituted an “accident” covered by the Warsaw Convention.Therefore,theCourtaffirmedthedecisionofthe lowercourts.

overruleit(meaningthatthequestionmaybeansweredor thattheofferedevidencewillbeallowed). Thewitnessesthatplaintiffsanddefendantscalltotestifyattrialmayincludethosewhocantestifyastorelevant factsofwhichtheyhavepersonalknowledge(oftencalled

Because global issues affect people in many different aspects of business, this material appears throughout the text instead of in a separate chapter on international issues. This feature brings to life global issues that are affecting business law. 09/11/2009:15PM

AccordingtothelegalrealistsdiscussedinChapter1,written “book law” is less important than what public decisionmakersactually do.Usingthisapproach,wediscover a Constitution that differs from the written Constitution xii A Guided Tour justdescribed.Theactualpowersoftoday’spresidency,for instance,exceedanythingonewouldexpectfromreading LOG ON BOXES ArticleII.Asyouwillsee,moreover,someconstitutional provisions have acquired a meaning different from their These appear throughout the chapters and direct students, meaningwhenfirstenacted.Americanconstitutionallaw where appropriate, tohasevolvedratherthanbeingstatic. relevant websites that will give them more information aboutManyofthesechangesresultfromthewayonepublic each featured topic. Many of these decision nine-member U.S. Supreme Court— are key legal sites that may bemaker—the used repeatedly by business law has interpreted the Constitution over time. Formal constudents and business professionals alike. stitutional change can be accomplished only through the amendmentprocess.Becausethisprocessisdifficulttoemploy,however,amendmentstotheConstitutionhavebeen relatively infrequent. As a practical matter, the Supreme Court has become the Constitution’s main “amender” through its many interpretations of constitutional First Pages provisions. Various factors help explain the Supreme Court’s ability and willingness to play this role. Because of their vagueness, some key constitutional provisions invite di3-22 Part One Foundations of American Law verseinterpretations.“Dueprocessoflaw”and“equalprotectionofthelaws”areexamples.Inaddition,thehistory CONCEPT REVIEW surrounding the enactment of constitutional provisions The First Amendment sometimesissketchy,confused,orcontradictory. Under the power of judicial review, courts can deLevelofFirstAmendment ConsequencesWhenGovernmentRegulates TypeofSpeech Protection ContentofSpeech clare the actions of other government bodies unconstiNoncommercial Full tutional. HowGovernmentactionisconstitutionalonlyifactionisnecessaryto courts exercise this power depends on fulfillmentofcompellinggovernmentpurpose.Otherwise,governmentactionviolatesFirstAmendment. how they choose to read the Constitution. Courts thus Commercial(nonmisleading Intermediate have politicalGovernmentactionisconstitutionalifgovernmenthassubstanpower—a conclusion especially applicable and about lawful activity) tialunderlyinginterest,actiondirectlyadvancesthatinterest,and actionisnomoreextensivethannecessarytofulfillmentofthat totheSupremeCourt.Indeed,theSupremeCourt’sjusinterest(i.e.,actionisnarrowlytailored). ticesare,toaconsiderableextent,publicpolicymakers. Commercial(misleading None Governmentactionisconstitutional. or about unlawful activity) Theirbeliefsareimportantinthedeterminationofhow the United States is governed. This is why the justices’ to enhance First Amendment protection for commercial speech),ithadnotmadeformaldoctrinalchangesasofthe timethisbookwenttopress. Matal v. Tam, which appears later in the chapter, addresses the four-part test utilized in determining the constitutionalityofcommercialspeechrestrictions,and illustrates the rigor with which the Supreme Court has applied the third and fourth parts of the test in recent years.

Court,reasoned,thegovernmentspeechdoctrineapplied and shielded the program against a First Amendment– basedchallengebyanassociationthatdidnotwanttoparticipateinthegovernment-createdprogram.Morerecently, in Walker v. Texas Division, Sons of Confederate Veterans, Inc., 576 U.S. 200 (2015), the Supreme Court held that theFirstAmendmentwasnotviolated—andthatthegovFigure 2.1 The Thirteen ernmentspeechdoctrineapplied—whentheStateofTexas rejectedagroup’srequestforaspecialtylicenseplateconFirst Circuit (Boston, sistingofanimageoftheConfederatebattleflag.IndecidMass.) Maine, pre3689X_ch03_001-044.indd 3-3 The Government Speech Doctrine Previous discusingthatthegovernmentspeechdoctrineapplied,theCourt Massachusetts, New Hampshire, Puerto Rico, sionhasrevealedthatwhenthegovernmentrestrictsthe stressedthegovernment’shistoricuseoflicenseplatesto Rhode Island contentofprivateparties’speech,aFirstAmendmentvioconvey messages and the supervisory control maintained lationislikelytohaveoccurred.Butwhenthegovernment by the government in running the specialty license plate itself speaks, it is free to convey its preferred viewpoints program. Figure 3.3, which appears later in the chapter, Fifth Circuit (New and to reject contrary views that private parties wish to exploresrecentrequirementstoincludegraphicwarnings Orleans, La.) Louisiana, express.Suchisthepremiseoftherecentlydeveloped,and ontobaccoproducts. Mississippi, TexasCourt stillnotpreciselydefined,government speech doctrine.  In Matal v. Tam, which follows, the Supreme Whether government speech is present depends struckdown,onFirstAmendmentgrounds,aprovisionin largely upon the extent to which the government crafted federallawthatallowedthegovernmenttorefusetoregisConfirming Pages the conveyed messages or supervised, through heavy teratrademarkthatisdisparagingtoindividualsorgroups. involvement, the communication of the messages. In (TrademarkregistrationisaddressedinChapter8.DiscusNinth Circuit (San Francisco, Johanns v. Livestock Marketing Association, 544 U.S. 550 sion of Tam also appears there.) In so ruling, Court Calif.) Alaska,the Arizona, (2005),forinstance,theSupremeCourtupheldafederal rejected the government’s attemptCalifornia, to invoke Guam, the governHawaii, Idaho, Montana, Nevada, statute that set up a program of paid advertisements dementspeechdoctrineandremindedreadersthattheFirst Northern Mariana Islands, signedtopromotetheimageandsaleofbeefproducts.The Amendmentprotectsagreatdealofspeechthatisoffen2-4 Part One Foundations of American Law Oregon, Washington Court emphasized that the U.S. Department of Agriculsiveinnature.Tamalsoexploresanissuenotedearlierin turedesignedtheprogram,establisheditscontours,andexthechapter:theproblematicnature,forFirstAmendment ercisedclosesupervisoryauthorityoverthemessagesthat purposes,oflawsthatdiscriminateamongspeakersonthe Abdouch v. Lopez   829 N.W.2d 662 (Neb. 2013) werecommunicatedintheadvertisements.Therefore,the basisoftheviewpointstheyexpress.

FIGURES

The figures appear occasionally in certain chapters. These features typically furnish further detail on special issues introduced more generally elsewhere in the text.

Helen Abdouch, an Omaha, Nebraska, resident, served as executive secretary of the Nebraska presidential campaign of John F. Kennedy in 1960. Ken Lopez, a Massachusetts resident, and his Massachusetts-based company, Ken Lopez Bookseller (KLB), are engaged in the rare book business. In 1963, Abdouch received a copy of a book titled RevolutionaryRoad. Its author, Richard Yates, inscribed the copy with a note to Abdouch. The inscribed copy was later stolen from Abdouch. In 2009, Lopez and KLB bought the inscribed copy from a seller in Georgia. They sold it that same year to a customer from a state other than Nebraska. In 2011, Abdouch learned that Lopez had used the inscription and references to her in an advertisement on KLB’s website. The advertisement, which appeared on the pre3689X_ch03_001-044.indd 3-22 10/27/2004:25PM website for more than three years after Lopez and KLB sold the inscribed copy, contained a picture of the inscription, the word “SOLD,” and this statement:

putpoliticalconstraintsonjudgesbecausecourtsdepend on the other branches of government—and ultimately on publicbeliefinjudges’fidelitytotheruleoflaw—tomake theirdecisionseffective.Therefore,judgessometimesmay be reluctant to declare statutes unconstitutional because theyarewaryofpowerstruggleswithamorerepresentativebodysuchasCongress.

LOG ON For a great deal of information about the U.S. Supreme Court and access to the Court’s opinions in recent cases, see the Court’s website at http://www.supremecourtus.gov.

The Coverage and Structure of This Chapter Thischapterexaminescertainconstitutionalprovisionsthat areimportanttobusiness;itdoesnotdiscussconstitutional lawinitsentirety.Theseprovisionshelpdefinefederaland statepowertoregulatetheeconomy.TheU.S.Constitution limits government regulatory power in two general ways. First, it restricts federal legislative authority by listing the CONCEPT REVIEWS powersCongresscanexercise.TheseareknownastheenuThese boxes visually represent important concepts merated powers.Federallegislationcannotbeconstitutional presented in the text to help summarize key ideas at ifitisnotbasedonapowerspecificallystatedintheConstiatution.Second,theU.S.Constitutionlimitsbothstate glance and simplify students’ conceptualization ofand federalpowerbyplacingcertainindependent checksinthe complicated issues. path of each. In effect, the independent checks establish thatevenifCongresshasanenumeratedpowertolegislate onaparticularmatterorastateconstitutionauthorizesa statetotakecertainactions,therestillarecertainprotected spheresintowhichneitherthefederalgovernmentnorthe Confirming Pages stategovernmentmayreach.

Chapter Two The Resolution of Private Disputes

Federal Judicial Circuits Second Circuit (New York, N.Y.) Connecticut, New York, Vermont

Third Circuit (Philadelphia, Pa.) Delaware, New Jersey, Pennsylvania, Virgin Islands

Fourth Circuit (Richmond, Va.) Maryland, North 10/27/2004:25PM Carolina, South Carolina, Virginia, West Virginia

Sixth Circuit (Cincinnati, Ohio) Kentucky, Michigan, Ohio, Tennessee

Seventh Circuit (Chicago, Ill.) Illinois, Indiana, Wisconsin

Eighth Circuit (St. Louis, Mo.) Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, South Dakota

Tenth Circuit (Denver, Colo.) Colorado, Kansas, New Mexico, Oklahoma, Utah, Wyoming

Eleventh Circuit (Atlanta, Ga.) Alabama, Florida, Georgia

District of Columbia Circuit (Washington, D.C.)

CASES

Federal Circuit (Washington, D.C.)

The cases in each chapter help to provide concrete examples of the rules stated in the text. A list of cases appears at the front of the text.

controversies between the United States and a state; and

This copy is inscribed by Yates: ‘For Helen Abdouch—with admiration and best wishes. Dick Yates. 8/19/63.’ Yates had worked as a casesinwhichastateproceedsagainstcitizensofanother speech writer for Robert Kennedy when Kennedy served as Attorney General; Abdouch was the executivestateoragainstaliens. secretary of the Nebraska (John F.) Kennedy organization when Robert Kennedy was campaign manager. . . . A scarce book, and it is extremely uncommon to find this advance issue of it signed. Given the date of the inscription—that is, during JFK’s Presidency—and the connection between writer and recipient, it’s reasonable to suppose this was an author’s copy, presented to Abdouch by Yates.

Civil Procedure

Because Lopez and KLB did not obtain her permission before mentioning her and using the inscription in the advertisement, AbIdentify the major douch filed an invasion-of-privacy lawsuit against Lopez and KLB in a Nebraska state district court. Contending that the Nebraska court steps in a civil lawsuit’s progression LO2-5 lacked in personam jurisdiction, Lopez and KLB filed a motion to dismiss the case. The state district court grantedfrom the motion. Abdouch beginning to end. then appealed to the Supreme Court of Nebraska. (Further facts bearing upon the in personam jurisdiction issue appear in the following edited version of the Supreme Court’s opinion.)

McCormack, Judge Abdoucharguesthatthedistrictcourterredinfindingthatthe Statelackedinpersonamjurisdiction[,oftenreferredtohereas personal jurisdiction,]overLopezandKLB.Abdoucharguesthat [thedefendants’]activewebsitedeliberatelytargetedherwithtortiousconduct.Sheallegesthesecontactsaresufficienttocreate thenecessaryminimumcontactsforspecificjurisdiction. Personaljurisdictionisthepowerofatribunaltosubjectand

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Civil procedure is the set of legal rules establishing how a civil lawsuit proceeds from beginning to end.5 Because

minimumcontactswiththeforumstatesoasnottooffendtracivil procedure sometimes varies with the jurisdiction in ditional notions of fair play and substantial justice. [See Interquestion,6thefollowingpresentationsummarizesthemost national Shoe Co. v. Washington,326U.S.310,316(1945).]The benchmark...iswhetherthedefendant’sminimumcontactswith widelyacceptedrulesgoverningcivilcasesinstateandfedthe forum state are such that theeralcourts.Knowledgeofthesebasicproceduralmatters defendant should reasonably anticipate being haled into court there. Whether a forum state willbeusefulifyoubecomeinvolvedinacivillawsuitand court has personal jurisdiction over a nonresident defendant willhelpyouunderstandthecasesinthistext. depends on whether the defendant’s actions created substantial

positionsbeforeajudgeandpossiblyajury.Towinacivil case,theplaintiffmustproveeachelementofhis,her,orits claimbyapreponderance of the evidence.7Thisstandardof proofrequirestheplaintifftoshowthatthegreaterweight oftheevidence—bycredibility,notquantity—supportsthe existence of each element. In other words, the plaintiff must convince the fact-finder that the existence of each element is more probable than its nonexistence. The attorneyforeachpartypresentshisorherclient’sversion ofthefacts,triestoconvincethejudgeorjurythatthis versionistrue,andattemptstorebutconflictingfactual allegations by the other party. Each attorney also seeks topersuadethecourtthathisorherreadingofthelaw iscorrect.

Service of the Summons A summons notifies the defendant that he, she, or it is being sued. The summons typically names the plaintiff and states the time

Confirming Pages



PROBLEMS AND PROBLEM CASES Problem cases appear at the end of each chapter for student review and discussion.

KEY TERMS Key terms are in color and bolded throughout the important terminology.

A Guided Tour

xiii Chapter Two The Resolution of Private Disputes

2-29

Problems and Problem Cases

residentsAnneandJimCornelsen.WhenAnneCornelson telephoned the Bomblisses and said she was readytoselltwolittersofTibetanmastiffpuppies,Ron Bomblissexpressedinterestinpurchasingtwofemales ofbreedingquality.TheCornelsenshadawebsitethat allowedcommunicationsregardingdogsavailablefor purchasebutdidnotpermitactualsalesviathewebsite.TheBomblissestraveledtoOklahomatoseethe Cornelsens’puppiesandendeduppurchasingtwoof them. The Cornelsens provided a guarantee that the puppies were suitable for breeding purposes. Followingthesale,theCornelsensmailed,totheBomblisses’ home in Illinois, American Kennel Club registration papersforthepuppies.Aroundthissametime,Anne CornelsenpostedcommentsinanInternetchatroom frequented by persons interested in Tibetan mastiffs. Thesecommentssuggestedthatthemotherofcertain Tibetanmastiffpuppies(includingonetheBomblisses hadpurchased)mayhavehadageneticdisorder.The comments were made in the context of an apparent dispute between the Cornelsens and Richard Eich2. Alex Ferrer, a former judge who appeared as “Judge horn,whoownedthemothermastiffandhadmadeit Alex” on a television program, entered into a conavailabletotheCornelsensforbreedingpurposes.The tractwithArnoldPreston,aCaliforniaattorneywho Bomblisses believed that the comments would have renderedservicestopersonsintheentertainmentinbeen seen by other persons in Illinois and elsewhere dustry.Seekingfeesallegedlydueunderthecontract, andwouldhaveimpairedtheBomblisses’abilitytosell Preston invoked the clause setting forth the parties’ theirpuppieseventhough,whentested,theirpuppies agreementtoarbitrate“anydispute... relatingtothe werehealthy.TheBomblissesthereforesuedtheCorterms of [the contract] or the breach, validity, or lenelsensinanIllinoiscourtonvariouslegaltheories. galitythereof... inaccordancewiththerules[ofthe TheCornelsensaskedtheIllinoiscourttodismissthe AmericanArbitrationAssociation].”Ferrercountered caseonthegroundthatthecourtlackedinpersonam Preston’s demand for arbitration by filing, with the jurisdiction over them. Did the Illinois court lack in CaliforniaLaborCommissioner,apetitioninwhichhe personamjurisdiction? contendedthatthecontractwasunenforceableunder the California Talent Agencies Act (CTAA) because 4. HallStreetAssociateswasthelandlordandMattelInc. Preston supposedly acted as a talent agent without wasthetenantundervariousleasesforpropertythat thelicenserequiredbytheCTAA.Inaddition,Ferrer Mattel used as a manufacturing site for many years. suedPrestoninaCaliforniacourt,seekingadeclaraTheleasesprovidedthatthetenantwouldindemnify tionthatthedisputebetweenthepartiesregardingthe thelandlordforanycostsresultingfromthetenant’s contractanditsvaliditywasnotsubjecttoarbitration. failure to follow environmental laws while using the Ferrer also sought an injunction restraining Preston premises. Tests of the property’s well water in 1998 fromproceedingbeforethearbitratorunlessanduntil showedhighlevelsoftrichloroethylene(TCE),theaptheLaborCommissionerconcludedthatshedidnot parentresidueofmanufacturingdischargesconnected haveauthoritytoruleontheparties’dispute.Preston withMattel’soperationsonthesitebetween1951and respondedbymovingtocompelarbitration,inreliance 1980. After the Oregon Department of Environmentext ontheFederalArbitrationAct.TheCaliforniacourt and defined in the Glossary at the end oftalthe text(DEQ) for discovered better comprehension Quality even more pollutants, of deniedPreston’smotiontocompelarbitrationandisMattel signed a consent order with the DEQ providsued the injunction sought by Ferrer. Was the court ing for cleanup of the site. After Mattel gave notice correctindoingso? of intent to terminate the lease in 2001, Hall Street sued, contesting Mattel’s right to vacate on the date 3. Dog-breedersRonandCatherineBomblisslivedinIlitgaveandclaimingthattheleasesobligedMattelto linois. They bred Tibetan mastiffs, as did Oklahoma 1. VictoriaWilson,aresidentofIllinois,wishestobring an invasion of privacy lawsuit against XYZ Co. because XYZ used a photograph of her, without her consent, in an advertisement for one of the company’s products. Wilson will seek money damages of $150,000 from XYZ, whose principal offices are locatedinNewJersey.ANewJerseynewspaperwas the only print media outlet in which the advertisement was published. However, XYZ also placed the advertisementonthefirm’swebsite.Thiswebsitemay beviewedbyanyonewithInternetaccess,regardless oftheviewer’sgeographiclocation.Where,inageographic sense, may Wilson properly file and pursue her lawsuit against XYZ? Must Wilson pursue her caseinastatecourt,ordoesshehavetheoptionof litigatinginfederalcourt?AssumingthatWilsonfiles hercaseinstatecourt,whatstrategicoptionmayXYZ exerciseifitactspromptly?

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BUSINESS LAW APPLICATIONBASED ACTIVITIES (ABAS) Application-based activities for business law provide students valuable practice using problem-solving skills to apply their knowledge to realistic scenarios. Students progress from understanding basic concepts to using their knowledge to analyze complex scenarios and solve problems. Applicationbased activities have been developed for the topics most often taught (as ranked by instructors) in the business law course. These unique activities are assignable and auto-gradable in Connect.

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BUSINESS LAW CASE REPOSITORY Available in Connect, the Case Repository is a collection of cases from current and previous editions. 

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Brief Contents Brief Contents

Preface v

Part 1 Foundations of American Law The Nature of Law 1-3 The Resolution of Private Disputes 2-1 Business and the Constitution 3-1 Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking 4-1

1 2 3 4

Part 2 Crimes and Torts Criminal Law and Procedure 5-3 Intentional Torts 6-1 Negligence and Strict Liability 7-1 Intellectual Property and Unfair Competition 8-1

5 6 7 8

Part 3 Contracts 9 10 11 12 13 14 15 16 17 18

Introduction to Contracts 9-3 The Agreement: Offer 10-1 The Agreement: Acceptance 11-1 Consideration 12-1 Reality of Consent 13-1 Capacity to Contract 14-1 Illegality 15-1 Writing 16-1 Rights of Third Parties 17-1 Performance and Remedies 18-1

Part 4 Sales 19 20 21 22

Formation and Terms of Sales Contracts 19-3 Product Liability 20-1 Performance of Sales Contracts 21-1 Remedies for Breach of Sales Contracts 22-1

Part 5 Property 23 24 25 26 27

Personal Property and Bailments 23-3 Real Property 24-1 Landlord and Tenant 25-1 Estates and Trusts 26-1 Insurance Law 27-1

Part 6 Credit 28 Introduction to Credit and Secured Transactions 28-3 29 Security Interests in Personal Property 29-1 30 Bankruptcy 30-1

Part 7 Commercial Paper 31 Negotiable Instruments 31-3 xx

32 Negotiation and Holder in Due Course 32-1 33 Liability of Parties 33-1 34 Checks and Electronic Transfers 34-1

Part 8 Agency Law 35 The Agency Relationship 35-3 36 Third-Party Relations of the Principal and the Agent 36-1

Part 9 Partnerships 37 Introduction to Forms of Business and Formation of Partnerships 37-3 38 Operation of Partnerships and Related Forms 38-1 39 Partners’ Dissociation and Partnerships’ Dissolution and Winding Up 39-1 40 Limited Liability Companies and Limited Partnerships 40-1

Part 10 Corporations 41 History and Nature of Corporations 41-3 42 Organization and Financial Structure of Corporations 42-1 43 Management of Corporations 43-1 44 Shareholders’ Rights and Liabilities 44-1 45 Securities Regulation 45-1 46 Legal and Professional Responsibilities of  Auditors, Consultants, and Securities Professionals 46-1

Part 11 Regulation of Business 47 Administrative Law 47-3 48 The Federal Trade Commission Act and Consumer Protection Laws 48-1 49 Antitrust: The Sherman Act 49-1 50 The Clayton Act, the Robinson–Patman Act, and Antitrust Exemptions and Immunities 50-1 51 Employment Law 51-1 52 Environmental Regulation 52-1 Glossary G-1 Appendix A The Constitution of the United States of America A-1 Appendix B Uniform Commercial Code B-1 Index I-1

Contents Contents

1

Alternative Dispute Resolution 2-24 Common Forms of ADR 2-24 Other ADR Devices 2-28

Preface v

Part 1 Foundations of American Law 1

The Nature of Law 1-3

3

An Overview of the U.S. Constitution 3-2 The Evolution of the Constitution and the Role of the Supreme Court 3-3 The Coverage and Structure of This Chapter 3-3 State and Federal Power to Regulate 3-4 State Regulatory Power 3-4 Federal Regulatory Power 3-4 Burden on, or Discrimination against, Interstate Commerce 3-13 Independent Checks on the Federal Government and the States 3-13 Incorporation 3-13 Government Action 3-14 Means-Ends Tests 3-14 Business and the First Amendment 3-15 Due Process 3-27 Equal Protection 3-28 Independent Checks Applying Only to the States 3-37 The Contract Clause 3-37 Federal Preemption 3-38 The Takings Clause 3-39

Types and Classifications of Law 1-4 The Types of Law 1-4 Priority Rules 1-8 Classifications of Law 1-10 Jurisprudence 1-10 Legal Positivism 1-11 Natural Law 1-11 American Legal Realism 1-11 Sociological Jurisprudence 1-12 Other Schools of Jurisprudence 1-12 The Functions of Law  1-13 Legal Reasoning 1-13 Case Law Reasoning 1-14 Statutory Interpretation 1-18 Limits on the Power of Courts 1-27 APPENDIX  Reading and Briefing Cases 1-29

2

The Resolution of Private Disputes 2-1 State Courts and Their Jurisdiction 2-2 Courts of Limited Jurisdiction 2-2 Trial Courts 2-2 Appellate Courts 2-3 Jurisdiction and Venue 2-3 Federal Courts and Their Jurisdiction 2-9 Federal District Courts 2-9 Specialized Federal Courts 2-12 Federal Courts of Appeals 2-12 The U.S. Supreme Court 2-12 Civil Procedure 2-13 Service of the Summons 2-13 The Pleadings 2-14 Motion to Dismiss 2-14 Discovery 2-15 Summary Judgment 2-17 The Pretrial Conference 2-17 The Trial 2-17 Appeal 2-20 Enforcing a Judgment 2-20 Class Actions 2-20

Business and the Constitution 3-1

4

Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking 4-1 Why Study Business Ethics? 4-2 The Corporate Social Responsibility Debate 4-3 Ethical Theories 4-3 Rights Theory 4-5 Justice Theory 4-7 Utilitarianism 4-7 Shareholder Theory 4-8 Virtue Theory 4-11 Improving Corporate Governance and Corporate Social Responsibility 4-12 Independent Boards of Directors 4-13 The Law 4-15 Guidelines for Ethical Decision Making 4-16

xxi

xxii

Contents

What Facts Impact My Decision? 4-16 What Are the Alternatives? 4-17 Who Are the Stakeholders? 4-17 How Do the Alternatives Impact Society as a Whole? 4-17 How Do the Alternatives Impact My Business Firm? 4-18 How Do the Alternatives Impact Me, the Decision Maker? 4-18 What Are the Ethics of Each Alternative? 4-19 What Are the Practical Constraints of Each Alternative? 4-20 What Course of Action Should Be Taken and How Do We Implement It? 4-20 Knowing When to Use the Guidelines 4-21 Thinking Critically 4-21 Non Sequiturs 4-22 Appeals to Pity 4-22 False Analogies 4-22 Begging the Question 4-22 Argumentum ad Populum 4-23 Bandwagon Fallacy 4-23 Argumentum ad Baculum 4-23 Argumentum ad Hominem 4-23 Argument from Authority 4-24 False Cause 4-24 The Gambler’s Fallacy 4-24 Reductio ad Absurdum 4-25 Appeals to Tradition 4-25 The Lure of the New 4-25 Sunk Cost Fallacy 4-25 Common Characteristics of Poor Decision Making 4-26 Failing to Remember Goals 4-26 Overconfidence 4-26 Complexity of the Issues 4-27 Resisting Requests to Act Unethically 4-27 Recognizing Unethical Requests and Bosses 4-27 Buying Time 4-28 Find a Mentor and a Peer Support Group 4-28 Find Win–Win Solutions 4-28 Work within the Firm to Stop the Unethical Act 4-29 Prepare to Lose Your Job 4-30 Leading Ethically 4-30 Be Ethical 4-30 Communicate the Firm’s Core Ethical Values 4-30

Connect Ethical Behavior with the Firm’s and Workers’ Best Interests 4-31 Reinforce Ethical Behavior 4-31

2

Part 2 Crimes and Torts 5

Criminal Law and Procedure 5-3 Role of the Criminal Law 5-5 Nature of Crimes 5-5 Purpose of the Criminal Sanction 5-6 Essentials of Crime 5-8 Constitutional Limitations on Power to Criminalize Behavior 5-10 Criminal Procedure 5-15 Criminal Prosecutions: An Overview 5-15 Role of Constitutional Safeguards 5-15 The Fourth Amendment 5-16 Key Fourth Amendment Questions 5-16 Warrantless Searches and the Fourth Amendment 5-19 The Fifth Amendment 5-24 The Sixth Amendment 5-29 White-Collar Crimes and the Dilemmas of Corporate Control 5-29 Introduction 5-29 Evolution of Corporate Criminal Liability 5-30 Corporate Criminal Liability Today 5-31 Individual Liability for Corporate Crime 5-32 New Directions 5-33 Important White-Collar Crimes  5-34 Regulatory Offenses 5-34 Fraudulent Acts 5-34 The Sarbanes–Oxley Act 5-37 Bribery and Giving of Illegal Gratuities 5-37 Computer Crime 5-38

6

Intentional Torts 6-1 Interference with Personal Rights 6-5 Battery 6-5 Assault 6-8 Intentional Infliction of Emotional Distress 6-8 False Imprisonment 6-11 Defamation 6-13 Invasion of Privacy 6-27 Misuse of Legal Proceedings 6-33 Deceit (Fraud) 6-34



Contents

Interference with Property Rights 6-34 Trespass to Land 6-34 Private Nuisance 6-35 Conversion 6-37 Other Examples of Intentional Tort Liability 6-38

7

Negligence and Strict Liability 7-1 Negligence 7-2 Duty and Breach of Duty 7-3 Causation of Injury 7-16 Res Ipsa Loquitur 7-27 Negligence Defenses 7-28 Strict Liability 7-29 Abnormally Dangerous Activities 7-29 Statutory Strict Liability 7-33 Tort Reform 7-33

8

Intellectual Property and Unfair Competition 8-1 Protection of Intellectual Property 8-2 Patents 8-2 Copyrights 8-11 Trademarks 8-25 Trade Secrets 8-35 Definition of a Trade Secret 8-37 Ownership and Transfer of Trade Secrets 8-38 Misappropriation of Trade Secrets 8-38 Commercial Torts 8-40 Injurious Falsehood 8-40 Interference with Contractual Relations 8-41 Interference with Prospective Advantage 8-42 Lanham Act § 43(a) 8-45

3

Part 3 Contracts 9

Introduction to Contracts 9-3 The Nature of Contracts 9-3 The Functions of Contracts 9-4 The Evolution of Contract Law 9-4 The Methods of Contracting 9-4 Basic Elements of a Contract 9-5 Basic Contract Concepts and Types 9-7 Bilateral and Unilateral Contracts 9-7 Valid, Unenforceable, Voidable, and Void Contracts 9-8 Express and Implied Contracts 9-8 Executed and Executory Contracts 9-8

xxiii

Sources of Law Governing Contracts 9-9 The Uniform Commercial Code: Origin and Purposes 9-9 Application of Article 2 9-9 Application of the Common Law of Contracts 9-9 Law Governing “Hybrid” Contracts 9-9 Relationship of the UCC and the Common Law of Contracts 9-9 Basic Differences in the Nature of Article 2 and the Common Law of Contracts 9-11 Influence of Restatement (Second) of  Contracts 9-12 “Noncontract” Obligations 9-12 Quasi-Contract 9-13 Promissory Estoppel 9-13

10 The Agreement: Offer 10-1 Requirements for an Offer 10-2 Intent to Contract 10-2 Definiteness of Terms 10-2 Communication to Offeree 10-7 Special Offer Problem Areas 10-7 Advertisements 10-7 Rewards 10-8 Auctions 10-10 Bids 10-11 Which Terms Are Included in the Offer? 10-11 Termination of Offers 10-13 Terms of the Offer 10-13 Lapse of Time 10-13 Revocation 10-13 Rejection 10-15 Death or Mental Incapacity of Either Party 10-18 Destruction of Subject Matter 10-18 Intervening Illegality 10-18

11 The Agreement: Acceptance 11-1 What Is an Acceptance? 11-1 Intention to Accept 11-2 Intent and Acceptance on the Offeror’s Terms 11-5 Communication of Acceptance 11-9 When Is Acceptance Communicated? 11-9 Acceptances by Instantaneous Forms of Communication 11-9 Acceptances by Noninstantaneous Forms of Communication 11-9 Stipulated Means of Communication 11-13 Special Acceptance Problem Areas 11-13

xxiv

Contents

Acceptance in Unilateral Contracts 11-13 Acceptance in Bilateral Contracts 11-13 Silence as Acceptance 11-14 Acceptance When a Writing Is Anticipated 11-16 Acceptance of Ambiguous Offers 11-18 Who Can Accept an Offer? 11-19

12 Consideration 12-1 Elements of Consideration 12-2 Legal Value 12-2 Bargained-For Exchange 12-3 Exchanges That Fail to Meet Consideration Requirements 12-5 Illusory Promises 12-5 Preexisting Duties 12-8 Past Consideration 12-12 Exceptions to the Consideration Requirement 12-13 Promissory Estoppel 12-14 Promises to Pay Debts Barred by Statutes of Limitations 12-17 Promises to Pay Debts Barred by Bankruptcy Discharge 12-17 Charitable Subscriptions 12-18

13 Reality of Consent 13-1 Effect of Doctrines Discussed in This Chapter 13-1 Necessity for Prompt and Unequivocal Rescission 13-2 Misrepresentation and Fraud 13-2 Relationship between Misrepresentation and Fraud 13-2 Requirements for Rescission on the Ground of Misrepresentation 13-2 Mistake 13-8 Nature of Mistake 13-8 Requirements for Mutual Mistake 13-9 Requirements for Unilateral Mistake 13-11 Duress 13-13 Nature of Duress 13-13 Requirements for Duress 13-14 Economic Duress 13-17 Undue Influence 13-17 Nature of Undue Influence 13-17 Determining Undue Influence 13-17

14 Capacity to Contract 14-1 What Is Capacity? 14-1 Effect of Lack of Capacity 14-2 Capacity of Minors 14-2 Minors’ Right to Disaffirm 14-2 Period of Minority 14-5 Emancipation 14-5 Time of Disaffirmance 14-5 Ratification 14-5 Duties upon Disaffirmance 14-6 Effect of Misrepresentation of Age 14-8 Capacity of Mentally Impaired Persons 14-8 Theory of Incapacity 14-8 Test for Mental Incapacity 14-9 The Effect of Incapacity Caused by Mental Impairment 14-9 Contracts of Intoxicated Persons 14-11 Intoxication and Capacity 14-11

15 Illegality 15-1 Meaning of Illegality 15-1 Determining Whether an Agreement Is Illegal 15-2 Agreements in Violation of Statute 15-4 Agreements Declared Illegal by Statute 15-4 Agreements That Violate the Public Policy of a Statute 15-4 Agreements That May Be in Violation of Public Policy Articulated by Courts 15-5 Agreements in Restraint of Competition 15-5 Exculpatory Clauses 15-9 Family Relationships and Public Policy 15-12 Unfairness in Agreements: Contracts of Adhesion and Unconscionable Contracts 15-13 Unconscionability 15-13 Contracts of Adhesion 15-16 Effect of Illegality 15-17 General Rule: No Remedy for Breach of Illegal Agreements 15-17 Exceptions 15-17

16 Writing 16-1 The Significance of Writing in Contract Law 16-1 Purposes of Writing 16-1 Writing and Contract Enforcement 16-2 Overview of the Statute of Frauds 16-2



Contents

History and Purposes 16-2 Effect of Violating the Statute of Frauds 16-2 Contracts Covered by the Statute of Frauds 16-2 Collateral Contracts 16-3 Interest in Land 16-3 Contracts That Cannot Be Performed within One Year 16-6 Promise of Executor or Administrator to Pay a Decedent’s Debt Personally 16-9 Contract in Which Marriage Is the Consideration 16-10 Meeting the Requirements of the Statute of Frauds 16-11 Nature of the Writing Required 16-11 UCC: Alternative Means of Satisfying the Statute of Frauds in Sale of Goods Contracts 16-12 Promissory Estoppel and the Statute of Frauds 16-15 The Parol Evidence Rule 16-16 Explanation of the Rule 16-16 Scope of the Parol Evidence Rule 16-16 Admissible Parol Evidence 16-17 Interpretation of Contracts 16-19

17 Rights of Third Parties 17-1 Assignment of Contracts 17-1 Nature of Assignment of Rights 17-2 Creating an Assignment 17-3 Assignability of Rights 17-3 Nature of Assignee’s Rights 17-6 Subsequent Assignments 17-7 Successive Assignments 17-7 Assignor’s Warranty Liability to Assignee 17-7 Delegation of Duties 17-8 Nature of Delegation 17-8 Delegable Duties 17-8 Language Creating a Delegation 17-10 Assumption of Duties by Delegatee 17-11 Discharge of Delegator by Novation 17-11 Third-Party Beneficiaries 17-13 Intended Beneficiaries versus Incidental Beneficiaries 17-13 Vesting of Beneficiary’s Rights 17-17

18 Performance and Remedies 18-1 Conditions 18-2 Nature of Conditions 18-2 Types of Conditions 18-2

xxv

Creation of Express Conditions 18-7 Excuse of Conditions 18-7 Performance of Contracts 18-8 Level of Performance Expected of the Promisor 18-8 Good-Faith Performance 18-8 Breach of Contract 18-9 Effect of Material Breach 18-9 Determining the Materiality of the Breach 18-10 Anticipatory Repudiation 18-12 Recovery by a Party Who Has Committed Material Breach 18-13 Excuses for Nonperformance 18-14 Impossibility 18-14 Commercial Impracticability 18-17 Other Grounds for Discharge 18-17 Discharge by Mutual Agreement 18-17 Discharge by Accord and Satisfaction 18-17 Discharge by Waiver 18-17 Discharge by Alteration 18-17 Discharge by Statute of Limitations 18-18 Discharge by Decree of Bankruptcy 18-18 Remedies for Breach of Contract 18-18 Types of Contract Remedies 18-18 Interests Protected by Contract Remedies 18-18 Legal Remedies (Damages) 18-19 Equitable Remedies 18-24 Restitution 18-26

4

Part 4 Sales 19 Formation and Terms of Sales Contracts 19-3 Sale of Goods 19-4 Leases 19-6 Higher Standards for Merchants 19-6 UCC Requirements 19-6 Terms of Sales Contracts 19-6 Gap Fillers 19-6 Price Terms 19-7 Quantity Terms 19-8 Output and Needs Contracts 19-8 Exclusive Dealing Contracts 19-8 Time for Performance 19-10 Delivery Terms 19-11 Title 19-11

xxvi

Contents

UCC Changes 19-11 General Title Rule 19-11 Title and Third Parties 19-13 Obtaining Good Title 19-13 Transfers of Voidable Title 19-13 Buyers in the Ordinary Course of Business 19-14 Entrusting of Goods 19-14 Risk of Loss 19-16 Terms of the Agreement 19-16 Shipment Contracts 19-17 Destination Contracts 19-17 Goods in the Possession of Third Parties 19-17 Risk Generally 19-17 Effect of Breach on Risk of Loss 19-19 Insurable Interest 19-19 Sales on Trial 19-19 Sale or Return 19-19 Sale on Approval 19-19

20 Product Liability 20-1 The Evolution of Product Liability Law 20-3 The 19th Century 20-3 The 20th and 21st Centuries 20-3 The Current Debate over Product Liability Law 20-3 Theories of Product Liability Recovery 20-3 Express Warranty 20-4 Implied Warranty of Merchantability 20-5 Implied Warranty of Fitness 20-5 Negligence 20-10 Strict Liability 20-14 The Restatement (Third) 20-16 Other Theories of Recovery 20-20 Time Limitations 20-20 Damages in Product Liability Cases 20-22 The No-Privity Defense 20-23 Tort Cases 20-23 Warranty Cases 20-23 Disclaimers and Remedy Limitations 20-24 Implied Warranty Disclaimers 20-24 Express Warranty Disclaimers 20-29 Disclaimers of Tort Liability 20-29 Limitation of Remedies 20-29 Defenses 20-29 The Traditional Defenses 20-29 Comparative Principles 20-33 Preemption and Regulatory Compliance 20-35

21 Performance of Sales Contracts 21-1 General Rules 21-2 Good Faith 21-2 Course of Dealing 21-2 Usage of Trade 21-2 Modification 21-4 Waiver 21-4 Assignment 21-5 Delivery 21-5 Basic Obligation 21-5 Place of Delivery 21-5 Seller’s Duty of Delivery 21-5 Inspection and Payment 21-6 Buyer’s Right of Inspection 21-6 Payment 21-6 Acceptance, Revocation, and Rejection 21-6 Acceptance 21-6 Effect of Acceptance 21-9 Revocation of Acceptance 21-9 Buyer’s Rights on Improper Delivery 21-12 Rejection 21-12 Right to Cure 21-15 Buyer’s Duties after Rejection 21-15 Assurance, Repudiation, and Excuse 21-16 Assurance 21-16 Anticipatory Repudiation 21-16 Excuse 21-16

22 Remedies for Breach of Sales Contracts 22-1 Agreements as to Remedies 22-2 Statute of Limitations 22-4 Seller’s Remedies 22-5 Remedies Available to an Injured Seller 22-5 Cancellation and Withholding of Delivery 22-5 Resale of Goods 22-5 Recovery of the Purchase Price 22-6 Damages for Rejection or Repudiation 22-8 Seller’s Remedies Where Buyer Is Insolvent 22-9 Seller’s Right to Stop Delivery 22-10 Liquidated Damages 22-10 Buyer’s Remedies 22-10 Buyer’s Remedies in General 22-10 Buyer’s Right to Damages 22-11 Buyer’s Right to Cover 22-12 Incidental Damages 22-12 Consequential Damages 22-13



Contents

Damages for Nondelivery 22-13 Damages for Defective Goods 22-15 Buyer’s Right to Specific Performance 22-18 Buyer and Seller Agreements as to Remedies 22-18

5

Part 5 Property 23 Personal Property and Bailments 23-3 Nature of Property 23-4 Classifications of Property 23-4 Personal Property versus Real Property 23-4 Tangible versus Intangible Personal Property 23-4 Public and Private Property 23-4 Acquiring Ownership of Personal Property 23-5 Production or Purchase 23-5 Possession of Unowned Property 23-5 Rights of Finders of Lost, Mislaid, and Abandoned Property 23-5 Legal Responsibilities of Finders 23-6 Leasing 23-8 Gifts 23-9 Conditional Gifts 23-9 Uniform Transfers to Minors Act 23-9 Will or Inheritance 23-11 Confusion 23-11 Accession 23-11 Bailments 23-12 Nature of Bailments 23-12 Elements of a Bailment 23-12 Creation of a Bailment 23-12 Types of Bailments 23-12 Special Bailments 23-13 Duties of the Bailee 23-13 Duty of Bailee to Take Care of Property 23-13 Bailee’s Duty to Return the Property 23-14 Bailee’s Liability for Misdelivery 23-14 Limits on Liability 23-14 Right to Compensation 23-16 Bailor’s Liability for Defects in the Bailed Property 23-16 Special Bailments 23-17 Common Carriers 23-17 Hotelkeepers 23-17 Safe-Deposit Boxes 23-17 Involuntary Bailments 23-18 Documents of Title 23-18

xxvii

Warehouse Receipts 23-18 Bills of Lading 23-19 Duty of Care 23-20 Negotiation of Document of Title 23-21 Rights Acquired by Negotiation 23-21 Warranties of Transferor of Document of Title 23-21

24 Real Property 24-1 Scope of Real Property 24-2 Fixtures 24-2 Rights and Interests in Real Property 24-5 Estates in Land 24-5 Co-ownership of Real Property 24-6 Interests in Real Property Owned by Others 24-9 Easements 24-9 Creation of Easements 24-10 Profits 24-12 Licenses 24-12 Restrictive Covenants 24-12 Acquisition of Real Property 24-18 Acquisition by Purchase 24-18 Acquisition by Gift 24-18 Acquisition by Will or Inheritance 24-18 Acquisition by Tax Sale 24-18 Acquisition by Adverse Possession 24-18 Transfer by Sale 24-20 Steps in a Sale 24-20 Contracting with a Real Estate Broker 24-21 Contract of Sale 24-21 Fair Housing Act 24-21 Deeds 24-22 Form and Execution of Deed 24-23 Recording Deeds 24-23 Methods of Assuring Title 24-24 Seller’s Responsibilities Regarding the Quality of Residential Property 24-24 Implied Warranty of Habitability 24-25 Duty to Disclose Hidden Defects 24-25 Other Property Condition–Related Obligations of Real Property Owners and Possessors 24-25 Expansion of Premises Liability 24-26 Americans with Disabilities Act 24-26 Land Use Control 24-27 Nuisance Law 24-27 Eminent Domain 24-28

xxviii

Contents

Zoning and Subdivision Laws 24-31 Land Use Regulation and Taking 24-32

25 Landlord and Tenant 25-1 Leases and Tenancies 25-2 Nature of Leases 25-2 Types of Tenancies 25-2 Execution of a Lease 25-3 Rights, Duties, and Liabilities of the Landlord 25-4 Landlord’s Rights 25-4 Landlord’s Duties 25-4 Landlord’s Responsibility for Condition of Leased Property 25-5 Landlord’s Tort Liability 25-9 Rights, Duties, and Liabilities of the Tenant 25-15 Rights of the Tenant 25-15 Duty to Pay Rent 25-15 Duty Not to Commit Waste 25-15 Assignment and Subleasing 25-15 Tenant’s Liability for Injuries to Third Persons 25-16 Termination of the Leasehold 25-16 Eviction 25-16 Agreement to Surrender 25-16 Abandonment 25-16

26 Estates and Trusts 26-1 The Law of Estates and Trusts 26-2 Estate Planning 26-2 Wills 26-2 Right of Disposition by Will 26-2 Nature of a Will 26-2 Common Will Terminology 26-2 Testamentary Capacity 26-3 Execution of a Will 26-6 Incorporation by Reference 26-8 Informal Wills 26-8 Joint and Mutual Wills 26-8 Construction of Wills 26-8 Limitations on Disposition by Will 26-8 Revocation of Wills 26-9 Codicils 26-10 Advance Directives: Planning for Incapacity 26-10 Durable Power of Attorney 26-10 Living Wills 26-10

Durable Power of Attorney for Health Care 26-10 Federal Law and Advance Directives 26-11 Intestacy 26-12 Characteristics of Intestacy Statutes 26-12 Special Rules 26-12 Simultaneous Death 26-15 Administration of Estates 26-16 The Probate Estate 26-16 Determining the Existence of a Will 26-16 Selecting a Personal Representative 26-16 Responsibilities of the Personal Representative 26-16 Trusts 26-17 Nature of a Trust 26-17 Trust Terminology 26-17 Why People Create Trusts 26-18 Creation of Express Trusts 26-18 Charitable Trusts 26-18 Totten Trusts 26-20 Powers and Duties of the Trustee 26-20 Liability of Trustee 26-21 Spendthrift Trusts 26-21 Termination and Modification of a Trust 26-21 Implied and Constructive Trusts 26-21

27 Insurance Law 27-1 Nature and Benefits of Insurance Relationships 27-2 Insurance Policies as Contracts 27-3 Interested Parties 27-3 Offer, Acceptance, and Consideration 27-3 Effect of Insured’s Misrepresentation 27-6 Legality 27-6 Form and Content of Insurance Contracts 27-6 Performance and Breach by Insurer 27-8 Property Insurance 27-8 The Insurable Interest Requirement 27-9 Covered and Excluded Perils 27-9 Nature and Extent of Insurer’s Payment Obligation 27-13 Right of Subrogation 27-15 Duration and Cancellation of Policy 27-15 Liability Insurance 27-17 Types of Liability Insurance Policies 27-17 Liabilities Insured Against 27-17



Contents

Insurer’s Obligations 27-21 Is There a Liability Insurance Crisis? 27-25 Bad-Faith Breach of Insurance Contract 27-25

6

Part 6 Credit 28 Introduction to Credit and Secured

Transactions 28-3 Credit 28-4 Unsecured Credit 28-4 Secured Credit 28-4 Development of Security 28-5 Security Interests in Personal Property 28-5 Security Interests in Real Property 28-5 Suretyship and Guaranty 28-6 Sureties and Guarantors 28-6 Creation of Principal and Surety Relation 28-8 Defenses of a Surety 28-8 Creditor’s Duties to Surety 28-9 Subrogation, Reimbursement, and Contribution 28-9 Liens on Personal Property 28-10 Security Interests in Personal Property and Fixtures under the Uniform Commercial Code 28-10 Common Law Liens 28-10 Statutory Liens 28-10 Characteristics of Liens 28-10 Foreclosure of Lien 28-13 Security Interests in Real Property 28-13 Historical Developments of Mortgages 28-13 Form, Execution, and Recording 28-13 Rights and Liabilities 28-13 Foreclosure 28-14 Right of Redemption 28-14 Recent Development Concerning Foreclosures 28-15 Deed of Trust 28-16 Land Contracts 28-17 Mechanic’s and Materialman’s Liens 28-18 Rights of Subcontractors and Materialmen 28-18 Basis for Mechanic’s or Materialman’s Lien 28-18 Requirements for Obtaining a Lien 28-19 Priorities and Foreclosure 28-19 Waiver of Lien 28-19

29 Security Interests in Personal Property 29-1 Article 9 29-2 Security Interests under the Code 29-2

xxix

Security Interests 29-2 Types of Collateral 29-2 Obtaining a Security Interest 29-3 Attachment of the Security Interest 29-3 Attachment 29-3 The Security Agreement 29-3 Purchase Money Security Interests 29-3 Future Advances 29-5 After-Acquired Property 29-5 Proceeds 29-5 Perfecting the Security Interest 29-6 Perfection 29-6 Perfection by Public Filing 29-6 Possession by Secured Party as Public Notice 29-9 Control 29-9 Perfection by Attachment/Automatic Perfection 29-9 Exceptions to Perfection by Attachment: Consumer Goods 29-10 Motor Vehicles 29-11 Fixtures 29-12 Priority Rules 29-12 Importance of Determining Priority 29-12 General Priority Rules 29-12 Purchase Money Security Interest in Inventory 29-12 Purchase Money Security Interest in Noninventory Collateral 29-14 Rationale for Protecting Purchase Money Security Interests 29-15 Buyers in the Ordinary Course of Business 29-15 Artisan’s and Mechanic’s Liens 29-15 Liens on Consumer Goods Perfected Only by Attachment/ Automatic Perfection 29-18 Fixtures 29-18 Default and Foreclosure 29-20 Default 29-20 Right to Possession 29-20 Sale of the Collateral 29-20 Consumer Goods 29-20 Distribution of Proceeds 29-20 Liability of Creditor 29-21

30 Bankruptcy 30-1 The Bankruptcy Code 30-2 Bankruptcy Proceedings 30-2 Liquidations 30-2 Reorganizations 30-3 Family Farms 30-3

xxx

Contents

Consumer Debt Adjustments 30-3 The Bankruptcy Courts 30-3 Chapter 7: Liquidation Proceedings 30-3 Petitions 30-3 Involuntary Petitions 30-3 Automatic Stay Provisions 30-4 Order of Relief 30-5 Meeting of Creditors and Election of Trustee 30-5 Duties of the Trustee 30-5 The Bankruptcy Estate 30-6 Exemptions 30-6 Avoidance of Liens 30-9 Redemptions 30-9 Preferences (Preferential Payments or Liens) 30-9 Preferential Liens 30-10 Transactions in the Ordinary Course of Business 30-10 Fraudulent Transfers 30-10 Claims 30-13 Allowable Claims 30-13 Secured Claims 30-13 Priority Claims 30-13 Distribution of the Debtor’s Estate 30-14 Discharge in Bankruptcy 30-14 Discharge 30-14 Objections to Discharge 30-14 Acts That Bar Discharge 30-16 Nondischargeable Debts 30-16 Reaffirmation Agreements 30-18 Dismissal for Substantial Abuse 30-18 Chapter 11: Reorganizations 30-22 Reorganization Proceeding 30-22 Use of Chapter 11 30-25 Chapter 12: Family Farmers and Fishermen 30-28 Relief for Family Farmers and Fishermen 30-28 Chapter 13: Consumer Debt Adjustments 30-29 Relief for Individuals 30-29 Procedure 30-29 Discharge 30-33 Advantages of Chapter 13 30-33

7

Part 7 Commercial Paper 31 Negotiable Instruments 31-3 Nature of Negotiable Instruments 31-4 Uniform Commercial Code 31-4 Negotiable Instruments 31-4

Negotiability 31-4 Kinds of Negotiable Instruments 31-5 Promissory Notes 31-5 Certificates of Deposit 31-5 Drafts 31-6 Checks 31-7 Benefits of Negotiable Instruments 31-8 Rights of an Assignee of a Contract 31-8 Rights of a Holder of a Negotiable Instrument 31-9 Formal Requirements for Negotiability 31-9 Basic Requirements 31-9 Importance of Form 31-10 In Writing 31-10 Signed 31-10 Unconditional Promise or Order 31-10 Requirement of a Promise or Order 31-10 Promise or Order Must Be Unconditional 31-10 Fixed Amount of Money 31-12 Fixed Amount 31-12 Payable in Money 31-13 Payable on Demand or at a Definite Time 31-13 Payable on Demand 31-13 Payable at a Definite Time 31-13 Payable to Order or Bearer 31-14 Special Terms 31-16 Additional Terms 31-16 Ambiguous Terms 31-17

32 Negotiation and Holder in Due Course 32-1 Negotiation 32-2 Nature of Negotiation 32-2 Formal Requirements for Negotiation 32-2 Nature of Indorsement 32-2 Wrong or Misspelled Name 32-3 Checks Deposited without Indorsement  32-3 Transfer of Order Instrument 32-3 Indorsements 32-5 Effects of an Indorsement 32-5 Kinds of Indorsements 32-5 Rescission of Indorsement 32-7 Holder in Due Course 32-8 General Requirements 32-9 Holder 32-9 Value 32-11 Good Faith 32-11 Overdue or Dishonored 32-12 Notice of Unauthorized Signature or Alteration 32-13



Contents

Notice of Claims 32-13 Irregular and Incomplete Instruments 32-15 Shelter Rule 32-15 Rights of a Holder in Due Course 32-16 Claims and Defenses Generally 32-16 Importance of Being a Holder in Due Course 32-16 Real Defenses 32-17 Personal Defenses 32-18 Claims to the Instrument 32-20 Claims in Recoupment 32-20 Changes in the Holder in Due Course Rule for Consumer Credit Transactions 32-21 Consumer Disadvantages 32-21 State Consumer Protection Legislation 32-22 Federal Trade Commission Regulation 32-22

33 Liability of Parties 33-1 Liability in General 33-2 Contractual Liability 33-2 Primary and Secondary Liability 33-2 Obligation of a Maker 33-2 Obligation of a Drawee or an Acceptor 33-3 Obligation of a Drawer 33-3 Obligation of an Indorser 33-3 Obligation of an Accommodation Party 33-4 Signing an Instrument 33-6 Signature by an Authorized Agent 33-6 Unauthorized Signature 33-7 Contractual Liability in Operation 33-8 Presentment of a Note 33-8 Presentment of a Check or a Draft 33-8 Time of Presentment 33-10 Warranty Liability 33-10 Transfer Warranties 33-10 Presentment Warranties 33-12 Payment or Acceptance by Mistake 33-13 Operation of Warranties 33-13 Other Liability Rules 33-15 Negligence 33-15 Impostor Rule 33-15 Fictitious Payee Rule 33-15 Comparative Negligence Rule Concerning Impostors and Fictitious Payees 33-16 Fraudulent Indorsements by Employees 33-16 Conversion 33-19 Discharge of Contractual Liability on Negotiable Instruments 33-20

xxxi

Discharge of Contractual Liability 33-20 Discharge by Payment 33-21 Discharge by Cancellation 33-21 Altered Instruments: Discharge by Alteration 33-21 Discharge of Indorsers and Accommodation Parties 33-22

34 Checks and Electronic Transfers 34-1 The Drawer–Drawee Relationship 34-2 Bank’s Duty to Pay 34-2 Bank’s Right to Charge to Customer’s Account 34-2 Stop-Payment Order 34-5 Bank’s Liability for Payment after Stop-Payment Order 34-8 Certified Check 34-9 Cashier’s Check 34-9 Death or Incompetence of Customer 34-10 Forged and Altered Checks 34-10 Bank’s Right to Charge Account 34-10 Customer’s Duty to Report Forgeries and Alterations 34-12 Check Collection and Funds Availability 34-14 Check Collection 34-14 Funds Availability 34-18 Check 21 34-19 Electronic Transfers 34-20 Electronic Fund Transfer Act 34-20 Wire Transfers 34-22

8

Part 8 Agency Law 35 The Agency Relationship 35-3 Creation of an Agency 35-4 Formation 35-4 Capacity 35-5 Nondelegable Obligations 35-5 Agency Concepts, Definitions, and Types 35-5 Authority 35-6 General and Special Agents 35-6 Gratuitous Agents 35-6 Subagents 35-6 Employees and Nonemployee Agents 35-7 Duties of Agent to Principal 35-9 Agent’s Duty of Loyalty 35-10 Agent’s Duty to Obey Instructions 35-12 Agent’s Duty to Act with Care and Skill 35-12

xxxii

Contents

Agent’s Duty to Provide Information 35-12 Agent’s Duties of Segregation, Record-Keeping, and Accounting 35-12 Duty Not to Receive a Material Benefit 35-12 Duty of Good Conduct 35-12 Duties of Principal to Agent 35-12 Duty to Compensate Agent 35-13 Duties of Reimbursement and Indemnity  35-13 Termination of an Agency 35-14 Termination by Act of the Parties 35-14 Termination by Operation of Law 35-14 Termination of Agency Powers Given as Security 35-15 Effect of Termination on Agent’s Authority 35-16

36 Third-Party Relations of the Principal and the

Agent 36-1 Contract Liability of the Principal 36-2 Actual Authority 36-2 Apparent Authority 36-3 Agent’s Notification and Knowledge 36-3 Ratification 36-3 Estoppel 36-4 Contracts Made by Subagents 36-6 Contract Liability of the Agent 36-6 The Nature of the Principal 36-6 Liability of Agent by Agreement 36-8 Implied Warranty of Authority 36-8 Tort Liability of the Principal 36-10 Respondeat Superior Liability 36-10 Direct Liability 36-13 Liability for Torts of Nonemployee Agents 36-13 Liability for Agent’s Misrepresentations 36-13 Tort Liability of the Agent 36-14 Tort Suits against Principal and Agent 36-15

9

Part 9 Partnerships 37 Introduction to Forms of Business and Formation

of Partnerships 37-3 Types of Business Entities 37-4 Sole Proprietorship 37-4 Partnership 37-4 Limited Liability Partnership 37-5 Limited Partnership 37-5 Corporation 37-6 Professional Corporation 37-6

Limited Liability Company 37-6 Benefit Corporations 37-7 Partnerships 37-9 Creation of Partnership 37-9 RUPA Definition of Partnership 37-10 Creation of Joint Ventures 37-12 Creation of Mining Partnerships 37-13 Creation of Limited Liability Partnerships 37-13 Purported Partners 37-14 Purporting to Be a Partner 37-14 Reliance Resulting in a Transaction with the Partnership 37-14 Effect of Purported Partnership 37-14 Partnership Capital 37-16 Partnership Property 37-17 Examples 37-17 Need for Partnership Agreement 37-17 Partner’s Partnership Interest 37-19 Partner’s Transferable Interest 37-19 Effect of Partnership Agreement 37-20

38 Operation of Partnerships and Related

Forms 38-1 Duties of Partners to the Partnership and Each Other 38-2 Having Interest Adverse to Partnership 38-2 Competing against the Partnership 38-2 Duty to Serve 38-4 Duty of Care 38-4 Duty to Act within Actual Authority 38-4 Duty to Account 38-4 Other Duties 38-4 Joint Ventures and Mining Partnerships 38-5 Compensation of Partners 38-5 Profits and Losses 38-5 Management Powers of Partners 38-8 Individual Authority of Partners 38-8 Special Transactions 38-9 Disagreement among Partners: Ordinary Course of Business 38-10 When Unanimous Partners’ Agreement Is Required 38-11 Joint Ventures and Mining Partnerships 38-11 Effect of Partnership Agreement 38-11 Liability for Torts and Crimes 38-13 Torts 38-13 Tort Liability and Limited Liability Partnerships 38-14 Crimes 38-14



Contents

Lawsuits by and against Partnerships and Partners 38-14 Limited Liability Partnerships 38-14

39 Partners’ Dissociation and Partnerships’

Dissolution and Winding Up 39-1 Dissociation 39-2 Nonwrongful Dissociation 39-2 Wrongful Dissociation 39-3 Acts Not Causing Dissociation 39-3 Effect of Partnership Agreement 39-3 Dissolution and Winding Up the Partnership Business 39-3 Events Causing Dissolution and Winding Up 39-5 Joint Ventures and Mining Partnerships 39-7 Performing Winding Up 39-7 Partner’s Authority during Winding Up 39-9 Distribution of Dissolved Partnership’s Assets 39-11 Asset Distributions in a Limited Liability Partnership 39-12 Termination 39-12 When the Business Is Continued 39-12 Successor’s Liability for Predecessor’s Obligations 39-12 Dissociated Partner’s Liability for Obligations Incurred while a Partner 39-12 Dissociated Partner’s Liability for Obligations Incurred after Leaving the Partnership 39-13 Effect of LLP Status 39-14 Buyout of Dissociated Partners 39-14 Partners Joining an Existing Partnership 39-16 Liability of New Partners 39-16

40 Limited Liability Companies and Limited

Partnerships 40-1 Limited Liability Companies 40-1 Tax Treatment of LLCs 40-2 Formation of LLCs 40-2 Members’ Rights and Responsibilities 40-2 Members’ Dissociations and LLC Dissolution 40-5 Limited Partnerships 40-9 The Uniform Limited Partnership Acts 40-9 Use of Limited Partnerships 40-9 Creation of Limited Partnerships 40-10

xxxiii

Defective Compliance with Limited Partnership Statute 40-11 Rights and Liabilities of Partners in Limited Partnerships 40-12 Rights and Liabilities Shared by General and Limited Partners 40-12 Other Rights of General Partners 40-13 Other Liabilities of General Partners 40-13 Other Rights of Limited Partners 40-14 Other Liabilities of Limited Partners 40-14 Partners’ Dissociations and Limited Partnership Dissolution 40-14 Partners’ Dissociations 40-14 Limited Partnership Dissolutions 40-16 Mergers and Conversions 40-17

10

Part 10 Corporations 41 History and Nature of Corporations 41-3 History of Corporations 41-4 American Corporation Law 41-4 Classifications of Corporations 41-4 Regulation of For-Profit Corporations 41-6 State Incorporation Statutes 41-6 State Common Law of Corporations 41-7 Regulation of Nonprofit Corporations 41-7 Regulation of Foreign and Alien Corporations 41-7 Due Process Clause 41-8 Commerce Clause 41-8 Subjecting Foreign Corporations to Suit 41-8 Taxation 41-9 Qualifying to Do Business 41-9 Regulation of a Corporation’s Internal Affairs 41-12 Regulation of Foreign Nonprofit Corporations 41-12 Piercing the Corporate Veil 41-12 Nonprofit Corporations 41-14

42 Organization and Financial Structure of

Corporations 42-1 Promoters and Preincorporation Transactions 42-1 Corporation’s Liability on Preincorporation Contracts 42-2 Promoter’s Liability on Preincorporation Contracts 42-2 Obtaining a Binding Preincorporation Contract 42-2

xxxiv

Preincorporation Share Subscriptions 42-3 Relation of Promoter and Prospective Corporation 42-4 Liability of Corporation to Promoter 42-4 Incorporation 42-4 Steps in Incorporation 42-4 Close Corporation Elections 42-7 Defective Attempts to Incorporate 42-7 De Jure Corporation 42-7 De Facto Corporation 42-8 Corporation by Estoppel 42-8 Defective Incorporation 42-8 Modern Approaches to the Defective Incorporation Problem 42-8 Incorporation of Nonprofit Corporations 42-10 Liability for Preincorporation Transactions 42-11 Financing For-Profit Corporations 42-11 Equity Securities 42-11 Authorized, Issued, and Outstanding Shares 42-12 Options, Warrants, and Rights 42-12 Debt Securities 42-13 Consideration for Shares 42-13 Quality of Consideration for Shares 42-13 Quantity of Consideration for Shares 42-13 Share Subscriptions 42-16 Issuance of Shares 42-16 Transfer of Shares 42-17 Restrictions on Transferability of Shares 42-17 Financing Nonprofit Corporations 42-20

43 Management of Corporations 43-1 Corporate Objectives 43-2 Corporate Powers 43-3 Purpose Clauses in Articles of Incorporation 43-3 Powers of Nonprofit Corporations 43-3 The Board of Directors 43-3 Board Authority under Corporation Statutes 43-4 Committees of the Board 43-4 Who Is an Independent Director? 43-5 Powers, Rights, and Liabilities of Directors as Individuals 43-5 Election of Directors 43-5 Directors’ Meetings 43-8 Officers of the Corporation 43-9 Managing Close Corporations 43-9 Managing Nonprofit Corporations 43-10

Contents

Directors’ and Officers’ Duties to the Corporation 43-11 Acting within Authority 43-11 Duty of Care 43-11 Board Opposition to Acquisition of Control of a Corporation 43-16 Oversight of Legal Compliance 43-20 Duties of Loyalty 43-22 Conflicting Interest Transactions 43-22 Usurpation of a Corporate Opportunity 43-23 Oppression of Minority Shareholders 43-25 Trading on Inside Information 43-27 Duties of Directors and Officers of Nonprofit Corporations 43-27 Corporate and Management Liability for Torts and Crimes 43-28 Liability of the Corporation 43-28 Directors’ and Officers’ Liability for Torts and Crimes 43-29 Insurance and Indemnification 43-32 Mandatory Indemnification of Directors 43-32 Permissible Indemnification of Directors 43-32 Insurance 43-32 Nonprofit Corporations 43-32

44 Shareholders’ Rights and Liabilities 44-1 Shareholders’ Meetings 44-2 Notice of Meetings 44-2 Conduct of Meetings 44-2 Shareholder Action without a Meeting 44-2 Shareholders’ Election of Directors 44-2 Straight Voting 44-2 Cumulative Voting 44-3 Classes of Shares 44-3 Shareholder Control Devices 44-3 Fundamental Corporate Changes 44-6 Procedures Required 44-7 Dissenters’ Rights 44-7 Shareholders’ Inspection and Information Rights 44-13 Preemptive Right 44-15 Distributions to Shareholders 44-16 Dividends 44-16 Share Repurchases 44-18 Ensuring a Shareholder’s Return on Investment 44-19 Shareholders’ Lawsuits 44-19



Contents

Shareholders’ Individual Lawsuits 44-19 Shareholder Class Action Suits 44-19 Shareholders’ Derivative Actions 44-19 Defense of Corporation by Shareholder 44-22 Shareholder Liability 44-22 Shareholder Liability for Illegal Distributions 44-22 Shareholder Liability for Corporate Debts 44-22 Sale of a Control Block of Shares 44-22 Shareholders as Fiduciaries 44-23 Members’ Rights and Duties in Nonprofit Corporations 44-25 Members’ Meeting and Voting Rights 44-26 Member Inspection and Information Rights 44-26 Distributions of Assets 44-27 Resignation and Expulsion of Members 44-27 Derivative Suits 44-27 Dissolution and Termination of Corporations 44-27 Winding Up and Termination 44-29 Dissolution of Nonprofit Corporations 44-29

45 Securities Regulation 45-1 Purposes of Securities Regulation 45-2 Securities and Exchange Commission 45-3 SEC Actions 45-3 What Is a Security? 45-4 Securities Act of 1933 45-7 Registration of Securities under the 1933 Act 45-7 Mechanics of a Registered Offering 45-7 Registration Statement and Prospectus 45-7 Section 5: Timing, Manner, and Content of Offers and Sales 45-8 Exemptions from the Registration Requirements of the 1933 Act 45-12 Securities Exemptions 45-12 Transaction Exemptions 45-13 Intrastate Offering Exemption 45-13 Private Offering Exemption 45-13 Small Offering Exemptions 45-15 The JOBS Act and Regulation Crowdfunding 45-16 Transaction Exemptions for Nonissuers 45-16 Sale of Restricted Securities 45-17 Consequence of Obtaining a Securities or Transaction Exemption 45-20 Liability Provisions of the 1933 Act 45-20 Liability for Defective Registration Statements 45-21 Other Liability Provisions 45-26

xxxv

Criminal Liability 45-26 Securities Exchange Act of 1934 45-26 Registration of Securities under the 1934 Act 45-27 Holdings and Trading by Insiders 45-28 Proxy Solicitation Regulation 45-28 Liability Provisions of the 1934 Act 45-30 Liability for False Statements in Filed Documents 45-30 Section 10(b) and Rule 10b–5 45-31 Elements of a Rule 10b–5 Violation 45-31 Regulation FD 45-43 Criminal Liability 45-44 Tender Offer Regulation 45-44 Private Acquisitions of Shares 45-46 State Regulation of Tender Offers 45-46 State Securities Law 45-46 Registration of Securities 45-46

46 Legal and Professional Responsibilities

of Auditors, Consultants, and Securities Professionals 46-1 General Standard of Performance 46-3 Professionals’ Liability to Clients 46-3 Contractual Liability 46-3 Tort Liability 46-4 In Pari Delicto 46-7 Breach of Trust 46-7 Securities Law 46-8 Professionals’ Liability to Third Persons: Common Law 46-8 Negligence and Negligent Misrepresentation 46-8 Fraud 46-13 Professional’s Liability to Third Parties: Securities Law 46-13 Securities Act of 1933 46-14 Securities Exchange Act of 1934 46-15 State Securities Law 46-18 Securities Analysts’ Conflicts of Interest 46-18 Dodd–Frank Act and Broker-Dealers 46-20 Regulation Best Interest and Broker-Dealers 46-20 Qualified Opinions, Disclaimers of Opinion, Adverse Opinions, and Unaudited Statements 46-22 Criminal, Injunctive, and Administrative Proceedings 46-23 Criminal Liability under the Securities Laws 46-24

xxxvi

Other Criminal Law Violations 46-25 Injunctions 46-26 Administrative Proceedings 46-26 Securities Exchange Act Audit Requirements 46-27 SOX Section 404 46-27 Cooperation with PCAOB Investigations 46-27 Ownership of Working Papers 46-28 Professional–Client Privilege 46-28

11

Part 11 Regulation of Business 47 Administrative Law 47-3 Origins of Administrative Agencies 47-5 Agency Creation 47-6 Enabling Legislation 47-6 Administrative Agencies and the Constitution 47-7 Agency Types and Organization 47-11 Agency Types 47-11 Agency Organization 47-12 Agency Powers and Procedures 47-12 Nature, Types, and Source of Powers 47-12 Investigative Power 47-12 Rulemaking Power 47-14 Adjudicatory Power 47-16 Controlling Administrative Agencies 47-17 Presidential Controls 47-17 Congressional Controls 47-17 Judicial Review 47-18 Information Controls 47-27 Freedom of Information Act 47-27 Privacy Act of 1974 47-31 Government in the Sunshine Act 47-31 Issues in Regulation 47-31 “Old” Regulation versus “New” Regulation 47-31 “Captive” Agencies and Agencies’ “Shadows” 47-31 Is the Agency Doing Its Job? 47-31 Deregulation versus Reregulation 47-32

48 The Federal Trade Commission Act

and Consumer Protection Laws 48-1 The Federal Trade Commission 48-2 The FTC’s Powers 48-2

Contents

FTC Enforcement Procedures 48-2 Actions in Court 48-3 Anticompetitive Behavior 48-6 Deception and Unfairness 48-6 Deception 48-6 Unfairness 48-15 Remedies 48-15 Consumer Protection Laws 48-15 Telemarketing and Consumer Fraud and Abuse Prevention Act 48-15 Do-Not-Call Registry 48-16 Do Not Track 48-17 Magnuson–Moss Warranty Act 48-17 Truth in Lending Act 48-18 Fair Credit Reporting Act 48-19 FACT Act and the Identity Theft Problem 48-23 Equal Credit Opportunity Act 48-24 Fair Credit Billing Act 48-24 The Dodd–Frank Act 48-24 Fair Debt Collection Practices Act 48-25 Product Safety Regulation 48-30

49 Antitrust: The Sherman Act 49-1 The Antitrust Policy Debate 49-2 Chicago School Theories 49-3 Traditional Antitrust Theories 49-3 Impact of Chicago School 49-3 Jurisdiction, Types of Cases, and Standing 49-3 Jurisdiction 49-3 Types of Cases and the Role of Pretrial Settlements 49-4 Criminal Prosecutions 49-4 Civil Litigation 49-4 Standing 49-5 Section 1—Restraints of Trade 49-5 Concerted Action 49-5 Per Se versus Rule of Reason Analysis 49-9 Horizontal Price-Fixing 49-9 Vertical Price-Fixing 49-13 Horizontal Divisions of Markets 49-17 Vertical Restraints on Distribution 49-18 Group Boycotts and Concerted Refusals to Deal 49-18 Tying Agreements 49-19



Contents

Reciprocal Dealing Agreements 49-25 Exclusive Dealing Agreements 49-25 Joint Ventures by Competitors 49-25 Section 2—Monopolization 49-26 Monopolization 49-27 Attempted Monopolization 49-34 Conspiracy to Monopolize 49-35

50 The Clayton Act, the Robinson–Patman Act,

and Antitrust Exemptions and Immunities 50-1 Clayton Act Section 3 50-2 Tying Agreements 50-3 Exclusive Dealing Agreements 50-3 Clayton Act Section 7 50-3 Introduction 50-3 Federal Filing Requirements for Mergers 50-4 Relevant Market Determination 50-4 Horizontal Mergers 50-5 Vertical Mergers 50-13 Conglomerate Mergers 50-14 Clayton Act Section 8 50-15 The Robinson–Patman Act 50-16 Jurisdiction 50-16 Section 2(a) 50-17 Defenses to Section 2(a) Liability 50-22 Indirect Price Discrimination 50-23 Buyer Inducement of Discrimination 50-24 Antitrust Exceptions and Exemptions 50-24 Statutory Exemptions 50-24 State Action Exemption 50-25 The Noerr–Pennington Doctrine 50-25 Patent Licensing 50-29 Foreign Commerce 50-29

51 Employment Law 51-1 Legislation Protecting Employee Health, Safety, and Well-Being 51-2 Workers’ Compensation 51-2 The Occupational Safety and Health Act 51-6 The Family and Medical Leave Act 51-6 Legislation Protecting Wages, Pensions, and Benefits 51-7 Social Security 51-7 Unemployment Compensation 51-7 ERISA 51-8 The Fair Labor Standards Act 51-8

xxxvii

Collective Bargaining and Union Activity 51-8 Equal Opportunity Legislation 51-10 The Equal Pay Act 51-10 Title VII 51-11 Section 1981 51-27 The Age Discrimination in Employment Act 51-27 The Americans with Disabilities Act 51-28 Genetic Information Nondiscrimination Act 51-32 Immigration Reform and Control Act 51-32 Uniformed Services Employment and Reemployment Rights Act 51-32 Executive Order 11246 51-33 State Antidiscrimination Laws 51-33 Retaliation 51-33 Employee Privacy 51-34 Polygraph Testing 51-34 Drug and Alcohol Testing 51-35 Employer Searches 51-36 Records and References 51-36 Employer Monitoring 51-36 Job Security 51-36 The Doctrine of Employment at Will 51-36 The Common Law Exceptions 51-37

52 Environmental Regulation 52-1 Historical Perspective 52-2 The Environmental Protection Agency 52-2 The National Environmental Policy Act 52-3 Air Pollution 52-3 Background 52-3 Clean Air Act 52-3 Ambient Air Control Standards 52-3 Acid Rain Controls 52-4 Control of Hazardous Air Pollutants 52-4 New Source Controls 52-4 Permits 52-7 Enforcement 52-7 Automobile Pollution 52-8 International Air Problems  52-9 Water Pollution 52-12 Background 52-12 Early Federal Legislation 52-12 Clean Water Act 52-12 Discharge Permits 52-12 Water Quality Standards 52-13 Enforcement 52-13

xxxviii

Contents

Wetlands 52-16 Waters of the United States 52-16 Ocean Dumping 52-16 Liability for Oil Spills 52-17 Drinking Water 52-19 Waste Disposal 52-19 Background 52-19 The Resource Conservation and Recovery Act 52-20 Underground Storage Tanks 52-20 State Responsibilities 52-20 Enforcement 52-20 Solid Waste 52-23 Superfund 52-23 Community Right to Know and Emergency Cleanup 52-26 Regulation of Chemicals 52-26 Background 52-26

Regulation of Agricultural Chemicals 52-26 Toxic Substances Control Act 52-27 International Developments Concerning Regulation of Toxic Substances 52-27 Biotechnology 52-29

Glossary G-1 Appendix A The Constitution of the United States of America A-1 Appendix B Uniform Commercial Code B-1 Index I-1

List of Cases Abdouch v. Lopez . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-4

Cordas v. Uber Technologies, Inc.. . . . . . . . . . . . . . . . . . . . 10-12

Advance Dental Care, Inc. v. SunTrust Bank. . . . . . . . . . . . . . 1-9

Coyle v. Schwartz. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42-19

Aliaga Medical Center v. Harris Bank. . . . . . . . . . . . . . . . . . . 34-6

Currie v. Chevron U.S.A., Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . 7-7

Alice Corporation Ltd. v. CLS Bank International . . . . . . . . . 8-4

D’Agostino v. Federal Insurance Company . . . . . . . . . . . . . 10-16

Allstate Lien & Recovery Corporation v. Stansbury . . . . . . 28-11

Day v. Fortune Hi-Tech Marketing, Inc.. . . . . . . . . . . . . . . . . 12-5

American Greetings Corp. v. Bunch. . . . . . . . . . . . . . . . . . . . 51-4

DePetris & Bachrach, LLP v. Srour . . . . . . . . . . . . . . . . . . . . 36-9

American Needle, Inc. v. National Football League . . . . . . . 49-6

Dixon v. Crawford, McGilliard, Peterson & Yelish. . . . . . . 39-14

A Note on United States v. Apple. . . . . . . . . . . . . . . . . . . . . . 49-13

Dodge v. Ford Motor Co.. . . . . . . . . . . . . . . . . . . . . . . . . . . 44-16

Arthur Andersen LLP v. United States. . . . . . . . . . . . . . . . . 46-29

Doe v. Roman Catholic Archdiocese of Indianapolis . . . . . 12-13

AT&T Mobility LLC v. Concepcion. . . . . . . . . . . . . . . . . . . . 2-25

Domingo v. Mitchell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10-3

Ballard v. Dornic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24-7

Drake Manufacturing Company, Inc. v. Polyflow, Inc.. . . . 41-10

Bank of America, N.A. v. Inda . . . . . . . . . . . . . . . . . . . . . . . 32-10

Durham v. McDonald’s Restaurants of Oklahoma, Inc.. . . . . 6-9

Banks v. Lockhart. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-6

Duro Textiles, LLC v. Sunbelt Corporation. . . . . . . . . . . . . . 11-8

Bauer v. Qwest Communications Company, LLC. . . . . . . . 11-14

Dynegy, Inc. v. Yates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16-4

Beau Townsend Ford Lincoln v. Don Hinds Ford. . . . . . . . . 22-6

EEOC v. Kohl’s Dep’t Stores, Inc. . . . . . . . . . . . . . . . . . . . . 51-30

Beer v. Bennett. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22-11

E & G Food Corp. v. Cumberland Farms. . . . . . . . . . . . . . . 32-18

Berghuis v. Thompkins. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-25

Escott v. BarChris Construction Corp.. . . . . . . . . . . . . . . . . 45-22

Bertrand v. Mullin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-20

Evory v. RJM Acquisitions Funding, L.L.C.. . . . . . . . . . . . . 48-26

Bissinger v. New Country Buffet. . . . . . . . . . . . . . . . . . . . . . . 20-6

Exxon Shipping Co. v. Baker. . . . . . . . . . . . . . . . . . . . . . . . . 52-17

Black v. William Insulation Co.. . . . . . . . . . . . . . . . . . . . . . . . 7-22

Farrell v. Macy’s Retail Holdings, Inc.. . . . . . . . . . . . . . . . . . 6-11

Bostock v. Clayton County, Georgia. . . . . . . . . . . . . . . . . . . 51-18

Federal Trade Commission v. Ross. . . . . . . . . . . . . . . . . . . . . 48-4

Bouchat v. Baltimore Ravens Limited Partnership. . . . . . . . . 8-21

Federal Trade Commission v. Staples, Inc.. . . . . . . . . . . . . . 50-10

Branham v. Ford Motor Co. . . . . . . . . . . . . . . . . . . . . . . . . . 20-17

Ferris, Baker Watts, Inc. v. Ernst & Young, LLP . . . . . . . . 46-16

Brehm v. Eisner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43-13

Filer, Inc. v. Staples, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17-5

Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. .50-18

Finch v. Raymer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37-18

Brooks v. Lewin Realty III, Inc.. . . . . . . . . . . . . . . . . . . . . . . . 25-6

Fish v. Tex. Legislative Serv., P’ship. . . . . . . . . . . . . . . . . . . . 38-6

Browning v. Poirier. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16-7

Fitzgerald v. Racing Association of Central Iowa . . . . . . . . . 3-28

Cabot Oil & Gas Corporation v. Daugherty Petroleum, Inc. .11-16

Forcht Bank v. Gribbins. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34-4

Cahaba Disaster Recovery v. Rogers. . . . . . . . . . . . . . . . . . . 22-15

Francini v. Goodspeed Airport, LLC. . . . . . . . . . . . . . . . . . 24-11

Capshaw v. Hickman. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19-18

Frontier Leasing Corp. v. Links Engineering, LLC. . . . . . . . 36-5

CBS Corp. v. FCC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35-7

Gamboa v. Alvarado. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15-18

Cincinnati Insurance Company v. Wachovia  Bank National Association . . . . . . . . . . . . . . . . . . . . . . . . . . 34-10

Garden Ridge, L.P. v. Advance International, Inc.. . . . . . . . 18-22

Citizens National Bank of Paris v. Kids Hope United, Inc.. 26-19

Gelman v. Buehler. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39-6

Citizens United v. Federal Election Commission . . . . . . . . . 3-17

General Credit Corp. v. New York Linen Co.. . . . . . . . . . . 32-19

Clark’s Sales and Service, Inc. v. Smith . . . . . . . . . . . . . . . . . 15-7

George v. Al Hoyt & Sons, Inc.. . . . . . . . . . . . . . . . . . . . . . . 18-20

Coggins v. New England Patriots Football Club, Inc.. . . . . 43-26

Gniadek v. Camp Sunshine at Sebago Lake, Inc.. . . . . . . . . 35-16

Coleman v. Retina Consultants, P.C. . . . . . . . . . . . . . . . . . . . 8-39 Columbia Realty Ventures v. Dang. . . . . . . . . . . . . . . . . . . . . 28-6

Gold v. Deloitte & Touche, LLP (In re NM Holdings  Co., LLC). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46-5

Coma Corporation v. Kansas Department of Labor . . . . . . . 15-2

Grace Label, Inc. v. Kliff. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21-3

Coomer v. Kansas City Royals Baseball Corp.. . . . . . . . . . . . 1-15

Grande v. Jennings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23-7

Gaskell v. University of Kentucky. . . . . . . . . . . . . . . . . . . . . 51-13

xxxix

xl

List of Cases

Green v. Ford Motor Co.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 20-33

Kirtsaeng v. John Wiley & Sons, Inc.. . . . . . . . . . . . . . . . . . . 8-16

Green Garden Packaging Co. v. Schoenmann Produce Co..16-14

Kolodziej v. Mason . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10-8

Green Wood Industrial Company v.  Forceman International Development Group . . . . . . . . . . . 22-13

Kraft, Inc. v. Federal Trade Commission. . . . . . . . . . . . . . . . 48-7

Grimes v. Young Life, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-10

Krupinski v. Deyesso. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42-9

Grodner & Associates v. Regions Bank . . . . . . . . . . . . . . . . 34-13

Kruser v. Bank of America NT & SA. . . . . . . . . . . . . . . . . . 34-21

Guth v. Loft, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43-24

Lach v. Man O’War, LLC. . . . . . . . . . . . . . . . . . . . . . . . . . . 40-17

Gyamfoah v. EG&G Dynatrend (now EG&G  Technical Services) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23-20

Leegin Creative Leather Products v. PSKS, Inc. . . . . . . . . . 49-14

Harrison v. Family Home Builders, LLC . . . . . . . . . . . . . . . 18-10

Lewis-Gale Medical Center, LLC v. Alldredge. . . . . . . . . . . . 8-42

Hecht v. Andover Assoc. Mgmt. Co.. . . . . . . . . . . . . . . . . . . . 40-4

Lincoln Composites, Inc. v. Firetrace USA, LLC . . . . . . . . 20-30

Helena Chemical Co. v. Williamson. . . . . . . . . . . . . . . . . . . . 22-2

Lindh v. Surman. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23-10

Heritage Bank v. Bruha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31-12

Long v. Provide Commerce, Inc.. . . . . . . . . . . . . . . . . . . . . . . 11-2

Hertz Corp. v. Friend. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-10

Lord v. D & J Enterprises, Inc.. . . . . . . . . . . . . . . . . . . . . . . . 7-11

Hicks v. Sparks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-10

Macomb Mechanical, Inc. v. LaSalle Group, Inc. . . . . . . . . . 18-5

Hill v. Nakai (In re Estate of Hannifin) . . . . . . . . . . . . . . . . 26-13

Magri v. Jazz Casino Co., LLC. . . . . . . . . . . . . . . . . . . . . . . . . 7-3

Hillerich & Bradsby Co. v. Charles Products. . . . . . . . . . . . 21-13

Marion T v. Northwest Metals Processors. . . . . . . . . . . . . . . 33-6

Holiday Motor Corp. v. Walters . . . . . . . . . . . . . . . . . . . . . . 20-12

Mark v. FSC Securities Corp.. . . . . . . . . . . . . . . . . . . . . . . . 45-14

Houseman v. Dare. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18-25

Massachusetts v. Environmental Protection Agency. . . . . . 52-10

Huntington National Bank v. Guishard, Wilburn & Shorts. 33-11

Matal v. Tam. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-23

Hutchison v. Kaforey. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26-3

Mathias v. Accor Economy Lodging, Inc.. . . . . . . . . . . . . . . . . 6-3

Hyman v. Capital One Auto Finance . . . . . . . . . . . . . . . . . . 29-21

Mayo Foundation for Medical Education v. United States. . . .47-23

In re Bernard L. Madoff Investment Securities . . . . . . . . . . 30-11

McDonough v. McDonough. . . . . . . . . . . . . . . . . . . . . . . . . . 40-7

In re Borden. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29-15

McLellan v. Charly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12-15

In re Burt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30-30

McMillian v. McMillian. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38-2

In re Caremark Int’l Inc. Derivative Litig. . . . . . . . . . . . . . . 43-20

Medmarc Casualty Insurance Co. v. Avent America, Inc.. . 27-21

In re Foreclosure Cases. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28-15

Meyer v. Christie . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39-4

In re Lance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29-10

Michigan Battery Equipment, Inc. v. Emcasco  Insurance Co.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27-11

In re Made In Detroit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30-24 In re Rogers (Wallace v. Rogers). . . . . . . . . . . . . . . . . . . . . . .30-7

Krakauer v. Dish Network, L.L.C. . . . . . . . . . . . . . . . . . . . . . 35-4

Lehigh Presbytery v. Merchants Bancorp. . . . . . . . . . . . . . . . 32-6

In re Siegenberg. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30-19

Mid-American Salt, LLC v. Morris County Cooperative  Pricing Council. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12-7

James v. City of Costa Mesa. . . . . . . . . . . . . . . . . . . . . . . . . . 1-24

Miller v. Burnett. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25-17

Janke v. Brooks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19-5

Milner v. Department of the Navy . . . . . . . . . . . . . . . . . . . . 47-28

J.D. Fields & Company, Inc. v. United States  Steel International, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10-5

Mitchell Partners, L.P. v. Irex Corp.. . . . . . . . . . . . . . . . . . . 44-24

Johnson v. Bank of America, N.A. . . . . . . . . . . . . . . . . . . . . . 17-9

Montgomery Cellular Holding Co., Inc. v. Dobler. . . . . . . . . 44-8

Johnson v. Fluor Corporation. . . . . . . . . . . . . . . . . . . . . . . . 51-25

Mortgage Grader, Inc. v. Ward & Olivo, L.L.P . . . . . . . . . . 38-15

Johnson v. J. Walter Thompson U.S.A., LLC . . . . . . . . . . . 51-23

Moser v. Moser. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40-11

Jones v. Wells Fargo Bank, N.A.. . . . . . . . . . . . . . . . . . . . . . 33-19

Moss v. Batesville Casket Co.. . . . . . . . . . . . . . . . . . . . . . . . . 20-9

Jordan v. Jewel Food Stores, Inc. . . . . . . . . . . . . . . . . . . . . . . 6-29

MP Nexlevel of Cal., Inc. v. CVIN. . . . . . . . . . . . . . . . . . . . 37-15

J.T. ex rel. Thode v. Monster Mountain, LLC . . . . . . . . . . . . 14-2

Music Acceptance Corp. v. Lofing. . . . . . . . . . . . . . . . . . . . 32-22

Kelo v. City of New London. . . . . . . . . . . . . . . . . . . . . . . . . 24-29

National College Loan Trust 2004-1 v. Irizarry . . . . . . . . . . . 33-4

Kibler v. Hall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-31

National Federation of Independent  Business v. Sebelius . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-9

*

Killian v. Ricchetti. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18-3

Mogilevsky v. Rubicon Technology, Inc.. . . . . . . . . . . . . . . . 24-4



List of Cases

xli

National Music Museum: America’s Shrine to  Music v. Johnson. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19-12

SmithStearn Yachts, Inc. v. Gyrographic  Communications, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42-3

NBN Broadcasting, Inc. v. Sheridan Broadcasting  Networks, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38-12

Sogeti USA LLC v. Scariano. . . . . . . . . . . . . . . . . . . . . . . . . . 17-3

Neumann v. Liles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-14

SRM Global Fund L.P. v. Countrywide Financial Corp.. . . 45-32

Noble Roman’s v. Pizza Boxes . . . . . . . . . . . . . . . . . . . . . . . . 19-9

Stahlecker v. Ford Motor Co.. . . . . . . . . . . . . . . . . . . . . . . . . 7-24

North Atlantic Instruments, Inc. v. Haber . . . . . . . . . . . . . . 35-10

Star Athletica, LLC v. Varsity Brands, Inc.. . . . . . . . . . . . . . . 8-12

North Carolina State Board of Dental  Examiners v. Federal Trade Commission . . . . . . . . . . . . . . 50-26

Steinberg v. United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12-3

Nye Capital Appreciation Partners, L.L.C. v. Nemchik. . . . . 45-5

Stratford v. Long . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24-19

Obergefell v. Hodges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-30

Stuart v. Pittman. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27-3

Obsidian Finance Group, LLC v. Cox . . . . . . . . . . . . . . . . . . 6-24

Supply Chain Assocs., LLC v. ACT Electronics, Inc.. . . . . 41-14

O’Connor v. Oakhurst Dairy. . . . . . . . . . . . . . . . . . . . . . . . . . 1-19

Suture Express, Inc. v. Owens & Minor Distribution, Inc.. . 49-20

Olmsted v. Saint Paul Public Schools. . . . . . . . . . . . . . . . . . 13-15

Synergies3 Tec Services, LLC v. Corvo . . . . . . . . . . . . . . . . 36-11

Omnicare, Inc. v. NCS Healthcare, Inc.. . . . . . . . . . . . . . . . . 43-7

Tan v. Arnel Management Company . . . . . . . . . . . . . . . . . . 25-13

Paciaroni v. Crane . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39-10

Tedeton v. Tedeton. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42-14

Palmatier v. Wells Fargo Financial National Bank. . . . . . . . . 29-4 Paramount Communications, Inc. v. Time, Inc.. . . . . . . . . . 43-18

The Industrial Development Board of the City of  Montgomery v. Russell. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17-11

Patterson v. CitiMortgage, Inc.. . . . . . . . . . . . . . . . . . . . . . . 13-12

Thomas v. Archer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-15

Pearson v. Shalala. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47-7

Timothy v. Keetch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-7

Pelican National Bank v. Provident Bank of Maryland . . . . 31-14

Toms v. Calvary Assembly of God, Inc.. . . . . . . . . . . . . . . . . 7-30

Pena v. Fox. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-5

Town of Freeport v. Ring. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32-3

Peterson v. AT&T Mobility Services, LLC. . . . . . . . . . . . . . 51-38 Philibert v. Kluser. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-17

Toyo Tire North America  Manufacturing, Inc. v. Davis. . . . . . . . . . . . . . . . . . . . . . . . . . 6-35

Pittman v. Henry Moncure Motors. . . . . . . . . . . . . . . . . . . . 21-10

Trapani Construction Co. v. Elliot Group, Inc.. . . . . . . . . . . . 9-6

POM Wonderful LLC v. Coca-Cola Co.. . . . . . . . . . . . . . . . . 8-45

Treadwell v. J.D. Construction Co.. . . . . . . . . . . . . . . . . . . . . 36-7

POM Wonderful, LLC v.  Federal Trade Commission . . . . . 48-9

Tricontinental Industries, Ltd. v.  PricewaterhouseCoopers, LLP . . . . . . . . . . . . . . . . . . . . . . . 46-10

Price v. High Pointe Oil Company, Inc.. . . . . . . . . . . . . . . . . . 1-5 ProMedica Health System, Inc. v. Federal Trade  Commission. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50-6 PWS Environmental, Inc. v. All Clear Restoration  and Remediation, LLC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-14

South Dakota v. Wayfair, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . 3-5

Stephen A. Wheat Trust v. Sparks. . . . . . . . . . . . . . . . . . . . . . 13-4

Triffin v. Sinha. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32-15 Trump Endeavor 12 LLC v. Fernich, Inc. d/b/a The  Paint Spot. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28-19 Tyson Foods, Inc. v. Bouaphakeo. . . . . . . . . . . . . . . . . . . . . . 2-21

Rasmussen v. Jackson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37-12

United States v. Anderson. . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-35

Reynolds Health Care Services, Inc. v. HMNH, Inc.. . . . . . . 44-4

United States v. Domenic Lombardi Realty. . . . . . . . . . . . . 52-24

Riegel v. Medtronic, Inc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 20-37

United States v. Goyal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46-24

Rochester Gas and Electric Corporation. v. Delta Star. . . . 21-17

United States v. Hopkins. . . . . . . . . . . . . . . . . . . . . . . . . . . . 52-13

Rogers v. Household Life Insurance Co.. . . . . . . . . . . . . . . . .14-9

United States v. Hsiung. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49-10

Rosenberg v. N.Y. State Higher Education Services Corp.. 30-16

United States v. Jensen . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43-29

RR Maloan Investment v. New HGE. . . . . . . . . . . . . . . . . . 32-11

United States v. Jones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-17

Safeco Insurance Co. of America v. Burr. . . . . . . . . . . . . . . 48-20

United States v. Microsoft Corp.. . . . . . . . . . . . . . . . . . . . . . 49-28

SEC v. Dorozhko. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45-37

United States v. Newman. . . . . . . . . . . . . . . . . . . . . . . . . . . . 45-40

Sekhar v. United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-8

United States v. Ohio Edison Company. . . . . . . . . . . . . . . . . 52-5

Shaw v. United States. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-13

United States v. Salman. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45-41

Singh v. Uber Technologies Inc.. . . . . . . . . . . . . . . . . . . . . . 15-14

United States v. Southern Union Co. . . . . . . . . . . . . . . . . . . 52-20

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List of Cases

United States Life Insurance Company in the City  of New York v. Wilson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-10

Wendzel v. Feldstein . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25-10

United Techs. Corp. v. Treppel. . . . . . . . . . . . . . . . . . . . . . . 44-14

Wilke v. Woodhouse Ford, Inc.. . . . . . . . . . . . . . . . . . . . . . . 20-25

Urbain v. Beierling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39-8

Winger v. CM Holdings, L.L.C.. . . . . . . . . . . . . . . . . . . . . . . 7-14

Utility Air Regulatory Group v. Environmental  Protection Agency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47-19

World Harvest Church v. Grange Mutual Casualty Co.. . . . 27-18

Valley Bank of Ronan v. Hughes. . . . . . . . . . . . . . . . . . . . . . 34-16

Woven Treasures v. Hudson Capital . . . . . . . . . . . . . . . . . . 29-13

Victory Clothing Co. v. Wachovia Bank, N.A.. . . . . . . . . . . 33-16

Wykeham Rise, LLC v. Federer . . . . . . . . . . . . . . . . . . . . . . 24-13

Volvo Trucks North America, Inc. v.  Reeder-Simco GMC, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . 50-20

Yung-Kai Lu v. University of Utah . . . . . . . . . . . . . . . . . . . . 16-18

Wallis v. Brainerd Baptist Church. . . . . . . . . . . . . . . . . . . . . 17-14

Zaretsky v. William Goldberg Diamond Corp.. . . . . . . . . . . 19-14

Walters v. YMCA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15-10

Zelnick v. Adams. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-7

Weil v. Murray. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21-8

Zimmerman v. Allen . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26-6

Weissman v. City of New York. . . . . . . . . . . . . . . . . . . . . . . 23-15

ZUP, LLC v. Nash Manufacturing, Inc.. . . . . . . . . . . . . . . . . . 8-7

Welsh v. Lithia Vaudm, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . 12-9

Whitman v. American Trucking Associations . . . . . . . . . . . 47-10

World of Boxing LLC v. King. . . . . . . . . . . . . . . . . . . . . . . . 18-15

Zapata Corp. v. Maldonado. . . . . . . . . . . . . . . . . . . . . . . . . . 44-21

t One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One Part One Part One One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One Part One One Part One Part One Part One Part One Part One Part One Part One Part One t One Part One Part One One Part One Part One Part One Part One Part One Part One Part One Part One Part One

Part One

Chapter 1

The Nature of Law

Chapter 2

Foundations of American Law

The Resolution of Private Disputes

Chapter 3

Business and the Constitution

Chapter 4

Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

Pixtal/AGE Fotostock

CHAPTER 1

The Nature of Law

A

ssume that you have taken on a management position at MKT Corp. If MKT is to make sound business decisions, you and your management colleagues must be aware of a broad array of legal considerations. These may range, to use a nonexhaustive list, from issues in contract, agency, and employment law to considerations suggested by tort, intellectual property, securities, and constitutional law. Sometimes, legal principles may constrain MKT’s business decisions; at other times, the law may prove a valuable ally of MKT in the successful operation of the firm’s business. Of course, you and other members of the MKT management group will rely on the advice of in-house counsel (an attorney who is an MKT employee) or of outside attorneys who are in private practice. The approach of simply “leaving the law to the lawyers,” however, is likely to be counterproductive. It will often be up to nonlawyers such as you to identify a potential legal issue or pitfall about which MKT needs professional guidance. If you fail to spot the issue in a timely manner and legal problems are allowed to develop and fester, even the most skilled attorneys may have difficulty rescuing you and the firm from the resulting predicament. If, on the other hand, your failure to identify a legal consideration means that you do not seek advice in time to obtain an advantage that applicable law would have provided MKT, the corporation may lose out on a beneficial opportunity. Either way—that is, whether the relevant legal issue operates as a constraint or offers a potential advantage—you and the firm cannot afford to be unfamiliar with the legal environment in which MKT operates. This may sound intimidating, but it need not be. The process of acquiring a working understanding of the legal environment of business begins simply enough with these basic questions: • What major types of law apply to the business activities and help shape the business decisions of firms such as MKT? • What ways of examining and evaluating law may serve as useful perspectives from which to view the legal environment in which MKT and other businesses operate? • What role do courts play in making or interpreting law that applies to businesses such as MKT and to employees of those firms, and what methods of legal reasoning do courts utilize? • What is the relationship between legal standards of behavior and notions of ethical conduct?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1-1

Identify the respective makers of the different types of law (constitutions, statutes, common law, and administrative regulations and decisions). 1-2 Identify the type of law that takes precedence when two types of law conflict.

1-3 Explain the basic differences between the criminal law and civil law classifications. 1-4 Describe key ways in which the major schools of jurisprudence differ from each other.

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Part One Foundations of American Law

1-5 Describe the respective roles of adhering to precedent (stare decisis) and distinguishing precedent in case law reasoning.

Types and Classifications of Law The Types of Law Identify the respective makers of the different types of law

LO1-1 (constitutions, statutes, common law, and administrative

regulations and decisions).

Constitutions Constitutions, which exist at the state and federal levels, have two general functions.1 First, they set up the structure of government for the political unit they control (a state or the federal government). This involves creating the branches and subdivisions of the government and stating the powers given and denied to each. Through its separation of powers, the U.S. Constitution establishes the Congress and gives it power to make law in certain areas, provides for a chief executive (the president) whose function is to execute or enforce the laws, and helps create a federal judiciary to interpret the laws. The U.S. Constitution also structures the relationship between the federal government and the states. In the process, it respects the principle of federalism by recognizing the states’ power to make law in certain areas. The second function of constitutions is to prevent the government from taking certain actions or passing certain laws, sometimes even if those actions or laws would otherwise appear to fall within the authority granted to the government under the first function. Constitutions do so mainly by prohibiting government action that restricts certain individual rights. The Bill of Rights to the U.S. Constitution is an example. You could see the interaction of those two functions, for instance, where Congress is empowered to regulate interstate commerce but cannot do so in a way that would abridge the First Amendment’s free speech guarantee. Statutes Statutes are laws created by elected representatives in Congress or a state legislature. They are stated in an authoritative form in statute books or codes. As you will see, however, their interpretation and application are often difficult. Chapter 3 discusses constitutional law as it applies to government regulation of business. 1

1-6 Identify what courts focus on when applying the major statutory interpretation techniques (plain meaning, legislative purpose, legislative history, and general public purpose).

Throughout this text, you will encounter state statutes that were originally drafted as uniform acts. Uniform acts are model statutes drafted by private bodies of lawyers and scholars. They do not become law until a legislature enacts them. Their aim is to produce state-by-state uniformity on the subjects they address. Examples include the Uniform Commercial Code (which deals with a wide range of commercial law subjects), the Revised Uniform Partnership Act, and the Revised Model Business Corporation Act. Common Law The common law (also called judge-made law or case law) is law made and applied by judges as they decide cases not governed by statutes or other types of law. Although, as a general matter, common law exists only at the state level, both state courts and federal courts become involved in applying it. The common law originated in medieval England and developed from the decisions of judges in settling disputes. Over time, judges began to follow the decisions of other judges in similar cases, called precedents. This practice became formalized in the doctrine of stare decisis (let the decision stand). As you will see later in the chapter, stare decisis is not completely rigid in its requirement of adherence to precedent. It is flexible enough to allow the common law to evolve to meet changing social conditions. The common law rules in force today, therefore, often differ considerably from the common law rules of earlier times. The common law came to America with the first English settlers, was applied by courts during the colonial period, and continued to be applied after the Revolution and the adoption of the Constitution. It still governs many cases today. For example, the rules of tort, contract, and agency discussed in this text are mainly common law rules. In some instances, states have codified (enacted into statute) some parts of the common law. States and the federal government have also passed statutes superseding the common law in certain situations. As discussed in Chapter 9, for example, the states have established special rules for contract cases involving the sale of goods by enacting Article 2 of the Uniform Commercial Code.



Chapter One The Nature of Law

This text’s torts, contracts, and agency chapters often refer to the Restatement—or Restatement (Second) or (Third)—rule on a particular subject. The Restatements are collections of common law (and occasionally statutory) rules covering various areas of the law. Because they are written by the American Law Institute rather than by courts, the Restatements are not law and do not bind courts. However, state courts often find Restatement rules persuasive and adopt them as common law rules within their states. The Restatement rules usually are the rules followed by a majority of the states. Occasionally, however, the Restatements stimulate changes in the common law by suggesting new rules that the courts later decide to follow.

1-5

Because the judge-made rules of common law apply only when there is no applicable statute or other type of law, common law fills in gaps left by other legal rules if sound social and public policy reasons call for those gaps to be filled. As a result, with regard to the common law, judges sometimes serve in the unexpected role of crafting legal rules in addition to interpreting the law. In Price v. High Pointe Oil Company, Inc., which follows shortly, the court surveys the relevant legal landscape and concludes that a longstanding common law rule should remain in effect. A later section in the chapter will focus on the process of case law reasoning, in which courts engage when they make and apply common law rules. That process is exemplified by the first half of the Price opinion.

Price v. High Pointe Oil Company, Inc.   828 N.W.2d 660 (Mich. 2013) In 2006, Beckie Price replaced the oil furnace in her house with a propane furnace. The oil furnace was removed, but the pipe that had been used to fill the furnace with oil remained in place. At the time the furnace was replaced, Price canceled her contract for oil refills with the predecessor of High Pointe Oil Company, the defendant. Somehow, though, in November 2007, High Pointe mistakenly placed Price’s address back on its “keep full list.” Subsequently, a High Pointe truck driver pumped around 400 gallons of fuel oil into Price’s basement through the oil-fill pipe before realizing the mistake. Price’s house and her belongings were destroyed. The house was eventually torn down, the site was remediated, and a new house was built on a different part of Price’s property. Price’s personal property was all cleaned or replaced. All of her costs related to her temporary homelessness were reimbursed to her, as well. Thus, she was fully compensated for all of her economic losses resulting from High Pointe’s error. Nevertheless, Price sued High Pointe alleging a number of claims. The only of her claims to survive to trial was one focused on her noneconomic losses—for example, pain and suffering, humiliation, embarrassment, and emotional distress. A jury found in Price’s favor and awarded her $100,000 in damages. High Pointe filed an appeal to the intermediate appellate court but lost. High Pointe then appealed to the Michigan Supreme Court, excerpts of whose opinion is below. Markman, J. III. Analysis The question in this case is whether noneconomic damages are recoverable for the negligent destruction of real property. Absent any relevant statute, the answer to that question is a matter of common law.  A. Common Law As this Court explained in [a prior case], the common law “is but the accumulated expressions of the various judicial tribunals in their efforts to ascertain what is right and just between individuals in respect to private disputes[.]” The common law, however, is not static. By its nature, it adapts to changing circumstances. . . . The common law is always a work in progress and typically develops incrementally, i.e., gradually evolving as individual disputes are decided and existing common-law rules are considered and sometimes adapted to current needs in light of changing times and circumstances.

The common-law rule with respect to the damages recoverable in an action alleging the negligent destruction of property was set forth in [a 1933 case]: If injury to property caused by negligence is permanent or irreparable, the measure of damages is the difference in its market value before and after said injury, but if the injury is reparable, and the expense of making repairs is less than the value of the property, the measure of damages is the cost of making repairs. Michigan common law has continually followed [that] rule. . . . Accordingly, the long-held common-law rule in Michigan is that the measure of damages for the negligent destruction of property is the cost of replacement or repair. Because replacement and repair costs reflect economic damages, the logical implication of this rule is that the measure of damages excludes noneconomic damages. Lending additional support to this conclusion is the simple fact that, before the Court of Appeals’ opinion below, no case ever in the history of the Michigan common law has approvingly discussed the recovery of noneconomic damages for the negligent

1-6

Part One Foundations of American Law

destruction of property. Indeed, no case has even broached this issue except through the negative implication arising from limiting damages for the negligent destruction or damage of property to replacement and repair costs. . . . Moreover, the Court of Appeals has decided two relatively recent cases concerning injury to personal property in which noneconomic damages were disallowed. In Koester v. VCA Animal Hospital, the plaintiff dog owner sought noneconomic damages . . . against his veterinarian following the death of his dog . . . . The trial court [ruled in favor of the veterinarian], holding that “emotional damages for the loss of a dog do not exist.” On appeal, the Court of Appeals affirmed, noting that pets are personal property under Michigan law and explaining that there “is no Michigan precedent that permits the recovery of damages for emotional injuries allegedly suffered as a consequence of property damage.” Later, in Bernhardt v. Ingham Regional Medical Center, the plaintiff [accidentally left] her grandmother’s 1897 wedding ring (which was also her wedding ring) and a watch purchased in 1980 around the time of her brother’s murder . . . in the [hospital’s] washbasin and left the hospital. Upon realizing her mistake, the plaintiff contacted the defendant and was advised that she could retrieve the jewelry from hospital security. However, when she tried to retrieve the jewelry, it could not be located. The plaintiff sued, and the defendant . . . argu[ed] that the plaintiff’s damages did not exceed the $25,000 [minimum amount for a valid case in the] trial court. The plaintiff countered that her damages exceeded that limit because the jewelry possessed great sentimental value. The trial court granted the defendant’s motion. On appeal, the Court of Appeals affirmed, citing Koester for the proposition that there “is no Michigan precedent that permits the recovery of damages for emotional injuries allegedly suffered as a consequence of property damage”. . . . In support of its conclusion, Bernhardt quoted the following language from the Restatement Second of Torts: If the subject matter cannot be replaced, however, as in the case of a destroyed or lost family portrait, the owner will be compensated for its special value to him, as evidenced by the original cost, and the quality and condition at the time of the loss. . . . In these cases, however, damages cannot be based on sentimental value. Compensatory damages are not given for emotional distress caused merely by the loss of the things, except that in unusual circumstances damages may be awarded for humiliation caused by deprivation, as when one is deprived of essential elements of clothing. While Koester and Bernhardt both involved negligent injury to personal property, they speak of property generally. Although the Court of Appeals in the instant case seeks to draw distinctions between personal and real property, neither that Court nor plaintiff has explained how any of those distinctions, even if they had some pertinent foundation in the law, are relevant with regard to

the propriety of awarding noneconomic damages. In short, while it is doubtlessly true that many people are highly emotionally attached to their houses, many people are also highly emotionally attached to their pets, their heirlooms, their collections, and any number of other things. But there is no legally relevant basis that would logically justify prohibiting the recovery of noneconomic damages for the negligent killing of a pet or the negligent loss of a family heirloom but allow such a recovery for the negligent destruction of a house. Accordingly, Koester and Bernhardt underscore [the long-standing] exclusion of noneconomic damages for negligent injury to real and personal property. Finally, we would be remiss if we did not address Sutter v. Biggs, which the Court of Appeals cited as providing the “general rule” for the recovery of damages in tort actions. Sutter stated: The general rule, expressed in terms of damages, and long followed in this State, is that in a tort action, the [party that committed the tort] is liable for all injuries resulting directly from his wrongful act, whether foreseeable or not, provided the damages are the legal and natural consequences of the wrongful act, and are such as, according to common experience and the usual course of events, might reasonably have been anticipated. Remote contingent, or speculative damages are not considered in conformity to the general rule. Although Sutter articulates a “general rule,” it is a “general rule” that has never been applied to allow the recovery of noneconomic damages in a case involving only property damage, and it is a “general rule” that must be read in light of the more narrow and specific “general rule” [that Michigan has always followed with regard to the noneconomic damages exclusion in cases involving property damage]. The development of the common law frequently yields “general rules” from which branch more specific “general rules” that apply in limited circumstances. Where tension exists between those rules, the more specific rule controls. . . . With respect to this case, although Sutter articulated a general rule, [the rule excluding noneconomic damages for property damages is] a more specific “general rule”. . . . Accordingly, because this case involves only property damage, the [latter] rule . . . controls. B. Altering the Common Law Because the Court of Appeals determined that the “general rule” is that “in a tort action, the [party who committed the tort] is liable for all injuries,” the Court of Appeals contended that it was not altering the common law but, rather, “declin[ing] to extend” to real property the personal property “exception” set forth in Koester and Bernhardt. However, as previously mentioned, the Court of Appeals’ opinion constitutes the first and only Michigan case to support the recovery of noneconomic damages for the negligent destruction of property. Accordingly, contrary to the Court of Appeals’ own characterization and for the reasons



Chapter One The Nature of Law

1-7

discussed [above], the Court of Appeals’ holding represents an alteration of the common law. With that understanding, we address whether the common law should be altered. “This Court is the principal steward of Michigan’s common law,” . . . and it is “axiomatic that our courts have the constitutional authority to change the common law in the proper case. . . .” However, this Court has also explained that alteration of the common law should be approached cautiously with the fullest consideration of public policy and should not occur through sudden departure from longstanding legal rules. . . . Among them has been our attempt to “avoid capricious departures from bedrock legal rules as such tectonic shifts might produce unforeseen and undesirable consequences.” . . . As this emphasis on incrementalism suggests, when it comes to alteration of the common law, the traditional rule must prevail absent compelling reasons for change. This approach ensures continuity and stability in the law. With the foregoing principles in mind, we respectfully decline to alter the common-law rule that the appropriate measure of damages for negligently damaged property is the cost of replacement or repair. We are not oblivious to the reality that destruction of property or property damage will often engender considerable mental distress, and we are quite prepared to believe that the particular circumstances of the instant case were sufficient to have caused exactly such distress. However, we are persuaded that the present rule is a rational one and justifiable as a matter of reasonable public policy. We recognize that might also be true of alternative rules that could be constructed by this Court. In the final analysis, however, the venerability of the present rule and the lack of any compelling argument that would suggest its objectionableness in light of changing social and economic circumstances weigh, in our judgment, in favor of its retention. Because we believe the rule to be sound, if change is going to come, it must come by legislative alteration. A number of factors persuade us that the longstanding character of the present rule is not simply a function of serendipity or of judicial inertia, but is reflective of the fact that the rule serves legitimate purposes and values within our legal system. First, one of the most fundamental principles of our economic system is that the market sets the price of property. This is so even though every individual values property differently as a function of his or her own particular preferences. . . . Second, economic damages, unlike noneconomic damages, are easily

verifiable, quantifiable, and measurable. Thus, when measured only in terms of economic damages, the value of property is easily ascertainable. . . . Third, limiting damages to the economic value of the damaged or destroyed property limits disparities in damage awards from case to case. Disparities in recovery are inherent in legal matters in which the value of what is in dispute is neither tangible nor objectively determined, but rather intangible and subjectively determined. . . . Fourth, the present rule affords some reasonable level of certainty to businesses regarding the potential scope of their liability for accidents caused to property resulting from their negligent conduct. [U]nder the Court of Appeals’ rule, those businesses that come into regular contact with real ­property—contractors, repairmen, and fuel suppliers, for example—would be exposed to the uncertainty of not knowing whether their exposure to tort liability will be defined by a plaintiff who has an unusual emotional attachment to the property or by a jury that has an unusually sympathetic opinion toward those emotional attachments. Once again, it is not our view that the common-law rule in Michigan cannot be improved, or that it represents the best of all possible rules, only that the rule is a reasonable one and has survived for as long as it has because there is some reasonable basis for the rule and that no compelling reasons for replacing it have been set forth by either the Court of Appeals or plaintiff. We therefore leave it to the Legislature, if it chooses to do so at some future time, to more carefully balance the benefits of the current rule with what that body might come to view as its shortcomings.

Equity The body of law called equity historically concerned itself with accomplishing “rough justice” when common law rules would produce unfair results. In medieval England, common law rules were technical and rigid and the remedies available in common law courts were too few. This meant that some deserving parties could not obtain adequate relief. As

a result, separate equity courts began hearing cases that the common law courts could not resolve fairly. In these equity courts, procedures were flexible, and rigid rules of law were deemphasized in favor of general moral maxims. Equity courts also provided several remedies not available in the common law courts (which generally awarded

IV. Conclusion The issue in this case is whether noneconomic damages are recoverable for the negligent destruction of real property. No Michigan case has ever allowed a plaintiff to recover noneconomic damages resulting solely from the negligent destruction of property, either real or personal. Rather, the common law of this state has long provided that the appropriate measure of damages in cases involving the negligent destruction of property is simply the cost of replacement or repair of the negligently destroyed property. We continue today to adhere to this rule and decline to alter it. Accordingly, we reverse the judgment of the Court of Appeals and remand this case to the trial court for entry of summary disposition in defendant’s favor.

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only money damages or the recovery of property). The most important of these equitable remedies was—and continues to be—the injunction, a court order forbidding a party to do some act or commanding him to perform some act. Others include the contract remedies of specific performance (whereby a party is ordered to perform according to the terms of her contract), reformation (in which the court rewrites the contract’s terms to reflect the parties’ real intentions), and rescission (a cancellation of a contract and a return of the parties to their precontractual position). As was the common law, equity principles were brought to the American colonies and continued to be used after the Revolution and the adoption of the Constitution. Over time, however, the once-sharp line between law and equity has become blurred. Nearly all states have abolished separate equity courts and have enabled courts to grant whatever relief is appropriate, whether it be the legal remedy of money damages or one of the equitable remedies discussed earlier. Equitable principles have been blended together with common law rules, and some traditional equity doctrines have been restated as common law or statutory rules. An example is the doctrine of unconscionability discussed in Chapter 15. Administrative Regulations and Decisions As Chapter 47 reveals, the administrative agencies established by Congress and the state legislatures have acquired considerable power, importance, and influence over business. A major reason for the rise of administrative agencies was the collection of social and economic problems created by the industrialization of the United States that began late in the 19th century. Because legislatures generally lacked the time and expertise to deal with these problems on a continuing basis, the creation of specialized, expert agencies was almost inevitable. Administrative agencies obtain the ability to make law through a delegation (or grant) of power from the legislature. Agencies normally are created by a statute that specifies the areas in which the agency can make law and the scope of its power in each area. Often, these statutory delegations are worded so broadly that the legislature has, in effect, merely pointed to a problem and given the agency wide-ranging powers to deal with it. The two types of law made by administrative agencies are administrative regulations and agency decisions. As do statutes, administrative regulations appear in a precise form in one authoritative source. They differ from statutes, however, because the body enacting regulations is not an elected body. Many agencies have an internal courtlike structure that enables them to hear

cases arising under the statutes and regulations they enforce. The resulting agency decisions are legally binding, though appeals to the judicial system are sometimes allowed. Treaties According to the U.S. Constitution, ­treaties made by the president with foreign governments and approved by two-thirds of the U.S. Senate become “the supreme Law of the Land.” As will be seen, treaties invalidate inconsistent state (and sometimes federal) laws. Ordinances State governments have subordinate units that exercise certain functions. Some of these units, such as school districts, have limited powers. Others, such as counties, municipalities, and townships, exercise various governmental functions. The enactments of counties and municipalities are called ordinances; zoning ordinances are an example. Ordinances resemble statutes, and the techniques of statutory interpretation described later in this chapter typically are used to interpret ambiguous language in ordinances. Executive Orders In theory, the president or a state’s governor is a chief executive who enforces the laws but has no law-making powers. However, these officials sometimes have limited power to issue laws called executive orders. This power normally results from a legislative delegation.

Priority Rules LO1-2

Identify the type of law that takes precedence when two types of law conflict.

Because the different types of law may, from time to time, conflict, rules for determining which type takes priority are necessary. Here, we briefly describe the most important such rules. 1. According to the principle of federal supremacy, the U.S. Constitution, federal laws enacted pursuant to it, and treaties are the supreme law of the land. This means that federal law defeats conflicting state law. 2. Constitutions defeat other types of law within their domain. Thus, a state constitution defeats all other state laws inconsistent with it. The U.S. Constitution, however, defeats inconsistent laws of whatever type. 3. When a treaty conflicts with a federal statute over a purely domestic matter, the measure that is later in time usually prevails. 4. Within either the state or the federal domain, statutes defeat conflicting laws that depend on a legislative



Chapter One The Nature of Law

delegation for their validity. For example, a state statute defeats an inconsistent state administrative regulation. 5. Statutes and any laws derived from them by delegation defeat inconsistent common law rules. Accordingly, either a statute or an administrative regulation defeats a conflicting common law rule. Courts are careful to avoid finding a conflict between the different types of law unless the conflict is clear. In fact, one maxim of statutory interpretation (described later in this chapter) instructs courts to choose an interpretation that avoids unnecessary conflicts with other types of law, particularly constitutions that would preempt the statute. Statutes will sometimes explicitly state

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the enacting legislature’s intent to displace a common law rule. In the absence of that, though, courts will look for significant overlap and inconsistency between a statute and a common law rule to determine that there is a conflict for which the statute must take priority. The following Advance Dental Care, Inc. v. SunTrust Bank case illustrates this. Notice how the court first looks to the statutory language for explicit instruction regarding displacement of the common law rule. Then it considers whether the statute and common law rule overlap, particularly whether the statute offers a sufficient remedy to replace the common law rule. Finally, the court notes an important inconsistency between the statute and the common law rule.

Advance Dental Care, Inc. v. SunTrust Bank    816 F. Supp. 2d 268 (D. Md. 2011)

Michelle Rampersad was an employee of Advance Dental at its dental office in Prince George’s County, Maryland. During a period of more than three years ending in fall 2007, Rampersad took approximately 185 insurance reimbursement checks that were written to Advance Dental and endorsed them to herself. She then took the checks to SunTrust Bank and deposited them into her personal accounts. The checks totaled $400,954.04. Advance Dental filed a lawsuit against SunTrust after it discovered Rampersad’s unauthorized endorsement and deposit of the checks. The lawsuit claimed SunTrust violated two provisions of the Maryland version of the Uniform Commercial Code (UCC) dealing with negligence and conversion. It also stated a claim of negligence pursuant to the common law of Maryland. The court had previously dismissed the UCC negligence claim for reasons not relevant here. In the opinion that follows, the court considers whether Advance Dental’s common-law negligence claim has been displaced by the statutory UCC conversion claim. Alexander Williams, Jr., U.S. District Court Judge III. Legal Analysis In this case of first impression, the Court must determine whether section 3-420 of the Maryland U.C.C. [(the U.C.C. conversion provision)] displaces common-law negligence when a payee seeks to recover from a depositary bank that accepted unauthorized and fraudulently endorsed checks. A. Availability of an Adequate U.C.C. Remedy [C]ourts have held that common-law negligence claims can proceed only in the absence of an adequate U.C.C. remedy. In the present case, it is indisputable that Advance Dental has an adequate U.C.C. remedy—conversion—for which Advance Dental has already filed a claim. Therefore, in light of the overwhelming case law, . . . [the U.C.C. conversion provision] displaces common-law negligence because Advance Dental has an adequate U.C.C. remedy. B. Indistinct Causes of Action with Conflicting Defenses Statutory authority also emphasizes the necessity of displacing common-law negligence in this case. Section 1-103(b) of

the Maryland U.C.C. establishes the U.C.C.’s position regarding the survival of common-law actions alongside the U.C.C.: “[u]nless displaced by the particular provisions of Titles 1-10 of this article, the principles of law and equity . . . shall supplement its provisions. . . .” Since the U.C.C. has no express “displacement” provision, the Court must determine whether [the U.C.C. conversion provision] is a “particular provision” that displaces the common law. The Court finds significant overlap between [the U.C.C. conversion provision] and common-law negligence. [The U.C.C. conversion provision] defines conversion as “payment with respect to [an] instrument for a person not entitled to enforce the instrument or receive payment.” Here, Advance Dental alleges that SunTrust is liable in negligence for allowing Rampersad to fraudulently endorse and deposit checks made payable to Advance Dental into her personal account. Therefore, . . . both negligence and conversion require a consideration of whether there was payment over a wrongful endorsement. The duplicative nature of these two theories suggests the U.C.C.’s intention to create a comprehensive regulation of payment over unauthorized or fraudulent endorsements. . . . In the presence

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of such intent, courts have preempted common-law claims. To do otherwise would destroy the U.C.C.’s attempt to establish reliability, uniformity, and certainty in commercial transactions. Here, Advance Dental’s common-law negligence action has no independent significance apart from [the U.C.C. conversion provision]. In fact, when discussing common-law negligence, Advance Dental simply refers to the same conduct alleged in Count I (conversion) to argue that SunTrust has breached its duty of reasonable and ordinary care. . . . In other words, [the U.C.C. conversion provision] has effectively subsumed common-law negligence claims. Not only is common-law negligence insufficiently distinct from [the U.C.C. conversion provision], but the conflicting

defenses available for each cause of action are also problematic. The U.C.C. is based on the principle of comparative negligence. In contrast, contributory negligence remains a defense for common-law negligence.[2] Displacement is thus required since Maryland courts “hesitate to adopt or perpetuate a common law rule that would be plainly inconsistent with the legislature’s intent. . . .”

Classifications of Law Three common classifi-

of substantive law. A statute making murder a crime, for example, is a rule of substantive law. The rules describing the proper conduct of a trial, however, are procedural. This text focuses on substantive law, although Chapters 2 and 5 examine some of the procedural rules governing civil and criminal cases.

cations of law cut across the different types of law. These classifications involve distinctions between (1) criminal law and civil law; (2) substantive law and procedural law; and (3) public law and private law. One type of law might be classified in each of these ways. For example, a burglary statute would be criminal, substantive, and public; a rule of contract law would be civil, substantive, and private. LO1-3

Explain the basic differences between the criminal law and civil law classifications.

Criminal and Civil Law Criminal law is the law under which the government prosecutes someone for committing a crime. It creates duties that are owed to the public as a whole. Civil law mainly concerns obligations that private parties owe to each other. It is the law applied when one private party sues another. The government, however, may also be a party to a civil case. For example, a city may sue, or be sued by, a construction contractor. Criminal penalties (e.g., imprisonment or fines) differ from civil remedies (e.g., money damages or equitable relief). Although most of the legal rules in this text are civil law rules, Chapter 5 deals specifically with the criminal law. Even though the civil law and the criminal law are distinct bodies of law, the same behavior will sometimes violate both. For instance, if A commits an intentional act of physical violence on B, A may face both a criminal prosecution by the state and B’s civil suit for damages. Substantive Law and Procedural Law Substantive law sets the rights and duties of people as they act in society. Procedural law controls the behavior of government bodies (mainly courts) as they establish and enforce rules

IV. Conclusion For the foregoing reasons [and reasons not included in this edited version of the opinion], the Court GRANTS Defendant’s Renewed Motion to Dismiss Count III of Plaintiff’s Complaint.

Public and Private Law Public law concerns the powers of government and the relations between government and private parties. Examples include constitutional law, administrative law, and criminal law. Private law establishes a framework of legal rules that enables parties to set the rights and duties they owe each other. Examples include the rules of contract, property, and agency.

Jurisprudence LO1-4

Describe key ways in which the major schools of jurisprudence differ from each other.

The various types of law sometimes are called positive law. Positive law comprises the rules that have been laid down by a recognized political authority. Knowing the types of positive law is essential to an understanding of the American legal system and the topics discussed in this text.

The comparative and contributory negligence defenses are discussed in detail in Chapter 7. They address in different manners whether and to what extent a plaintiff’s own negligence in the actions upon which a claim is based ought to excuse the defendant from liability. Here the defenses would be relevant in that SunTrust might argue that Advance Dental was at fault for failing to discover and to prevent Rampersad’s fraudulent activities on its own. 2



Chapter One The Nature of Law

Yet defining law by listing these different kinds of positive law is no more complete or accurate than defining “automobile” by describing all the vehicles going by that name. To define law properly, some say, we need a general description that captures its essence. The field known as jurisprudence seeks to provide such a description. Over time, different schools of jurisprudence have emerged, each with its own distinctive view of the essence of the law.

Legal Positivism One feature common to all types

of law is their enactment by a governmental authority such as a legislature or an administrative agency. This feature underlies the definition of law that characterizes the school of jurisprudence known as legal positivism. Legal positivists define law as the command of a recognized political authority. As the British political philosopher Thomas Hobbes observed, “Law properly, is the word of him, that by right hath command over others.” The commands of recognized political authorities may be good, bad, or indifferent in moral terms. To legal positivists, such commands are valid law regardless of their “good” or “bad” content. In other words, positivists see legal validity and moral validity as entirely separate questions. Some (but not all) positivists say that every properly enacted positive law should be enforced and obeyed, whether just or unjust. Similarly, a judge who views the law through a positivist lens would typically try to enforce the law as written, excluding her own moral views from the process. Note, however, that this does not mean that a positivist is bound to accept the law as static or unchangeable. Rather, a positivist who was unhappy with the law as written would point to established political processes as the appropriate mechanism for the law to evolve (e.g., by lobbying a legislature to amend or repeal a statute).

Natural Law At first glance, legal positivism’s “law is

law, just or not” approach may seem to be perfect common sense. It presents a problem, however, for it could mean that any positive law—no matter how unjust—is valid law and should be enforced and obeyed so long as some recognized political authority enacted it. The school of jurisprudence known as natural law rejects the positivist separation of law and morality. Natural law adherents usually contend that some higher law or set of universal moral rules binds all human beings in all times and places. The Roman statesman Marcus Cicero described natural law as “the highest reason, implanted in nature, which commands what ought to be done and forbids the opposite.” Because this higher law

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determines what is ultimately good and ultimately bad, it serves as a criterion for evaluating positive law. To Saint Thomas Aquinas, for example, “every human law has just so much of the nature of law, as it is derived from the law of nature.” To be genuine law, in other words, positive law must resemble the law of nature by being “good”—or at least by not being “bad.” Unjust positive laws, then, are not valid law under the natural law view. As Cicero put it: “What of the many deadly, the many pestilential statutes which are imposed on peoples? These no more deserve to be called laws than the rules a band of robbers might pass in their assembly.” An “unjust” law’s supposed invalidity does not translate into a natural law defense that is recognized in court, however. Nonetheless, judges may sometimes take natural law-oriented views into account when interpreting the law. As compared with positivist judges, judges influenced by natural law ideas may be more likely to read constitutional provisions broadly in order to strike down positive laws they regard as unjust. They also may be more likely to let morality influence their interpretation of the law. Of course, neither judges nor natural law thinkers always agree about what is moral and immoral—a major difficulty for the natural law position. This difficulty allows legal positivists to claim that only by keeping legal and moral questions separate can we obtain stability and predictability in the law.

American Legal Realism To some, the debate

between natural law and legal positivism may seem disconnected from reality. Not only is natural law unworkable, such people might say, but sometimes positive law does not mean much either. For example, juries sometimes pay little attention to the legal rules that are supposed to guide their decisions, and prosecutors have discretion concerning whether to enforce criminal statutes. In some legal proceedings, moreover, the background, biases, and values of the judge—and not the positive law—drive the result. An old joke reminds us that justice sometimes is what the judge ate for breakfast. Remarks such as these typify the school of jurisprudence known as American legal realism. Legal realists regard the law in the books as less important than the law in action—the conduct of those who enforce and interpret the positive law. American legal realism defines law as the behavior of public officials (mainly judges) as they deal with matters before the legal system. Because the actions of such decision makers—and not the rules in the books—really affect people’s lives, the realists say, this behavior is what deserves to be called law.

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It is doubtful whether the legal realists have ever developed a common position on the relation between law and morality or on the duty to obey positive law. They have been quick, however, to tell judges how to behave. Many realists feel that the modern judge should be a social engineer who weighs all relevant values and considers social science findings when deciding a case. Such a judge would make the positive law only one factor in her decision. Because judges inevitably base their decisions on personal considerations, the realists assert, they should at least do this honestly and intelligently. To promote this kind of decision making, the realists have sometimes favored fuzzy, discretionary standards that allow judges to decide each case according to its unique facts.

Sociological

Jurisprudence  Sociological jurisprudence is a general label uniting several different approaches that examine law within its social context. The following quotation from Justice Oliver Wendell Holmes is consistent with such approaches: The life of the law has not been logic: it has been experience. The felt necessities of the time, the prevalent moral and political theories, intuitions of public policy, avowed or unconscious, even the prejudices which judges share with their fellow-men, have had a good deal more to do than the syllogism in determining the rules by which men should be governed. The law embodies the story of a nation’s development through many centuries, and it cannot be dealt with as if it contained only the axioms and corollaries of a book of mathematics.3

Despite these approaches’ common outlook, there is no distinctive sociological definition of law. If one were attempted, it might go as follows: Law is a process of social ordering reflecting society’s dominant interests and values. Different Sociological Approaches By examining examples of sociological legal thinking, we can add substance to the definition just offered. The “dominant interests” portion of the definition is exemplified by the writings of Roscoe Pound, an influential 20th-century American legal philosopher. Pound developed a detailed and changing catalog of the social interests that press on government and the legal system and thus shape positive law. An example of the definition’s “dominant values” component is the historical school of jurisprudence identified with the 19th-century German legal philosopher Friedrich Karl von Savigny. Savigny saw law as an unplanned, almost unconscious, reflection of the collective spirit of a particular society. In his view,

Oliver Wendell Holmes, The Common Law (1881).

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legal change could only be explained historically, as a slow response to social change. By emphasizing the influence of dominant social interests and values, Pound and Savigny undermine the legal positivist view that law is nothing more than the command of some political authority. The early 20th-century Austrian legal philosopher Eugen Ehrlich went even further in rejecting positivism. He did so by identifying two different “processes of social ordering” contained within our definition of sociological jurisprudence. The first of these is positive law. The second is the “living law,” informal social controls such as customs, family ties, and business practices. By regarding both as law, Ehrlich sought to demonstrate that positive law is only one element within a spectrum of social controls. The Implications of Sociological Jurisprudence  Because its definition of law includes social values, sociological jurisprudence seems to resemble natural law. Most sociological thinkers, however, are concerned only with the fact that moral values influence the law, and not with the goodness or badness of those values. Thus, it might seem that sociological jurisprudence gives no practical advice to those who must enforce and obey positive law. Sociological jurisprudence has at least one practical implication, however: a tendency to urge that the law must change to meet changing social conditions and values. In other words, the law should keep up with the times. Some might stick to this view even when society’s values are changing for the worse. To Holmes, for example, “[t]he first requirement of a sound body of law is, that it should correspond with the actual feelings and demands of the community, whether right or wrong.”

Other Schools of Jurisprudence During the past half century, legal scholars have fashioned additional ways of viewing law, explaining why legal rules are as they are and exploring supposed needs for changes in legal doctrines. For example, the law and economics movement examines legal rules through the lens provided by economic theory and analysis. This movement’s influence has extended beyond academic literature, with law and economics-oriented considerations, factors, and tests sometimes appearing in judicial opinions dealing with such matters as contract, tort, or antitrust law. The critical legal studies (CLS) movement regards law as inevitably the product of political calculation (mostly of the right-wing variety) and longstanding class biases on the part of lawmakers, including judges. Articles published by CLS adherents provide controversial assessments and critiques of legal rules. Given the thrust of CLS and the view it takes of



Chapter One The Nature of Law

lawmakers, however, one would be hard-pressed to find CLS adherents in the legislature or the judiciary. Other schools of jurisprudence that have acquired notoriety in recent years examine law and the legal system from the vantage points of particular groups of persons or sets of ideas. Examples include feminist and queer legal theory and critical disability theory. As you read the excerpts of judicial opinions throughout this text, consider whether one or more of these jurisprudential approaches appear to have influenced the judges’ thinking when interpreting or applying the law. Certainly judges seldom, if ever, explicitly reference those influences, but you may find them lurking significantly between the lines of some of the opinions.

The Functions of Law In societies of the past, people often viewed law as unchanging rules that deserved obedience because they were part of the natural order of things. Most lawmakers today, however, treat law as a flexible tool or instrument for the accomplishment of chosen purposes. For example, the law of negotiable instruments discussed later in this text is designed to stimulate commercial activity by promoting the free movement of money substitutes such as promissory notes, checks, and drafts. Throughout the text, moreover, you see courts manipulating existing legal rules to achieve desired results. One strength of this instrumentalist attitude is its willingness to adapt the law to further the social good. A weakness, however, is the legal instability and uncertainty those adaptations often produce. Just as individual legal rules advance specific purposes, law as a whole serves many general social functions. Among the most important of those functions are: 1. Peacekeeping. The criminal law rules discussed in Chapter 5 further this basic function of any legal system. Also, as Chapter 2 suggests, the resolution of private disputes serves as a major function of the civil law. 2. Checking government power and promoting personal freedom. Obvious examples are the constitutional restrictions examined in Chapter 3. 3. Facilitating planning and the realization of reasonable expectations. The rules of contract law discussed in Chapters 9, 10, 11, 12, 13, 14, 15, 16, 17, and 18 help fulfill this function of law. 4. Promoting economic growth through free competition. The antitrust laws discussed in Chapters 48, 49, and 50 are among the many legal rules that help perform this function.

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5. Promoting social justice. Throughout this century, government has intervened in private social and economic affairs to correct perceived injustices and give all citizens equal access to life’s basic goods. Examples include some of the employment laws addressed in Chapter 51. 6. Protecting the environment. The most important federal environmental statutes are discussed in Chapter 52. Obviously, the law’s various functions can conflict. The familiar clash between economic growth and environmental protection is an example. Chapter 5’s cases dealing with the constitutional aspects of criminal cases illustrate the equally familiar conflict between effective law enforcement and the preservation of personal rights. Only rarely does the law achieve one end without sacrificing others. In law, as in life, there generally is no such thing as a free lunch. Where the law’s objectives conflict, lawmakers may try to strike the best possible balance among those goals. This suggests limits on the law’s usefulness as a device for promoting particular social goals.

Legal Reasoning This text seeks to describe important legal rules affecting business. As texts generally do, it states those rules in what lawyers call “black letter” form, using sentences saying that certain legal consequences will occur if certain events happen. Although it provides a clear statement of the law’s commands, this black letter approach can be misleading. It suggests definiteness, certainty, permanence, and ­predictability—attributes the law frequently lacks. To illustrate, and to give you some idea how lawyers and judges think, we now discuss the two most important kinds of legal reasoning: case law reasoning and statutory interpretation.4 However, we first must examine legal reasoning in general. Legal reasoning is basically deductive, or syllogistic. The legal rule is the major premise, the facts are the minor premise, and the result is the product of combining the two. Suppose a state statute says that a driver operating an automobile between 55 and 70 miles per hour must pay a $50 fine (the rule or major premise) and that Jim Smith drives his car at 65 miles per hour (the facts or minor premise). If Jim is arrested, and if the necessary facts can be proved, he will be required to pay the $50 fine. As you will

The reasoning courts employ in constitutional cases resembles that used in common law cases, but often is somewhat looser. See Chapter 3. 4

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Ethics and Compliance in Action Some schools of jurisprudence discussed in this chapter concern themselves with the relationship between law and notions of morality. These schools of jurisprudence involve considerations related to key aspects of ethical theories, which address ethical issues arising in business contexts, corporate governance, and compliance. Chapter 4 defines major ethical theories. Chapter 44 discusses corporate governance issues in more detail. And compliance, which refers to the processes by which an organization polices its own behavior to ensure that it conforms to applicable laws, is addressed throughout this text. In this Ethics and Compliance in Action feature, we will focus on those parallel considerations between two schools of jurisprudence and several ethical theories.

now see, however, legal reasoning often is more difficult than this example would suggest.

Case Law Reasoning Describe the respective roles of adhering to precedent

LO1-5 (stare decisis) and distinguishing precedent in case law

reasoning.

In cases governed by the common law, courts find the appropriate legal rules in prior cases called precedents. The standard for choosing and applying prior cases to decide present cases is the doctrine of stare decisis, which states that like cases should be decided alike. That is, the present case should be decided in the same way as past cases presenting the same facts and the same legal issues. If no applicable precedent exists, the court is free to develop a new common law rule to govern the case, assuming the court believes that sound public policy reasons call for the development of a new rule. When an earlier case may seem similar enough to the present case to constitute a precedent, but the court deciding the present case nevertheless identifies a meaningful difference between the cases, the court distinguishes the earlier decision. Because every present case differs from the precedents in some respect, it is always possible to spot a factual distinction. For example, one could attempt to distinguish a prior case dealing with a defense to a claim of breach of contract because both parties in that case had black hair, whereas one party in the present case dealing with that same defense has brown hair. Of course, such a distinction would be ridiculous because the difference it identifies is insignificant in moral, social policy, or legal terms. A valid distinction involves a

Natural law’s focus on rights thought to be independent of positive law has parallels in ethical theories that are classified under the rights theory heading. In its concern over unjust laws, natural law finds common ground with the ethical theory known as justice theory. When subscribers to sociological jurisprudence focus on the many influences that shape law and the trade-offs involved in a dynamic legal system, they may explore considerations that relate not only to rights theory or justice theory but also to the theory of utilitarianism and considerations central to shareholder theory. As you study Chapter 4 and later chapters, keep the schools of jurisprudence in mind. Think of them as you consider the extent to which a behavior’s probable legal treatment and the possible ethical assessments of it may correspond or, instead, diverge.

widely accepted ethical or policy reason for treating the present case differently from its predecessor. Because people disagree about moral ideas, public policies, and the degree to which they are accepted, and because all these factors change over time, judges may differ on the wisdom of distinguishing a prior case. This is a source of uncertainty in the common law, but it gives the common law the flexibility to adapt to changing social conditions.5 When a precedent has been properly distinguished, the common law rule it stated does not control the present case. The court deciding the present case may then fashion a new common law rule to govern the case. Consider, for instance, an example involving the employment-at-will rule, the prevailing common law rule regarding employees in the United States. Under this rule, an employee may be fired at any time—and without any reason, let alone a good one— unless a contract between the employer and the employee guaranteed a certain duration of employment or established that the employee could be fired only for certain recognized legal causes. Most employees are not parties to a contract containing such provisions. Therefore, they are employees-at-will. Assume that in a precedent case, an employee who had been doing good work challenged his firing and that the court hearing the case ruled against him on the basis of the employment-at-will rule. Also assume that in a later case, a fired employee has challenged her dismissal. Although the fired employee would appear to be subject to the ­employment-at-will rule applied in the seemingly similar precedent case, the court deciding the later case nevertheless identifies an important difference: that in the later case, Also, though they exercise the power infrequently, courts sometimes completely overrule their own prior decisions. 5



Chapter One The Nature of Law

the employee was fired in retaliation for having reported to law enforcement authorities that her employer was engaging in seriously unlawful business-related conduct. A firing under such ­circumstances appears to offend public policy notwithstanding the general acceptance of the employmentat-will rule. Having properly distinguished the precedent, the court deciding the later case would not be bound by the employment-at-will rule set forth in the precedent and would be free to develop a public policy–based exception under which the retaliatory firing would be deemed wrongful. (Chapter 51 will reveal that courts in a number of states have adopted such an exception to the employment-at-will rule.) The Coomer case, which follows, provides a further illustration of the process of case law reasoning. In Coomer, the Missouri Supreme Court scrutinizes various precedents as it attempts to determine whether Missouri’s courts should extend the so-called baseball rule, under which injuries

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suffered as a result of certain risks that are inherent to an activity—like being struck by a foul ball at a baseball game — are not legally considered to be the fault of the baseball team or stadium, even though it was theoretically possible for the team or stadium to have done more to protect the injured person from the risk. (Negligence law, upon which Coomer’s claim is based, is discussed in depth in Chapter 7.) Ultimately, the court decides not to expand the baseball rule to the facts of Coomer’s case, finding his injury did not result from a risk inherent to attending the baseball game.6

Though mastery of the nuances of the rules of baseball is not necessary to understand the court’s reasoning in the Coomer case, readers who are unfamiliar with baseball may find an explanation of the basics of  the game helpful. One such explanation can be found at www .howbaseballworks.com/FieldofPlay.htm. 6

Coomer v. Kansas City Royals Baseball Corp.   437 S.W.3d 184 (Mo. 2014) On September 8, 2009, John Coomer and his father attended a Major League Baseball game between the Kansas City Royals and the Detroit Tigers. The game, which took place in Kansas City at Kauffman Stadium, was less well attended than normal because it rained most of the day leading up to the first pitch. Early in the game, Coomer and his father moved from their assigned seats to better, empty seats six rows behind the visitor’s dugout. Shortly after Coomer moved to the better seats, Sluggerrr, the mascot for the Royals, mounted the dugout to begin the “Hotdog Launch,” which had been a feature of every Royals home game since 2000. The Launch happened between innings, when Sluggerrr used an air gun to shoot hotdogs from the roof of the visitor’s dugout to fans seated beyond hand-tossing range. When his assistants were reloading the air gun, Sluggerrr tossed hotdogs by hand to the fans seated nearby. Sluggerrr usually tossed the hotdogs underhand while facing the fans, but sometimes he threw them overhand, behind his back, or side-armed. At the game in question, Sluggerrr began to toss hotdogs by hand to fans seated near Coomer, while Sluggerrr’s assistants were reloading the hotdog-shaped air gun. Coomer testified that he saw Sluggerrr turn away from the crowd as if to prepare for a behind-the-back throw, but because Coomer chose that moment to turn and look at the scoreboard, he admits he never saw Sluggerrr throw the hotdog that he claims injured him. Coomer testified only that a “split second later . . . something hit me in the face,” and he described the blow as “pretty forceful.” A couple of days later, Coomer reported that he was “seeing differently” and something “wasn’t right” with his left eye. The problem progressed until, approximately eight days after the incident. Coomer saw a doctor and was diagnosed with a detached retina. Coomer underwent surgeries to repair the retina and to remove a “traumatic cataract” in the same eye. Coomer sued the Kansas City Royals Corp. for, among other things, negligence (i.e., that Sluggerrr’s careless acts, which were the responsibility of the Royals to oversee and control, caused his injury). The Royals did not deny responsibility for Sluggerrr’s acts but instead argued that Sluggerrr did not act negligently and, in any event, that Coomer had accepted the risk posed by Sluggerrr’s hotdog toss by buying a ticket and attending the game. The latter is a theory known as implied primary assumption of risk.7 Among the instructions the trial judge gave to the jury was one asking the jury to decide whether the risk of being injured by Sluggerrr’s hotdog toss is one of the inherent risks of watching a Royals home game, which Coomer assumed merely by attending the game. The jury found in favor of the Royals, and Coomer appealed. Paul C. Wilson, Judge In the past, this Court has held that spectators cannot sue a baseball team for injuries caused when a ball or bat enters the Chapter 7 includes a detailed discussion of the negligence defense of assumption of risk. 7

stands. Such risks are an unavoidable—even desirable—part of the joy that comes with being close enough to the Great American Pastime to smell the new-mown grass, to hear the crack of 42 inches of solid ash meeting a 95-mph fastball, or to watch a diving third baseman turn a heart-rending triple into a soul-soaring double-play. The risk of being injured by Sluggerrr’s hotdog toss,

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on the other hand, is not an unavoidable part of watching the Royals play baseball. That risk is no more inherent in watching a game of baseball than it is inherent in watching a rock concert, a monster truck rally, or any other assemblage where free food or T-shirts are tossed into the crowd to increase excitement and boost attendance. *** II. Implied Primary Assumption of the Risk and the “Baseball Rule” Long before the Kansas City Athletics moved to Oakland and the fledging [sic] Royals joined the Junior Circuit, an overwhelming majority of courts recognized that spectators at sporting events are exposed to certain risks that are inherent merely in watching the contest. Accordingly, under [the] implied primary assumption of the risk, these courts held that the home team was not liable to a spectator injured as a result of such risks. The archetypal example of this application of implied primary assumption of the risk is when a baseball park owner fails to protect each and every spectator from the risk of being injured by a ball or bat flying into the stands. Just as Missouri teams have led (and continue to lead) professional baseball on the field, Missouri courts helped lead the nation in defining this area of the law off the field. More than 50 years ago, this Court was one of the first to articulate the so-called “Baseball Rule”: [W]here a baseball game is being conducted under the customary and usual conditions prevailing in baseball parks, it is not negligence to fail to protect all seats in the park by wire netting, and that the special circumstances and specific negligence pleaded did not aid plaintiff or impose upon the defendant a duty to warn him against hazards which are necessarily incident to baseball and are perfectly obvious to a person in possession of his faculties. Anderson v. Kansas City Baseball Club, 231 S.W.2d 170, 172 (Mo. 1950) (emphasis added). Anderson was based on this Court’s earlier decision in Hudson v. Kansas City Baseball Club, 164 S.W.2d 318, 320 (Mo. 1942), which used the “no duty” language of implied primary assumption of the risk to explain its holding: The basis of the proprietor’s liability is his superior knowledge and if his invitee knows of the condition or hazard there is no duty on the part of the proprietor to warn him and there is no liability for resulting injury because the invitee has as much knowledge as the proprietor does and then by voluntarily acting, in view of his knowledge, assumes the risks and dangers incident to the known condition. Hudson, 164 S.W.2d at 323 (emphasis added) (applying Restatement (Second) of Torts, § 343). Hudson involved a spectator

with personal knowledge of the inherent risk of being injured by a foul ball while watching a baseball game. But, when the Court returned to this same issue eight years later in Anderson, it continued to rely on section 343 of the Restatement (Second) of Torts (i.e., the “open and obvious dangers” doctrine under the rules of premises liability) to extend Missouri’s noduty rule to cases involving baseball spectators with no prior knowledge of baseball or the risks inherent in watching it. All of the cases cited here and many others which are cited in Hudson v. Kansas City Baseball Club . . . emphasize that when due care has been exercised to provide a reasonable number of screened seats, there remains a hazard that spectators in unscreened seats may be struck and injured by balls which are fouled or otherwise driven into the stands. This risk is a necessary and inherent part of the game and remains after ordinary care has been exercised to provide the spectators with seats which are reasonably safe. It is a risk which is assumed by the spectators because it remains after due care has been exercised and is not the result of negligence on the part of the baseball club. It is clearly not an unreasonable risk to spectators which imposes a duty to warn [or protect]. Anderson, 231 S.W.2d at 173 (emphasis added). Anderson and Hudson are just two of the many dozens of cases around the country holding that, as long as some seats directly behind home plate are protected, the team owes “no duty” to spectators outside that area who are injured by a ball or bat while watching a baseball game. Despite being decided by such different courts across so many decades, all of these cases reflect certain shared principles. First, it is not possible for baseball players to play the game without occasionally sending balls or bats (or parts of bats) into the stands, sometimes at unsafe speeds. Second, it is not possible for the home team to protect each and every spectator from such risks without fundamentally altering the game or the spectators’ experience of watching it through such means as: (a) substituting foam rubber balls and bats that will not injure anyone (or be very fun to watch); (b) erecting a screen or other barrier around the entire field protecting all spectators while obstructing their view and making them feel more removed from the action; or (c) moving all spectators at least 600 feet away from home plate in all directions. Third, ordinary negligence principles do not produce reliably acceptable results in these circumstances because the risk of injury (and the extent of the harm) to spectators is substantial, yet the justification for not protecting spectators from that risk can be expressed only in terms of the amusement or entertainment value of watching the sport that brought the spectators to the stadium in the first place. Against this background, Anderson and Hudson (and dozens of Baseball Rule cases around the country) represent a



Chapter One The Nature of Law

conscious decision to favor the collective interests of all spectators by rejecting as a matter of law the individual claims of injured spectators. [T]he rationale [is] now identified as implied primary assumption of the risk, [and] these decisions protect the home team from liability for risks that are inherent in watching a baseball game based on the team’s failure to take steps that could defeat the reason spectators are there at all, i.e., to get as close as they can to the action without interfering with the game they came to watch. But the rationale for this rule—and, therefore, the rule itself— extends only to those risks that the home team is powerless to alleviate without fundamentally altering the game or spectator’s enjoyment of it. As a result, the solid wall of authority in support of the Baseball Rule is badly cracked in cases where a spectator is injured by a ball when the game is not underway or where fans ordinarily do expect to have to keep a careful lookout for balls or bats leaving the field. This Court has not had to address such a question and does not do so now. Moreover, even though the “no duty” rationale of the Baseball Rule applies to risks inherent in watching a baseball game, the home team still owes a duty of reasonable care not to alter or increase such inherent risks. One example, useful both for its facts and its analysis, is Lowe v. California League of Prof. Baseball, 56 Cal. App. 4th 112 (1997). In Lowe, even though the plaintiff was struck by a foul ball, he claimed that his injuries were not caused by that inherent risk. Instead, the plaintiff claimed he was prevented from watching for foul balls because he was repeatedly jostled and distracted by the team’s dinosaur mascot. The court agreed that the Baseball Rule did not bar such a claim: [T]he key inquiry here is whether the risk which led to plaintiff’s injury involved some feature or aspect of the game which is inevitable or unavoidable in the actual playing of the game. . . . Can [this] be said about the antics of the mascot? We think not. Actually, the . . . person who dressed up as Tremor, recounted that there were occasional games played when he was not there. In view of this testimony, as a matter of law, we hold that the antics of the mascot are not an essential or integral part of the playing of a baseball game. In short, the game can be played in the absence of such antics. Id. (emphasis added). Accordingly, even though implied primary assumption of the risk precludes recovery for injuries caused by the inherent risk of being hit by a foul ball while watching a baseball game, Lowe holds that the jury can hold the team liable for such injuries if the negligence of its mascot altered or increased that otherwise inherent risk and this negligence causes the plaintiff’s injuries. Accordingly, the proper application of implied primary assumption of the risk in this case . . . is this: if Coomer was

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injured by a risk that is an inherent part of watching the Royals play baseball, the team had no duty to protect him and cannot be liable for his injuries. But, if Coomer’s injury resulted from a risk that is not an inherent part of watching baseball in person—or if the negligence of the Royals altered or increased one of these inherent risks and caused Coomer’s injury—the jury is entitled to hold the Royals liable for such negligence. . . . *** IV. Being Injured by Sluggerrr’s Hotdog Toss Is Not a Risk Inherent in Watching Royals Baseball According to the Royals, the risk to a spectator of being injured by Sluggerrr’s hotdog toss shares the same essential characteristics as the other risks that this Court (and many others) determined long ago were inherent in watching a baseball game in person, i.e., risks that a spectator will be injured by a flying ball or bat. The Court disagrees. The rationale for barring recovery for injuries from risks that are inherent in watching a particular sport under implied primary assumption of the risk is that the defendant team owner cannot remove such risks without materially altering either the sport that the spectators come to see or the spectator’s enjoyment of it. No such argument applies to Sluggerrr’s hotdog toss. Millions of fans have watched the Royals (and its forebears in professional baseball) play the National Pastime for the better part of a century before Sluggerrr began tossing hotdogs, and millions more people watch professional baseball every year in stadiums all across this country without the benefit of such antics. Some fans may find Sluggerrr’s hotdog toss fun to watch between innings, and some fans may even have come to expect it, but this does not make the risk of injury from Sluggerrr’s hotdog toss an “inherent risk” of watching a Royals game. “[I]nherent” means “structural or involved in the constitution or essential character of something: belonging by nature or settled habit,” Webster’s Third New International Dictionary (1966), at 1163 (emphasis added). There is nothing about the risk of injury from Sluggerrr’s hotdog toss that is “structural” or involves the “constitution or essential character” of watching a Royals game at Kauffman Stadium. The Royals concede that Sluggerrr’s hotdog toss has nothing to do with watching the game of baseball but contend that the Hotdog Launch is a well-established (even customary) part of the overall stadium “experience.” In support, the Royals cite cases that have applied the Baseball Rule to risks that were not created directly from the game. These cases do not support the Royals’ argument. In Loughran v. The Phillies, 888 A.2d 872, 876–77 (Pa. Super. 2005), because a plaintiff was injured when a fielder tossed the ball into the stands after catching the last out of

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the inning, the court held that implied primary assumption of the risk barred the plaintiff’s claims. In rejecting the plaintiff’s claim that the Baseball Rule should not apply because the throw was not part of the game itself, Loughran holds that—even though the “‘no duty’ rule applies only to ‘common, expected, and frequent’ risks of the game”—the link between the game and the risk of being hit with a ball tossed into the stands by a player is undeniable. Id. at 876. Baseball is the reason centerfielder Marlon Byrd was there, just as it was the reason the fans were in the stands (including the many who were yelling for Byrd to toss the ball to them). Here, on the other hand, there is no link between the game and the risk of being hit by Sluggerrr’s hotdog toss. The Hotdog Launch is not an inherent part of the game; it is what the Royals do to entertain baseball fans when there is no game for them to watch. Sluggerrr may make breaks in the game more fun, but Coomer and his 12,000 rain-soaked fellow spectators were not there to watch Sluggerrr toss hotdogs; they were there to watch the Royals play baseball. Somewhat closer to the mark—but still inapposite—is the Royals’ reliance on Cohen v. Sterling Mets, L.P., 840 N.Y.S.2d 527 (N.Y. Sup. Ct. 2007), aff’d 58 A.D.3d (N.Y. App. Div. 2009). A vendor sued the team for injuries caused by a fan who hit the vendor while diving for a souvenir T-shirt that had been tossed into the crowd. The court dismissed these claims, stating: “When a ball is tossed into the stands by a player many spectators rush toward the ball in hopes of getting a souvenir, just as what allegedly occurred here during the t-shirt launch.” Id.

The Royals’ reliance on Cohen highlights one of the basic flaws in its effort to use implied primary assumption to bar Coomer’s claims, and it shows the importance of correctly identifying the risks and activity in each case. [W]hat makes a risk “inherent” for purposes of this doctrine . . . is that the risks are so intertwined (i.e., so “structural” or involved in the “constitution or essential character”) with the underlying activity that the team cannot control or limit the risk without abandoning the activity. In Cohen, because the Mets could not control how fans reacted to the T-shirt launch, that reaction was an inherent risk—not of watching a baseball game but—of taking part in the T-shirt launch (which the plaintiff’s work required him to do). Here, on the other hand, not only is being injured by Sluggerrr’s hotdog toss not an inherent risk of watching a Royals game, it is not an inherent risk of the Hotdog Launch. . . . Accordingly, the Court holds as a matter of law that the risk of injury from Sluggerrr’s hotdog toss is not one of the risks inherent in watching the Royals play baseball that Coomer assumed merely by attending a game at Kauffman Stadium. This risk can be increased, decreased or eliminated altogether with no impact on the game or the spectators’ enjoyment of it. As a result, Sluggerrr (and, therefore, the Royals) owe the fans a duty to use reasonable care in conducting the Hotdog Launch and can be held liable for damages caused by a breach of that duty.

Statutory Interpretation Because statutes are

deliberate ambiguity include the need for legislative compromise and legislators’ desire to avoid taking controversial positions. Ambiguity in statutory language can also arise from the vagaries of grammar, either as a result of sloppiness or because rules of grammar are contested. The following O’Connor case, for instance, illustrates just how much can ride on a “missing” comma, namely millions of dollars in unpaid overtime wages. As you read the case, consider what strategies the judges use to resolve the ambiguity. Those strategies correspond to the techniques of statutory interpretation that are described in the text following the case.

written in one authoritative form, their interpretation might seem easier than case law reasoning. However, this is not so. The natural ambiguity of language serves as one reason courts face difficulties when interpreting statutes. The problems become especially difficult when statutory words are applied to situations the legislature did not foresee. In some instances, legislators may deliberately use ambiguous language when they are unwilling or unable to deal specifically with each situation the statute was enacted to regulate. When this happens, the legislature expects courts and/or administrative agencies to fill in the details on a case-by-case basis. Other reasons for

Conclusion For the reasons set forth above, this Court vacates the judgment and remands the case.



Chapter One The Nature of Law

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O’Connor v. Oakhurst Dairy   851 F.3d 69 (1st Cir. 2017) A group of delivery drivers for Oakhurst Dairy sued the dairy and its parent company for unpaid overtime wages. Oakhurst Dairy processes, bottles, stores, markets, and distributes milk and other dairy products from facilities in Portland, Waterville, Bangor, and Presque Isle, Maine. Oakhurst designated the plaintiff drivers as “route salesmen” on their official job descriptions. The drivers, however, claimed they solely engaged in deliveries of Oakhurst’s products. State and federal wage and hour laws generally require employers to pay their employees a premium wage for any hours the employees work in excess of 40 hours in a given week, unless the employees are exempted from overtime rules by the relevant statutory language. The drivers argued that they were not exempted from the overtime wage requirement in the Maine wage and hour statute, while Oakhurst argued that they were exempt under a provision focused on workers who deal with perishable food products. The district court considered the question and agreed with Oakhurst. The drivers appealed.

BARRON, Circuit Judge For want of a comma, we have this case. It arises from a dispute between a Maine dairy company and its delivery drivers, and it concerns the scope of an exemption from Maine’s overtime law. Specifically, if that exemption used a serial comma to mark off the last of the activities that it lists, then the exemption would clearly encompass an activity that the drivers perform. And, in that event, the drivers would plainly fall within the exemption and thus outside the overtime law’s protection. But, as it happens, there is no serial comma to be found in the exemption’s list of activities, thus leading to this dispute over whether the drivers fall within the exemption from the overtime law or not. The District Court concluded that, despite the absent comma, the Maine legislature unambiguously intended for the last term in the exemption’s list of activities to identify an exempt activity in its own right. But, we conclude that the exemption’s scope is actually not so clear in this regard. And because, under Maine law, ambiguities in the state’s wage and hour laws must be construed liberally in order to accomplish their remedial purpose, we adopt the drivers’ narrower reading of the exemption. I. The Maine overtime law is part of the state’s wage and hour law. The overtime law provides that “[a]n employer may not require an employee to work more than 40 hours in any one week unless 1 1/2 times the regular hourly rate is paid for all hours actually worked in excess of 40 hours in that week.” [S]ome workers who fall within the statutory definition of “employee” nonetheless fall outside the protection of the overtime law due to a series of express exemptions from that law. The exemption to the overtime law that is in dispute here is ­Exemption F.

Exemption F covers employees whose work involves the ­ andling—in one way or another—of certain, expressly enumerh ated food products. Specifically, Exemption F states that the protection of the overtime law does not apply to: “The canning, processing, preserving, freezing, drying, marketing, storing, packing for shipment or distribution of: (1) Agricultural produce; (2) Meat and fish products; and (3) Perishable foods.” The parties’ dispute concerns the meaning of the words “packing for shipment or distribution.” The delivery drivers contend that, in combination, these words refer to the single activity of “packing,” whether the “packing” is for “shipment” or for “distribution.” The drivers further contend that, although they do handle perishable foods, they do not engage in “packing” them. As a result, the drivers argue that, as employees who fall outside Exemption F, the Maine overtime law protects them. Oakhurst responds that the disputed words actually refer to two distinct exempt activities, with the first being “packing for shipment” and the second being “distribution.” And because the delivery drivers do—quite obviously—engage in the “distribution” of dairy products, which are “perishable foods,” Oakhurst contends that the drivers fall within Exemption F and thus outside the overtime law’s protection. * * *    III. Each party recognizes that, by its bare terms, Exemption F raises questions as to its scope, largely due to the fact that no comma precedes the words “or distribution.” But each side also contends that the exemption’s text has a latent clarity, at least after one applies various interpretive aids. Each side then goes on to argue

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that the overtime law’s evident purpose and legislative history confirms its preferred reading. We conclude, however, that Exemption F is ambiguous, even after we take account of the relevant interpretive aids and the law’s purpose and legislative history. For that reason, we conclude that, under Maine law, we must construe the exemption in the narrow manner that the drivers favor, as doing so furthers the overtime law’s remedial purposes. Before explaining our reasons for reaching this conclusion, though, we first need to work our way through the parties’ arguments as to why, despite the absent comma, Exemption F is clearer than it looks. A. First, the text. In considering it, we do not simply look at the particular word “distribution” in isolation from the exemption as a whole. We instead must take account of certain linguistic conventions—canons, as they are often called—that can help us make sense of a word in the context in which it appears. Oakhurst argues that, when we account for these canons here, it is clear that the exemption identifies “distribution” as a stand-alone, exempt activity rather than as an activity that merely modifies the standalone, exempt activity of “packing.” Oakhurst relies for its reading in significant part on the rule against surplusage, which instructs that we must give independent meaning to each word in a statute and treat none as unnecessary. To make this case, Oakhurst explains that “shipment” and “distribution” are synonyms. For that reason, Oakhurst contends, “distribution” cannot describe a type of “packing,” as the word “distribution” would then redundantly perform the role that “­shipment”—as its synonym—already performs, which is to describe the type of “packing” that is exempt. By contrast, Oakhurst explains, under its reading, the words “shipment” and “distribution” are not redundant. The first word, “shipment,” describes the exempt activity of “packing,” while the second, “distribution,” describes an exempt activity in its own right. Oakhurst also relies on another established linguistic convention in pressing its case—the convention of using a conjunction to mark off the last item on a list. Oakhurst notes, rightly, that there is no conjunction before “packing,” but that there is one after “shipment” and thus before “distribution.” Oakhurst also observes that Maine overtime law contains two other lists in addition to the one at issue here and that each places a conjunction before the last item. Oakhurst acknowledges that its reading would be beyond dispute if a comma preceded the word “distribution” and that no comma is there. But, Oakhurst contends, that comma is missing for good reason. Oakhurst points out that the Maine Legislative Drafting Manual expressly instructs that: “when drafting Maine law or rules, don’t use a comma between the penultimate and the last item of a

series.” In fact, Oakhurst notes, Maine statutes invariably omit the serial comma from lists. B. If no more could be gleaned from the text, we might be inclined to read Exemption F as Oakhurst does. But, the delivery drivers point out, there is more to consider. And while these other features of the text do not compel the drivers’ reading, they do make the exemption’s scope unclear, at least as a matter of text alone. The drivers contend, first, that the inclusion of both “shipment” and “distribution” to describe “packing” results in no redundancy. Those activities, the drivers argue, are each distinct. They contend that “shipment” refers to the outsourcing of the delivery of goods to a third-party carrier for transportation, while “distribution” refers to a seller’s in-house transportation of products directly to recipients. And the drivers note that this distinction is, in one form or another, adhered to in [the New Oxford English American Dictionary and Webster’s Third New International Dictionary] definitions. Consistent with the drivers’ contention, Exemption F does use two different words (“shipment” and “distribution”) when it is hard to see why, on Oakhurst’s reading, the legislature did not simply use just one of them twice. After all, if “distribution” and “shipment” really do mean the same thing, as Oakhurst contends, then it is odd that the legislature chose to use one of them (“shipment”) to describe the activity for which “packing” is done but the other (“distribution”) to describe the activity itself. The drivers’ argument that the legislature did not view the words to be interchangeable draws additional support from another Maine statute. That statute clearly lists both “distribution” and “shipment” as if each represents a separate activity in its own right. And because Maine law elsewhere treats “shipment” and “distribution” as if they are separate activities in a list, we do not see why we must assume that the Maine legislature did not treat them that way here as well. After all, the use of these two words to describe “packing” need not be understood to be wasteful. Such usage could simply reflect the legislature’s intention to make clear that “packing” is exempt whether done for “shipment” or for “distribution” and not simply when done for just one of those activities.[a] Next, the drivers point to the exemption’s grammar. The ­drivers note that each of the terms in Exemption F that indisputably names an exempt activity—“canning, processing, preserving,” and so forth on through “packing”—is a gerund. By, contrast, We also note that there is some reason to think that the distinction between “shipment” and “distribution” is not merely one that only a lawyer could love. Oakhurst’s own internal organization chart seems to treat the two as if they are separate activities. [a]



Chapter One The Nature of Law

“distribution” is not. And neither is “shipment.” In fact, those are the only non-gerund nouns in the exemption, other than the ones that name various foods. Thus, the drivers argue, in accord with what is known as the parallel usage convention, that “distribution” and “shipment” must be playing the same grammatical role—and one distinct from the role that the gerunds play. In accord with that convention, the drivers read “shipment” and “distribution” each to be objects of the preposition “for” that describes the exempt activity of “packing.” And the drivers read the gerunds each to be referring to stand-alone, exempt activities—“canning, preserving. . . .” By contrast, in violation of the convention, Oakhurst’s reading treats one of the two non-gerunds (“distribution”) as if it is performing a distinct grammatical function from the other (“shipment”), as the latter functions as an object of a preposition while the former does not. And Oakhurst’s reading also contravenes the parallel usage convention in another way: it treats a non-gerund (again, “distribution”) as if it is performing a role in the list—­ naming an exempt activity in its own right—that gerunds otherwise exclusively perform. Finally, the delivery drivers circle back to that missing comma. They acknowledge that the drafting manual advises drafters not to use serial commas to set off the final item in a list—despite the clarity that the inclusion of serial commas would often seem to bring. But the drivers point out that the drafting manual is not dogmatic on that point. The manual also contains a proviso—“Be careful if an item in the series is modified”—and then sets out several examples of how lists with modified or otherwise complex terms should be written to avoid the ambiguity that a missing serial comma would otherwise create. Thus, the drafting manual’s seeming—and, from a judge’s point of view, entirely welcome—distaste for ambiguous lists does suggest a reason to doubt Oakhurst’s insistence that the missing comma casts no doubt on its preferred reading. For, as the drivers explain, the drafting manual cannot be read to instruct that the comma should have been omitted here if “distribution” was intended to be the last item in the list. In that event, the serial comma’s omission would give rise to just the sort of ambiguity that the manual warns drafters not to create. Still, the drivers’ textual points do not account for what seems to us to be Oakhurst’s strongest textual rejoinder: no conjunction precedes “packing.” Rather, the only conjunction in the exemption—“or”—appears before “distribution.” And so, on the drivers’ reading, the list is strangely stingy when it comes to conjunctions, as it fails to use one to mark off the last listed activity. To address this anomaly, the drivers cite to Antonin Scalia & Bryan Garner, Reading Law: The Interpretation of Legal Texts

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(2012), in which the authors observe that “[s]ometimes drafters will omit conjunctions altogether between the enumerated items [in a list],” in a technique called “asyndeton,” id. at 119. But those same authors point out that most legislative drafters avoid asyndeton. And, the delivery drivers do not provide any examples of Maine statutes that use this unusual grammatical device. Thus, the drivers’ reading of the text is hardly fully satisfying.[b] IV. The text has, to be candid, not gotten us very far. We are reluctant to conclude from the text alone that the legislature clearly chose to deploy the nonstandard grammatical device of asyndeton. But we are also reluctant to overlook the seemingly anomalous violation of the parallel usage canon that Oakhurst’s reading of the text produces. And so—there being no comma in place to break the tie—the text turns out to be no clearer on close inspection than it first appeared. As a result, we turn to the parties’ arguments about the exemption’s purpose and the legislative history.  A. Oakhurst contends that the evident purpose of the exemption strongly favors its reading. The whole point of the exemption, Oakhurst asserts (albeit without reference to any directly supportive text or legislative history), is to protect against the distorting effects that the overtime law otherwise might have on employer decisions about how best to ensure perishable foods will not spoil. And, Oakhurst argues, the risk of spoilage posed by the distribution of perishable food is no less serious than is the risk of spoilage posed by the other activities regarding the handling of such foods to which the exemption clearly does apply.  B. We are not so sure. Any analysis of Exemption F that depends upon an assertion about its clear purpose is necessarily somewhat

The drivers do also contend that their reading draws support from the noscitur a sociis canon, which “dictates that words grouped in a list should be given related meaning.” In particular, the drivers contend that distribution is a different sort of activity than the others, nearly all of which entail transforming perishable products to less perishable forms—“canning,” “processing,” “preserving,” “freezing,” “drying,” and “storing.” However, the list of activities also includes “marketing,” which Oakhurst argues undercuts the drivers’ noscitur a sociis argument. And even if “marketing” does not mean promoting goods or services, as in the case of advertising, and means only “to deal in a market,” . . . it is a word that would have at least some potential commonalities with the disputed word, “distribution.” For that reason, this canon adds little insight beyond that offered by the parallel usage convention. [b]

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Part One Foundations of American Law

speculative. Nothing in the overtime law’s text or legislative history purports to define a clear purpose for the exemption. Moreover, even if we were to share in Oakhurst’s speculation that the legislature included the exemption solely to protect against the possible spoilage of perishable foods rather than for some distinct reason related, perhaps, to the particular dynamics of certain labor markets, we still could not say that it would be arbitrary for the legislature to exempt “packing” but not “distributing” perishable goods. The reason to include “packing” in the exemption is easy enough to conjure. If perishable goods are not packed in a timely fashion, it stands to reason that they may well spoil. Thus, one can imagine the reason to ensure that the overtime law creates no incentives for employers to delay the packing of such goods. The same logic, however, does not so easily apply to explain the need to exempt the activity of distributing those same goods. Drivers delivering perishable food must often inevitably spend long periods of time on the road to get the goods to their destination. It is thus not at all clear that a legal requirement for employers to pay overtime would affect whether drivers would get the goods to their destination before they spoiled. No matter what delivery drivers are paid for the journey, the trip cannot be made to be shorter than it is. Of course, this speculation about the effect that a legal requirement to pay overtime may or may not have on increasing the risk of food spoilage is just that. But such speculation does make us cautious about relying on what is only a presumed legislative purpose to generate a firm conclusion about what the legislature must have intended in drafting the exemption. ***

Identify what courts focus on when applying the major LO1-6 statutory interpretation techniques (plain meaning, legislative purpose, legislative history, and general public purpose).

To deal with the problems of ambiguity that arise from drafting errors, unclear language, or the application of clear language to unanticipated circumstances, courts use various techniques of statutory interpretation. As you saw in the O’Connor case, different techniques may dictate different results in a particular case. Sometimes judges employ the techniques in an instrumentalist or result-oriented fashion, emphasizing the technique that will produce the result they want and downplaying the others. It is, therefore, unclear which technique should control when different techniques yield different results. Judges have considerable latitude in this regard.

C. To be clear, none of this evidence is decisive either way. It does highlight, however, the hazards of simply assuming—on the basis of no more than supposition about what would make sense—that the legislature could not have intended to craft Exemption F as the drivers contend that the legislature crafted it. Thus, we do not find either the purpose or the legislative history fully clarifying. And so we are back to where we began. V. We are not, however, without a means of moving forward. The default rule of construction under Maine law for ambiguous provisions in the state’s wage and hour laws is that they “should be liberally construed to further the beneficent purposes for which they are enacted.” Dir. of Bureau of Labor Standards v. Cormier, 527 A.2d 1297, 1300 (Me. 1987). The opening of the subchapter of Maine law containing the overtime statute and exemption at issue here declares a clear legislative purpose: “It is the declared public policy of the State of Maine that workers employed in any occupation should receive wages sufficient to provide adequate maintenance and to protect their health, and to be fairly commensurate with the value of the services rendered.” Thus, in accord with Cormier, we must interpret the ambiguity in Exemption F in light of the remedial purpose of Maine’s overtime statute. And, when we do, the ambiguity clearly favors the drivers’ narrower reading of the exemption. *** VI. Accordingly, the District Court’s grant of partial summary judgment to Oakhurst is reversed.

A conceptually helpful metaphor here might be to think of a judge approaching a question of statutory interpretation as a repairperson. The various techniques of statutory interpretation described here are the tools he or she might use for a repair job. Sometimes a particular tool is more suited to a particular job, but a repairperson uses his or her judgment in determining which tools to use to accomplish the goal of making the repair. Likewise, a judge retains the freedom to reach in the “statutory interpretation toolbox” for any of the tools described here, but professional norms and experience often guide a judge’s choice, just as it would a repairperson’s. Plain Meaning Courts routinely begin their interpretation of a statute with its actual language. If the statute’s words have a clear, common, accepted meaning, courts often employ the plain meaning rule. This approach calls for the court to apply the statute according to the usual meaning



Chapter One The Nature of Law

of its words, without concerning itself with anything else. At times, this approach is clear and settles the matter. Often, though, judges find the application of plain meaning unhelpful. It may lead to absurd or patently unjust results, or it might simply fail to resolve the ambiguity at issue. In James v. City of Costa Mesa, which follows the description of these statutory interpretation techniques, both the majority and the dissenting judges agree that the plain meaning of the statutory text at issue is ambiguous, even as they disagree as to what that meaning is. Legislative History and Legislative Purpose Courts sometimes refuse to follow a statute’s plain meaning when its legislative history suggests a different result. Almost all courts resort to legislative history when the statute’s language is ambiguous. A statute’s legislative history includes the following sources: reports of investigative committees or law revision commissions that led to the legislation, transcripts or summaries of hearings of legislative committees that originally considered the legislation, reports issued by such committees, records of legislative debates, reports of conference committees reconciling the chambers’ conflicting versions of the law in a bicameral legislature, amendments or defeated amendments to the legislation, other bills not passed by the legislature but proposing similar legislation, and discrepancies between a bill passed by one chamber of a bicameral legislature and the final version of the statute. Sometimes a statute’s legislative history provides no information or conflicting information about its meaning, scope, or purposes. Some sources prove to be more authoritative than others. The worth of debates, for instance, may depend on which legislator (e.g., the sponsor of the bill or an uninformed blowhard) is quoted. Some sources are useful only in particular situations; prior unpassed bills and amendments or defeated amendments are examples. Consider, for instance, whether mopeds are covered by an air pollution statute applying to “automobiles, trucks, buses, and other motorized passenger or cargo vehicles.” If the statute’s original version included mopeds, but this reference was removed by amendment, it is unlikely that the legislature wanted mopeds to be covered. The same might be true if six similar unpassed bills had included mopeds, but the bill that was eventually passed did not, or if one house had passed a bill including mopeds, but mopeds did not appear in the final version of the legislation. Courts use legislative history in two overlapping but distinguishable ways. They may use it to determine what the legislature thought about the specific meaning of statutory language. They may also use it to determine the overall aim, end, or goal of the legislation. In this second case, they then ask whether a particular interpretation of the statute is consistent with this

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legislative purpose. To illustrate the difference between these two uses of legislative history, suppose that a court is considering whether our pollution statute’s “other motorized passenger or cargo vehicles” language includes battery-powered vehicles. The court might scan the legislative history for specific references to battery-powered vehicles or other indications of what the legislature thought about their inclusion. The court might also use the same history to determine the overall aims of the statute and then ask whether including battery-powered vehicles is consistent with those aims. Because the history probably would reveal that the statute’s purpose was to reduce air pollution from internal combustion engines, the court might well conclude that covering battery-powered vehicles would be inconsistent with the legislative purpose and, therefore, decline to include them within the coverage of the statute. General Public Purpose Occasionally, courts construe statutory language in the light of various general public purposes. These purposes are not the purposes underlying the statute in question; rather, they are widely accepted general notions of public policy. For example, the Supreme Court once used the general public policy against racial discrimination in education as an argument for denying tax-exempt status to a private university that discriminated on the basis of race. Prior Interpretations Courts sometimes follow prior cases and administrative decisions interpreting a statute, regardless of the statute’s plain meaning or legislative history. The main argument for following these prior interpretations is to promote stability and certainty by preventing each successive court that considers a statute from adopting its own interpretation. The courts’ willingness to follow a prior interpretation depends on such factors as the number of past courts adopting the interpretation, the authoritativeness of those courts, and the number of years that the interpretation has been followed.8 Maxims Maxims are general rules of thumb employed in statutory interpretation. There are many maxims, which courts tend to use or ignore at their discretion. The O’Connor court used several maxims to interpret the Maine overtime law exemption in the case at the beginning of this section. Note here that this technique is related to, but distinct from, a court’s obligation to follow binding precedent. If a prior interpretation of a statute was handed down by a higher court whose rulings are binding on a lower court, then the lower court must follow that interpretation. As such, the application of binding precedent is not truly considered statutory interpretation. The technique of statutory interpretation that follows prior interpretations of a statute arises when courts look to nonprecedential decisions of other courts for guidance. 8

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Part One Foundations of American Law

The court there referred to the maxims as “canons” of statutory interpretation.   For our purposes, maxim and canon are synonyms. The judge in O’Connor explained the maxim of noscitur a sociis in the second footnote of the opinion. Another example of a maxim is the ejusdem generis rule, which says that when general words follow words of a specific, limited meaning, the general language should be limited to things of the same class as those specifically stated. Suppose that the pollution statute quoted earlier listed 12 types of gas-powered vehicles and ended with the words “and other motorized passenger or cargo vehicles.” In that instance, ejusdem generis probably would dictate that ­battery-powered vehicles not be included. The following James v. City of Costa Mesa case reports the decision of a three-judge panel of the U.S. Court of

Appeals for the Ninth Circuit. Two of the three judges agreed with one interpretation of the statutory language at issue; the third disagreed with that interpretation. The decision of the two judges who agreed is presented as the majority opinion of the court, while the disagreeing judge’s argument is in the dissenting opinion. Notice how each opinion uses plain meaning and legislative history and purpose (with a maxim or two peppered in for good measure) to interpret the language to different conclusions. This illustrates how, regardless of these consistent techniques described here, there is still substantial room for contested judgment in statutory interpretation. Likewise, you should compare and contrast the James court’s application of those techniques with the earlier O’Connor opinion.

James v. City of Costa Mesa   700 F.3d 394 (9th Cir. 2012) Marla James, Wayne Washington, James Armantrout, and Charles Daniel Dejong (collectively referred to here either as “the plaintiffs” or “James,” the name of the lead plaintiff) suffer from serious medical conditions. To alleviate pain associated with their impairments, they each use marijuana, as recommended and monitored by their doctors. In California, where the plaintiffs live, the medical use of marijuana is permissible according to state law. Marijuana, however, remains a controlled substance under the federal Controlled Substances Act (CSA). As a result, it is generally a federal crime to possess and distribute marijuana, even for medical purposes. The plaintiffs filed a lawsuit against the cities of Costa Mesa and Lake Forest, California, for taking steps to close down or otherwise prohibit the operation of marijuana-dispensing facilities within their boundaries. The plaintiffs claimed that the cities’ actions violated Title II of the Americans with Disabilities Act (ADA), which prohibits discrimination on the basis of disability in the provision of public services. The lawsuit asked the court to enjoin the cities’ actions (i.e., issue a decision ordering the cities to stop their efforts to close the marijuana-dispensing facilities). A judge in the U.S. District Court for the Central District of California declined to issue an injunction on the ground that the ADA does not protect against discrimination on the basis of plaintiffs’ marijuana use, even medical marijuana use supervised by a doctor in accordance with state law. The judge based his decision on a determination that the plaintiffs are not entitled to the protection of the ADA in this instance because only a “qualified individual with a disability” is protected from being denied the benefit of public services. The ADA states that “the term ‘individual with a disability’ does not include an individual who is currently engaging in the illegal use of drugs, when the covered entity acts on the basis of such use.” The plaintiffs appealed the District Court’s ruling to the U.S. Court of Appeals for the Ninth Circuit.

Raymond C. Fisher, Circuit Judge This case turns on whether the plaintiffs’ medical marijuana use constitutes “illegal use of drugs[.]” [The ADA] defines “illegal use of drugs” as the use of drugs, the possession or distribution of which is unlawful under the Controlled Substances Act. Such term does not include the use of a drug taken under supervision by a licensed health care professional, or other uses authorized by the Controlled Substances Act or other provisions of Federal law. The parties agree that the possession and distribution of marijuana, even for medical purposes, is generally unlawful under the

CSA, and thus that medical marijuana use falls within the exclusion set forth in [the above definition’s] first sentence. They dispute, however, whether medical marijuana use is covered by one of the exceptions in the second sentence. The plaintiffs contend their medical marijuana use falls within the exception for drug use supervised by a licensed health care professional. There are two reasonable interpretations of the [ADA]’s language excepting from the illegal drug exclusion “use of a drug taken under supervision by a licensed health care professional, or other uses authorized by the Controlled Substances Act or other provisions of Federal law.” The first interpretation—urged by the plaintiffs—is that this language creates two exceptions to



Chapter One The Nature of Law

the illegal drug exclusion: (1) an exception for professionally supervised drug use carried out under any legal authority, and (2) an independent exception for drug use authorized by the CSA or other provisions of federal law. The second interpretation— offered by the cities and adopted by the district court—is that the provision contains a single exception covering all uses authorized by the CSA or other provisions of federal law, including both CSAauthorized uses that involve professional supervision (such as use of controlled substances by prescription . . . and uses of controlled substances in connection with research and experimentation), and other CSA-authorized uses. Under the plaintiffs’ interpretation, their state-sanctioned, doctor-recommended marijuana use is covered under the supervised use exception. Under the cities’ interpretation, the plaintiffs’ state-authorized medical marijuana use is not covered by any exception because it is not authorized by the CSA or another provision of federal law. Although [the definition of “illegal use of drugs”] lacks a plain meaning and its legislative history is not conclusive, we hold, in light of the text and legislative history of the ADA, as well as the relationship between the ADA and the CSA, that the cities’ interpretation is correct. The meaning of [“illegal use of drugs”] cannot be discerned from the text alone. Both interpretations of the provision are somewhat problematic. The cities’ reading of the statute renders the first clause in [the definition]’s second sentence superfluous; if Congress had intended that the exception cover only uses authorized by the CSA and other provisions of federal law, it could have omitted the “taken under supervision” language altogether. But the plaintiffs’ interpretation also fails to give effect to each word of [the statute], for if Congress had really intended that the language excepting “other uses authorized by the Controlled Substances Act or other provisions of Federal law” be entirely independent of the preceding supervised use language, it could have omitted the word “other,” thus excepting “use of a drug taken under supervision by a licensed health care professional, or uses authorized by the Controlled Substances Act.” Moreover, unless the word “other” is omitted, the plaintiffs’ interpretation renders the statutory language outright awkward. One would not naturally describe “the use of a drug taken under supervision by a licensed health care professional, or other uses authorized by the Controlled Substances Act or other provisions of Federal law” unless the supervised uses were a subset of the uses authorized by the CSA and other provisions of federal law. The plaintiffs’ reading thus results not only in surplusage, but also in semantic dissonance. The cities’ interpretation also makes the most sense of the contested language when it is viewed in context. . . . Here, the context reveals Congress’ intent to define “illegal use of drugs” by reference to federal, rather than state, law. [The definition] mentions the CSA by name twice, and [a subsequent provision of the ADA] provides that “[t]he term ‘drug’ means a

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controlled substance, as defined in . . . the Controlled Substances Act.” We therefore conclude that the cities’ interpretation of the statutory text is the more persuasive, though we agree with the dissent that the text is ultimately inconclusive. We therefore look to legislative history, including related congressional activity. The legislative history of this provision, like its text, is indeterminate. It is true, as the plaintiffs point out, that Congress rejected an early draft of the “taken under supervision” exception in favor of a broader version. [The early version excepted drugs taken pursuant to a valid prescription, rather than the use of a drug taken under supervision by a licensed health care professional.] We are not persuaded, however, that this history compels the plaintiffs’ interpretation. Although the expansion of the supervised use exception suggests Congress wanted to cover more than just CSAauthorized prescription-based use, it does not demonstrate that the exception was meant to extend beyond the set of uses authorized by the CSA and other provisions of federal law. The CSA does authorize some professionally supervised drug use that is not prescription-based, and Congress could have intended simply to expand the supervised use exception to encompass all such uses. One House Committee Report does include a brief passage that arguably supports the notion that [the] supervised use language and [the] authorized use language are independent, stating “The term ‘illegal use of drugs’ does not include the use of controlled substances, including experimental drugs, taken under the supervision of a licensed health care professional. It also does not include uses authorized by the Controlled Substances Act or other provisions of federal law.” This discussion is of limited persuasive value, however, because it may rest on the unstated assumption—quite plausible at the time—that professionally supervised use of illegal drugs would always be consistent with the CSA. There is no reason to think that the 1990 Congress that passed the ADA would have anticipated later changes in state law facilitating professional supervision of drug use that federal law does not permit. The first such change came six years later, when California voters passed Proposition 215, now codified as the Compassionate Use Act of 1996. [D]uring and after adoption of the ADA there has been a strong and longstanding federal policy against medical marijuana use outside the limits established by federal law itself. . . . Under the plaintiffs’ view, the ADA worked a substantial departure from this accepted federal policy by extending federal protections to federally prohibited, but state-authorized, medical use of marijuana. That would have been an extraordinary departure from policy, and one that we would have expected Congress to take explicitly. It is unlikely that Congress would have wished to legitimize state-authorized, federally proscribed medical marijuana use without debate, in an ambiguously worded ADA provision. ***

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Affirmed.

2. Legislative History

DISSENT BY: Marsha S. Berzon, Circuit Judge

James’ reading of the statute also accords much better with the overall thrust of the legislative history. That history, while not entirely without ambiguity, strongly supports James’s interpretation.

The statutory interpretation issue at the core of this case is an unusually tough one, as the majority opinion recognizes. Looking at the language of [the definition of “illegal use of drugs”] alone, I would come out where the majority does—concluding that the statute is ambiguous. But unlike the majority, I would not declare a near-draw. Instead, looking at the words alone, I would conclude that the plaintiffs have much the better reading, but not by enough to be comfortable that their interpretation is surely correct. Turning then to the legislative history, I would again declare the plaintiffs the winner, this time sufficiently, when combined with the language considerations, to adopt their interpretation, absent some very good reason otherwise. 1. Statutory Text Although [the definition] is not entirely clear, James has very much the better reading of the statutory language. In James’s view, the phrases “use of a drug taken under supervision by a licensed health care professional” and “other uses authorized by the [CSA]” create two different exceptions, so that the ADA protects use of drugs under supervision of a doctor even when that use is not authorized by the CSA. If Congress intended to carve out only drug use authorized by the CSA, after all, the entire first clause—“the use of a drug under supervision by a licensed health care professional”—would have been unnecessary. a. The use of “other” [T]he word “other” is not necessarily redundant at all. It could be read to indicate that use under supervision of a doctor is meant to be a category of uses entirely subsumed by the larger category of uses authorized by the CSA, but this is not the only possible interpretation. Put another way, omitting the word “other” entirely would certainly have compelled the reading James advances, but its presence does not invalidate her interpretation. There is, after all, a middle ground between these two readings. . . . [T]he two clauses could . . . be seen as partially overlapping, with the group of uses supervised by a doctor partially included within the set of uses authorized by the CSA but also partially independent, encompassing in addition a set of uses not authorized by the CSA. This reading strikes me as the most sensible. Under this interpretation, “other” is not redundant. Instead, it accurately reflects the overlap. Were the “other” not there, the exception would have divided the relevant universe into two nonoverlapping sets. Yet, in fact the CSA authorizes some (but not all) uses of “drugs taken under supervision of a licensed health care professional.” The “other” serves to signal that there is no strict dichotomy between the two phrases, as the bulk of the CSA-­authorized uses are within the broader set covered by the first phrase. ***

a. Evolution of the exception As the majority observes, Congress replaced a draft of the exception that required that use of drugs be “pursuant to a valid ­prescription,” . . . with the broader language eventually enacted. Critically, the House Committee Report restates the exception, once amended, in precisely the cumulative manner I have suggested most accords with the statutory language: “The term ‘illegal use of drugs’ does not include the use of controlled substances, including experimental drugs, taken under the supervision of a licensed health care professional. It also does not include uses authorized by the [CSA] or other provisions of Federal law.” This summary is in no way ambiguous, and indicates at least that members of the House familiar with the statutory language understood it in the manner that, for reasons I have explained, most accords with ordinary principles of grammar and syntax. b. Congressional awareness of medical marijuana The majority discounts any significance in the way the current language is described in the relevant Committee report, observing that California voters did not pass Prop. 215 until 1996 and that there were no state laws in 1990 allowing for professionally supervised use of drugs in a manner inconsistent with the CSA. Congress would not have carefully drafted the exception to include non-CSA authorized medically supervised uses, the majority posits, as no such uses were legal under state law at the time. That explanation for dismissing the best reading of the statute and the only coherent reading of the Committee’s explanation of the statute won’t wash, for several reasons. First, while California in 1996 became the first of the sixteen states that currently legalize medical marijuana, the history of medical marijuana goes back much further, so that use for medical purposes was not unthinkable in 1990. At one time, “almost all States . . . had exceptions making lawful, under specified conditions, possession of marihuana by . . . persons for whom the drug had been prescribed or to whom it had been given by an authorized medical person.” What’s more, the Federal government itself conducted an experimental medical marijuana program from 1978 to 1992, and it continues to provide marijuana to the surviving participants. The existence of these programs indicates that medical marijuana was not a concept utterly foreign to Congress before 1996. *** The upshot is that the statutory language and history, taken together, fit much better with James’s version of what Congress meant than the Cities’.



Chapter One The Nature of Law

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CYBERLAW IN ACTION Section 230 of the Communications Decency Act (CDA), a federal statute, provides that “[n]o provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.” Although § 230 appears in a statute otherwise designed to protect minors against online exposure to indecent material, the broad language of § 230 has caused courts to apply it in contexts having nothing to do with indecent expression. For instance, various courts have held that § 230 protects providers of an interactive computer service (ICS) against liability for defamation when a user of the service creates and posts false, reputation-harming statements about someone else. (ICS is defined in the statute as “any information service, system, or access software provider that provides or enables computer access by multiple users to a computer server.”) With courts so holding, § 230 has the effect of superseding a common law rule of defamation that anyone treated as a publisher or speaker of defamatory material is liable to the same extent as the original speaker or writer of that material. Absent § 230, ICS providers could sometimes face defamation liability under the theory that they are publishers of statements made by someone else. (You will learn more about defamation in Chapter 6.) This application of § 230 illustrates two concepts noted earlier in the chapter: first, that federal law overrides state law when the two conflict, and second, that an applicable statute supersedes a common law rule. Cases in other contexts have required courts to utilize statutory interpretation techniques discussed in this chapter as they determine whether § 230’s shield against liability applies. For example, two cases presented the question whether § 230 protects website operators against liability for alleged Fair Housing Act (FHA) violations based on material that appears on their sites. The FHA states that it is unlawful to “make, print or publish” or to “cause” the making, printing, or publishing of, notices, statements, or advertisements that “with respect to the sale or rental of a dwelling[,] . . . indicate[s] any preference, limitation, or discrimination based on race, color,

Limits on the Power of Courts By now, you

may think that anything goes when courts decide common law cases or interpret statutes. Many factors, however, discourage courts from adopting a freewheeling approach. Their legal training and mental makeup cause judges to be likely to respect established precedents and the will of the legislature. Many courts issue written opinions, which expose judges to academic and professional criticism if the opinions are poorly reasoned. Lower court judges may be

religion, sex, handicap, familial status, or national origin, or an intention to make any such preference, limitation, or discrimination.” A civil rights organization sued Craigslist Inc., which operated a wellknown electronic forum for those who sought to buy, sell, or rent housing and miscellaneous goods and services. The plaintiff alleged that Craigslist users posted housing-related statements such as “No minorities” and “No children” and that those statements constituted FHA violations on the part of Craigslist. In Chicago Lawyers Committee for Civil Rights Under Law, Inc. v. Craigslist, Inc., 519 F.3d 666 (7th Cir. 2008), the U.S. Court of Appeals for the Seventh Circuit affirmed the district court’s dismissal of the plaintiff’s complaint. The Seventh Circuit held that a “natural reading” of § 230 of the CDA protected Craigslist against liability. The statements that allegedly violated the FHA were those of users of the electronic forum—meaning that Craigslist would be liable only if it were treated as a publisher or speaker of the users’ statements. The plain language of § 230, however, prohibited classifying Craigslist as a publisher or speaker of the content posted by the users. Neither did Craigslist “cause” users to make statements of the sort prohibited by the FHA. Using a commonsense interpretation of the word “cause,” the court concluded that merely furnishing the electronic forum was not enough to implicate Craigslist in having “cause[d]” the users’ statements. There were no facts indicating that Craigslist suggested or encouraged statements potentially running afoul of the FHA. Very shortly after the Craigslist decision, a different federal court of appeals decided Fair Housing Council v. Roommates. com, LLC. That case presented the question whether § 230 of the CDA protected Roommates.com against FHA liability for allegedly discriminatory housing-related statements posted by users of Roommates.com’s electronic forum. The case’s basic facts appear in problem case 10 at the end of this chapter. Review those facts and compare them to the facts of the Craigslist case. Then determine whether § 230 protected Roommates.com against liability (as it protected Craigslist) or whether the facts of the Roommates.com case warranted a different outcome.

discouraged from innovation by the fear of being overruled by a higher court. Finally, political factors inhibit judges. For example, some judges are elected, and even judges with lifetime tenure can sometimes be removed. An even more fundamental limit on the power of courts is that they cannot make or interpret law until parties present them with a case to decide. In addition, any such case must be a real dispute. That is, courts generally limit themselves to genuine, existing “cases or controversies”

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Part One Foundations of American Law

between real parties with tangible opposing interests in the lawsuit. Courts generally do not issue advisory opinions on abstract legal questions unrelated to a genuine dispute, and do not decide feigned controversies that parties concoct to seek answers to such questions. Courts may also refuse to decide cases that are insufficiently ripe to have matured into a genuine controversy, or that are moot because there no longer is a real dispute between the parties. Reflecting similar policies is the doctrine of standing to sue, which normally requires that the plaintiff have some direct, tangible, and substantial stake in the outcome of the litigation. State and federal declaratory judgment statutes, however, allow parties to determine their rights and duties

even though their controversy has not advanced to the point where harm has occurred and legal relief may be necessary. This enables them to determine their legal position without taking action that could expose them to liability. For example, if Darlene believes that something she plans to do would not violate Earl’s copyright on a work of authorship but she recognizes that he may take a contrary view, she may seek a declaratory judgment on the question rather than risk Earl’s lawsuit by proceeding to do what she had planned. Usually, a declaratory judgment is awarded only when the parties’ dispute is sufficiently advanced to constitute a real case or controversy.

The Global Business Environment Just as statutes may require judicial interpretation when a dispute arises, so may treaties. The techniques that courts use in interpreting treaties correspond closely to the statutory interpretation techniques discussed in this chapter. Olympic Airways v. Husain, 540 U.S. 644 (2004), furnishes a useful example. In Olympic Airways, the U.S. Supreme Court was faced with an interpretation question regarding a treaty, the Warsaw Convention, which deals with airlines’ liability for passenger deaths or injuries on international flights. Numerous nations (including the United States) subscribe to the Warsaw Convention, a key provision of which provides that in regard to international flights, the airline “shall be liable for damages sustained in the event of the death or wounding of a passenger or any other bodily injury suffered by a passenger, if the accident which caused the damage so sustained took place on board the aircraft or in the course of any of the operations of embarking or disembarking.” A separate provision imposes limits on the amount of money damages to which a liable airline may be subjected. The Olympic Airways case centered around the death of Dr. Abid Hanson, a severe asthmatic, on an international flight operated by Olympic. Smoking was permitted on the flight. Hanson was given a seat in the nonsmoking section, but his seat was only three rows in front of the smoking section. Because Hanson was extremely sensitive to secondhand smoke, he and his wife, Rubina Husain, requested various times that he be allowed, for health reasons, to move to a seat farther away from the smoking section. Each time, the request was denied by an Olympic flight attendant. When smoke from the smoking section began to give Hanson difficulty, he used a new inhaler and walked toward the front of the plane to get some fresher air. Hanson went into respiratory

distress, whereupon his wife and a doctor who was on board gave him shots of epinephrine from an emergency kit that Hanson carried. Although the doctor administered CPR and oxygen when Hanson collapsed, Hanson died. Husain, acting as personal representative of her late husband’s estate, sued Olympic in federal court on the theory that the Warsaw Convention made Olympic liable for Hanson’s death. The federal district court and the court of appeals ruled in favor of Husain. In considering Olympic’s appeal, the U.S. Supreme Court noted that the key issue was one of treaty interpretation: whether the flight attendant’s refusals to reseat Hanson constituted an “accident which caused” the death of Hanson. Noting that the Warsaw Convention itself did not define “accident” and that different dictionary definitions of “accident” exist, the Court looked to a precedent case, Air France v. Saks, 470 U.S. 392 (1985), for guidance. In the Air France case, the Court held that the term “accident” in the Warsaw Convention means “an unexpected or unusual event or happening that is external to the passenger.” Applying that definition to the facts at hand, the Court concluded in Olympic Airways that the repeated refusals to reseat Hanson despite his health concerns amounted to unexpected and unusual behavior for a flight attendant. Although the refusals were not the sole reason why Hanson died (the smoke itself being a key factor), the refusals were nonetheless a significant link in the causation chain that led to Hanson’s death. Given the definition of “accident” in the Court’s earlier precedent, the phrasing, the Warsaw Convention, and the underlying public policies supporting it, the Court concluded that the refusals to reseat Hanson constituted an “accident” covered by the Warsaw Convention. Therefore, the Court affirmed the decision of the lower courts.



Chapter One The Nature of Law

APPENDIX

Reading and Briefing Cases Throughout

this text, you will encounter cases—the judicial opinions accompanying court decisions. These cases are highly edited versions of their much longer originals. What follows are explanations and pointers to assist you in studying cases. 1. Each case has a case name that includes at least some of the parties to the case. Because the order of the parties may change when a case is appealed, do not assume that the first party listed is the plaintiff (the party suing) and the second the defendant (the party being sued). Also, because some cases have many plaintiffs and/or many defendants, the parties discussed in the court’s opinion sometimes differ from those found in the case name. 2. Each case also has a citation, which includes the volume and page number of the legal reporter in which the full case appears, plus the year the case was decided. James v. City of Costa Mesa, for instance, begins on page 394 of volume 700 of the third edition of the Federal Reporter (the official reporter that compiles the published opinions of the U.S. Circuit Courts of Appeal) and was decided in 2012. (Each of the many different legal reporters has its own abbreviation. The list is too long to include here.) In parentheses accompanying the date, we also give you some information about the court that decided the case. For example, “1st Cir.” is the U.S. Court of Appeals for the First Circuit, “D. Md.” is the U.S. District Court for the District of Maryland, “Mich.” is the Supreme Court of Michigan, and “Minn. Ct. App.” is the Minnesota Court of Appeals (a Minnesota intermediate appellate court). Chapter 2 describes the various kinds of courts. 3. At the beginning of each case, there is a statement of facts containing the most important facts that gave rise to the case. These appear in italics and are largely written by the authors of this text, though some of the language may be that of the court. 4. As part of the statement of facts, we give you the case’s procedural history. This history tells you what courts previously handled the case you are reading, and how they dealt with it. 5. Next comes your major concern: the body of the court’s opinion. Here, the court determines the applicable law and applies it to the facts to reach a conclusion. The court’s discussion of the relevant law may be elaborate; it may include prior cases, legislative history,

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applicable public policies, and more. The court’s application of the law to the facts usually occurs after it has arrived at the applicable legal rule(s), but also may be intertwined with its legal discussion. 6. At the very end of the case, we complete the procedural history by stating the court’s decision. For example, “Judgment reversed in favor of Smith” says that a lower court judgment against Smith was reversed on appeal. This means that Smith’s appeal was successful and Smith wins. 7. The cases’ main function is to provide concrete examples of rules stated in the text. (Frequently, the text tells you what point the case illustrates.) In studying law, it is easy to conclude that your task is finished once you have memorized a black letter rule. Real-life legal problems, however, seldom present themselves as abstract questions of law; instead, they are hidden in particular situations one encounters or particular actions one takes. Without some sense of a legal rule’s real-life application, your knowledge of that rule is incomplete. The cases help provide this sense. 8. You may find it helpful to brief the cases. There is no one correct way to brief a case, but most good briefs contain the following elements: (1) a short statement of the relevant facts, (2) the case’s prior history, (3) the question(s) or issue(s) the court had to decide, (4) the answer(s) to those question(s), (5) the reasoning the court used to justify its decision, and (6) the final result. A brief of Price v. High Pointe Oil Company, Inc. (a case included earlier) might look this way: Price v. High Pointe Oil Company, Inc. Facts Beckie Price’s house and all of her personal belongings were destroyed when High Pointe erroneously filled her basement with 400 gallons of oil through an oil fill pipe that formerly led to an oil furnace in the basement. Price had replaced the oil furnace with a propane furnace a year earlier and canceled her fill order with High Pointe. Somehow, though, her address was mistakenly included on a “keep full list.” Despite the fact that Price’s house was eventually rebuilt, her land was remediated, her personal belongings cleaned or replaced, and her expenses while she was displaced from her home covered, she sued High Pointe for negligence, including claims for noneconomic damages. History A Michigan jury found for Price on the claim they heard and awarded her $100,000. The Michigan appellate court affirmed. High Pointe appealed to the Michigan Supreme Court. Issues Should the Michigan common law include the recognition of noneconomic damages for the negligent destruction of real property?

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Part One Foundations of American Law

Holdings Michigan common law has never allowed the recovery of noneconomic damages for the negligent destruction of real or personal property and the court will not adopt a new common law rule doing so in this case. Reasoning The longstanding rule in Michigan is that the remedy for the negligent destruction of property is the market value of the property if it is destroyed or the repair cost of the property if it is only damaged. No cases have ever held differently. Two recent cases applied the exclusion of noneconomic damages to claims regarding personal property, and the Court found that the current case was not distinguishable from those cases. Consistent with the proper caution courts should exercise when considering changing the common law, the Court further declined to modify that longstanding rule for a number of reasons. The rule is rational and can be

Problems and Problem Cases 1. In August 2002, Dayle Trentadue, as the daughter and representative of the estate of Margarette Eby, sued various parties for their part in Eby’s 1986 murder at the home she rented in Flint, Michigan. The murder had been unsolved from 1986 until 2002, when DNA evidence established that Jeffrey Gorton had committed the crime. Gorton worked for his parents’ corporation, which serviced the sprinkler system on the grounds surrounding the rental home where Eby lived. In addition to Gorton, Trentadue sued Gorton’s parents, their corporation, the estate of the rentalhome owner, the property management company that managed the rental home, and two employees of the rental-home owner. The claims against the parties other than Gorton were negligence-based wrongful death theories. Those parties asked the court to dismiss Trentadue’s lawsuit against them, claiming the action was barred by Michigan’s three-year statute of limitations for wrongful death actions. Statutes of limitations require that a plaintiff who wishes to make a legal claim must file her lawsuit within a designated length of time after her claim accrues. Normally a claim accrues at the time the legal wrong was committed. If the plaintiff does not file her lawsuit within the time specified by the applicable statute of limitations, her claim cannot lawfully be pursued. The defendants other than Gorton argued that Trentadue’s case should be dismissed because her

justified by important considerations of public policy, including: 1. A reliance on the market for valuation of property; 2. Easy verifiability, quantifiability, and measurability of economic damages (and concomitant difficulty of those in noneconomic damages); 3. Avoidance of disparity among the valuation of the same property in different cases; and 4. Certainty for businesses that have frequent contact with property and might damage it through negligence. The Legislature is the appropriate entity to change the rule if it sees fit. Result The Supreme Court of Michigan reversed the judgment of the Court of Appeals and remanded the case to the trial court to enter judgment in favor of High Pointe.

claim accrued when Eby was killed in 1986—­meaning that the 2002 filing of the lawsuit occurred long after the three-year period had expired. Trentadue responded that a common law rule known as the “discovery rule” should be applied so as to suspend the running of the limitations period until 2002, when she learned the identity of Eby’s killer. Under the discovery rule, the 2002 filing of the lawsuit would have been timely because the limitations period would have been tolled, or suspended, until the 2002 discovery that Gorton was the murderer. The Michigan Compiled Laws (MCL)—the statute that includes the relevant three-year statute of limitations for wrongful death claims—does not include a tolling provision similar to the common law discovery rule for wrongful death claims, even though it does in other areas. Nonetheless, the statute likewise does not explicitly reject the discovery rule. How should the court determine whether the common law discovery rule applies to Trentadue’s claims or whether it has been displaced by the MCL’s statute of limitations? 2. Which of the following types of law will have priority in the event that they present an unresolvable and unavoidable conflict? • A federal administrative regulation and a state statute. • A federal statute and the U.S. Constitution. • A federal statute and a federal administrative regulation.



Chapter One The Nature of Law

• A state constitution and a treaty that has been ratified by Congress. 3. The Freedom of Access to Clinic Entrances Act (FACE), a federal statute, provides for penalties against anyone who “by force or threat of force or by physical obstruction . . . intentionally injures, intimidates, or interferes . . . with any person . . . in order to intimidate such person . . . from obtaining or providing reproductive health services.” Two persons, Lynch and Moscinski, blocked access to a clinic that offered such services. The federal government sought an injunction barring Lynch and Moscinski from impeding access to, or coming within 15 feet of, the clinic. In defense, the defendants argued that FACE protects the taking of innocent human life, that FACE is therefore contrary to natural law, and that, accordingly, FACE should be declared null and void. A federal district court issued the injunction after finding that Lynch and Moscinski had violated FACE by making entrance to the clinic unreasonably difficult. On appeal, the defendants maintained that the district court erred in not recognizing their natural law argument as a defense. Were the defendants correct? 4. Many states and localities used to have so-called Sunday Closing laws—statutes or ordinances forbidding certain business from being conducted on Sunday. A few may still have such laws. Often, these laws have not been obeyed or enforced. What would an extreme legal positivist tend to think about the duty to enforce and obey such laws? What would a natural law exponent who strongly believes in economic freedom tend to think about this question? What about a natural law adherent who is a Christian religious traditionalist? What observation would almost any legal realist make about Sunday Closing laws? With these laws looked at from a sociological perspective, finally, what social factors help explain their original passage, their relative lack of enforcement today, and their continued presence on the books despite their lack of enforcement? 5. Keith Rawlins and his daughter, Jenna, attended the July 20, 2012, baseball game between the Cleveland Indians and the Baltimore Orioles. That night, following the game, the Indians were hosting a post-game fireworks display. As a result, the Cleveland Fire Department ordered that certain sections of spectator seating had to be vacated prior to the display. The Rawlinses’ seats were in one of those sections. Rawlins and his daughter claimed that ushers indicated that they had to vacate their seats prior to the end of the game. Though they

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did not want to leave, they complied, and as they proceeded up the steps to leave the stadium, Rawlins was struck in the head with a foul ball. Rawlins was seriously injured as a result, and Jenna suffered emotional trauma from seeing her father injured in this way. They sued the Indians. Based on the discussion of the common law “baseball rule” in the Coomer case in this chapter and the precedents that applied and declined to apply it, if you were the judge in this case, would you apply the baseball rule to shield the Cleveland Indians from liability or would you distinguish this case from those where the baseball rule applies? Why? 6. Linda Hagan and her sister Barbara Parker drank from a bottle of Coke that they both agreed tasted flat. Hagan then held the bottle up to a light and observed what she and Parker thought was a used condom with “oozy stringy stuff coming out of the top.” Both women were distressed that they had consumed some foreign material, and Hagan immediately became nauseated. The bottle was later delivered to Coca-Cola for testing. Concerned about what they had drunk, the women went to a health care facility the next day and were given shots. The medical personnel at the clinic told them that they should be tested for HIV. Hagan and Parker were then tested and informed that the results were negative. Six months later, both women were again tested for HIV, and the results were again negative. Hagan and Parker brought a negligence action against Coca-Cola. Coca-Cola’s beverage analyst testified at trial that he had initially thought, as Hagan and Parker had, that the object in the bottle was a condom; however, upon closer examination, he concluded that the object was a mold and that, to a “scientific certainty,” the item floating in the Coke bottle was not a condom.  There is case law that lays out the so-called impact rule in negligence claims. The rule requires that before a plaintiff may recover damages for emotional distress, she must demonstrate that the emotional stress suffered flowed from injuries sustained in an impact. Nonetheless, there are a number of exceptions to the impact rule, in which a lack of physical impact would not preclude an otherwise viable claim for emotional distress. Those exceptions include bystander cases, wrongful birth cases, negligent stillbirth cases, and bad-faith claims against insurance carriers. Other courts had found that ingestion of a contaminated product could serve in the place of the traditionally required impact. Given that Hagan and Parker’s claim is in common law, how should the court go about determining whether the impact rule applies to their case?

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Part One Foundations of American Law

7. The federal Age Discrimination in Employment Act (ADEA) makes it unlawful for employers “to fail or refuse to hire or to discharge any individual or otherwise discriminate against any individual with respect to his compensation, terms, conditions, or privileges of employment, because of such individual’s age.” The ADEA also provides that the statute’s protection against discrimination applies only when the affected individual is at least 40 years of age. A pre-1997 collective bargaining agreement between the United Auto Workers (UAW) and General Dynamics Land Systems, Inc. (GDLS) called for GDLS to furnish health benefits to retired employees who had worked for the company for a qualifying number of years. In 1997, however, the UAW and GDLS entered into a new collective bargaining agreement that eliminated the obligation of GDLS to provide health benefits to employees who retired after the effective date of the new agreement, except for then-current workers who were at least 50 years old at the time of the agreement. Employees in that 50-and-over category would still receive health benefits when they retired. Dennis Cline and certain other GDLS employees objected to the new collective bargaining agreement because they were under 50 years of age when the agreement was adopted, and thus would not receive health benefits when they retired. Cline and the other objecting employees were all at least 40 years of age. In a proceeding before the Equal Employment Opportunity Commission (EEOC), Cline and the similarly situated employees asserted that the 1997 agreement violated the ADEA because they were within the ADEA’s protected class of persons (those at least 40 years of age) and because the agreement discriminated against them “with respect to . . . compensation, terms, conditions, or privileges of employment, because of [their] age” (quoting the ADEA). They contended that age discrimination occurred when their under-50 age served as the basis for denying them the more favorable treatment to be received by persons 50 years of age or older. After no settlement occurred despite the EEOC’s encouragement, Cline and the similarly situated employees sued GDLS for a supposed violation of the ADEA. In asserting that they had been discriminated against in favor of older workers, did Cline and the other plaintiffs state a valid claim under the ADEA? 8. A federal statute known as the Freedom of Information Act (FOIA) establishes a general rule that federal agencies must make records and documents publicly

available upon submission of a proper request. However, if those records or documents fall within certain exemptions set forth in FOIA, they can be withheld from public disclosure. After the Federal Communications Commission (FCC) conducted an investigation of AT&T regarding AT&T’s possible overbilling of the government under an FCC-administered program, the FCC and AT&T entered into an agreement to settle any allegations of wrongdoing. The agreement included a payment from AT&T to the government of $500,000, though AT&T admitted no wrongdoing. Subsequently, a trade association and some of AT&T’s competitors submitted a FOIA request to the FCC for records related to the investigation. The FCC withheld certain documents that contained AT&T trade secrets, pursuant to a specific FOIA exemption. But the FCC determined that other documents not containing trade secrets had to be disclosed despite AT&T’s contention that they should not be disclosed under Exemption 7(C), which exempts “records or information compiled for law enforcement purposes” if the records “could reasonably be expected to constitute unwarranted invasion of personal privacy.” The FCC determined that Exemption 7(C) did not apply because corporations like AT&T, unlike humans, do not possess “personal privacy” interests. This dispute ultimately ended up in court, requiring judges to determine the meaning of “personal privacy” in Exemption 7(C). How might a judge go about determining whether Exemption 7(C) applies to AT&T’s interests? 9. Law enforcement officers arrived at a Minnesota residence in order to execute arrest warrants for Andrew Hyatt. During the officers’ attempt to make the arrest, Hyatt yelled something such as, “Go ahead, just shoot me, shoot me,” and struck one of the officers. Another officer then called for assistance from City of Anoka, Minnesota, police officer Mark Yates, who was elsewhere in the residence with his leashed police dog, Chips. Yates entered the room where Hyatt was, saw the injured officer’s bloodied face, and observed Hyatt standing behind his wife (Lena Hyatt). One of the officers acquired the impression that Lena may have been serving as a shield for her husband. When Andrew again yelled, “Shoot me, shoot me” and ran toward the back of the room, Yates released Chips from the leash. Instead of pursuing Andrew, Chips apprehended Lena, taking her to the ground and performing a “bite and hold” on her leg and arm. Yates then pursued Andrew, who had fled through a window. When Yates



Chapter One The Nature of Law

later reentered the room, he released Chips from Lena and instructed another officer to arrest her on suspicion of obstruction of legal process. Lena was taken by ambulance to a hospital and treated for lacerations on her elbow and knee. She later sued the City of Anoka, seeking compensation for medical expenses and pain and suffering. Her complaint alleged liability on the basis of Minnesota’s dog bite statute, which read as follows: If a dog, without provocation, attacks or injures any person who is acting peaceably in any place where the person may lawfully be, the owner of the dog is liable in damages to the person so attacked or injured to the full amount of the injury sustained. The term “owner” includes any person harboring or keeping a dog but the owner shall be primarily liable. The term “dog” includes both male and female of the canine species. In defense, the city argued that the dog bite statute does not apply to police dogs and municipalities that own them. Was the city correct? 10. Roommates.com, LLC (“Roommates”) operated a widely used website designed to match people renting out spare rooms with people looking for a place to live. Before subscribers to Roommates could search listings or post housing opportunities on the website, they had to create profiles by answering a series of questions. Besides requesting basic information such as name, location, and e-mail address, Roommates required each subscriber to disclose his or her sex and sexual orientation and whether he or she would bring children to a household. Each subscriber was further required to describe his or her roommate preferences with respect to the same

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three criteria (sex, sexual orientation, and whether children would be brought to the household). Roommates also encouraged subscribers to provide “Additional Comments” describing themselves and their desired roommate in an open-ended essay. After a new subscriber completed the application, Roommates would assemble his or her answers into a profile page. Subscribers to Roommates were entitled to view their own profile pages and those of others, send personal e-mail messages through the site, and receive notices from Roommates regarding available housing opportunities matching their preferences. The Fair Housing Councils of the San Fernando Valley and San Diego (“Councils”) sued Roommates, alleging that its activities violated the federal Fair Housing Act (“FHA”). The FHA prohibits discrimination in the sale or rental of housing on the basis of “race, color, religion, sex, familial status, or national origin.” The FHA also bars mak[ing], print[ing], or publish[ing], or caus[ing] to be made, printed, or published, any notice, statement, or advertisement, with respect to the sale or rental of a dwelling that indicates any preference, limitation, or discrimination based on race, color, religion, sex, handicap, familial status, or national origin, or an intention to make any such preference, limitation, or discrimination. Roommates argued, however, that it was immune from liability under § 230 of the federal Communications Decency Act, which provides that “[n]o provider . . . of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.” Did § 230 protect Roommates against liability?

CHAPTER 2

The Resolution of Private Disputes

A

llnews Publishing Inc., a firm whose principal offices are located in Orlando, Florida, owns and publishes 33 newspapers. These newspapers are published in 21 different states of the United States. Among the Allnews newspapers is the Snakebite Rattler, the lone newspaper in the city of Snakebite, New Mexico. The Rattler is sold in print form only in New Mexico. However, many of the articles in the newspaper can be viewed by anyone with Internet access, regardless of his or her geographic location, by going to the Allnews website. In a recent Rattler edition, an article appeared beneath this headline: “Local Business Executive Sued for Sexual Harassment.” The accompanying article, written by a Rattler reporter (an Allnews employee), stated that a person named Phil Anderson was the defendant in the sexual harassment case. Besides being married, Anderson was a wellknown businessperson in the Snakebite area. He was active in his church and in community affairs in both Snakebite (his city of primary home) and Petoskey, Michigan (where he and his wife have a summer home). A stock photo of Anderson, which had been used in connection with previous Rattler stories mentioning him, appeared alongside the story about the sexual harassment case. Anderson, however, was not the defendant in that case. He was named in the Rattler story because of an error by the Rattler reporter. The actual defendant in the sexual harassment case was a local business executive with a similar name: Phil Anderer. Anderson plans to file a defamation lawsuit against Allnews because of the above-described falsehood in the Rattler story. He expects to seek $500,000 in damages for harm to his reputation and for other related harms. In Chapter 6, you will learn about the substantive legal issues that will arise in Anderson’s defamation case. For now, however, the focus is on important legal matters of a procedural nature. Consider the following questions regarding Anderson’s case as you read this chapter: • Where, in a geographic sense, may Anderson properly file and pursue his lawsuit against Allnews? • Must Anderson pursue his case in a state court, or does he have the option of litigating it in federal court? • Assuming that Anderson files his case in a state court, what strategic option may Allnews exercise if it acts promptly? • In the run-up to a possible trial in the case, what legal mechanisms may Anderson utilize in order to find out, on a pretrial basis, what the Rattler reporter and other Allnews employees would say in possible testimony at trial? Is Allnews entitled to do the same with regard to Anderson? • If Anderson’s case goes to trial, what types of trials are possible? • Through what legal mechanisms might a court decide the case without a trial? • Today, many legal disputes are decided through arbitration rather than through proceedings in court. Given the prevalence of arbitration these days, why isn’t Anderson’s case a candidate for arbitration?

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Part One Foundations of American Law

LEARNING OBJECTIVES

LO

After studying this chapter, you should be able to: 2-1 Describe the basic structures of state court systems and the federal court system. 2-2 Explain the difference between subject-matter jurisdiction and in personam jurisdiction. 2-3 Identify the major legal issues courts must resolve when deciding whether in personam jurisdiction exists with regard to a defendant in a civil case. 2-4 Explain what is necessary in order for a federal court to have subject-matter jurisdiction over a civil case. BUSINESS LAW COURSES examine many substantive legal rules that tell us how to behave in business and in society. Examples include the principles of contract, tort, and agency law, as well as those of many other legal areas addressed later in this text. Most of these principles are applied by courts as they decide civil cases involving private parties. This chapter lays a foundation for the text’s discussion of substantive legal rules by examining the court systems of the United States and by outlining how civil cases proceed from beginning to end. The chapter also explores related subjects, including alternative dispute resolution,  a collection of processes for resolving private disputes outside the court systems.

State Courts and Their Jurisdiction LO2-1

Describe the basic structures of state court systems and the federal court system.

The United States has 52 court systems—a federal system plus a system for each state and the District of Columbia. This section describes the various types of state courts. It also considers the important subject of jurisdiction, something a court must have if its decision in a case is to be binding on the parties.

Courts of Limited Jurisdiction Minor criminal cases and civil disputes involving small amounts of money or specialized matters frequently are decided in courts of limited jurisdiction. Examples include traffic courts, probate courts, and small claims courts. Such courts often handle a large number of cases. In some of

2-5 Identify the major steps in a civil lawsuit’s progression from beginning to end. 2-6 Describe the different forms of discovery available to parties in civil cases. 2-7 Explain the differences among the major forms of alternative dispute resolution.

these courts, procedures may be informal, and parties often argue their own cases without representation by attorneys. Courts of limited jurisdiction often are not courts of record—meaning that they may not keep a transcript of the proceedings conducted. Appeals from their decisions therefore require a new trial (a trial de novo) in a trial court.

Trial Courts Courts of limited jurisdiction find the

relevant facts, identify the appropriate rule(s) of law, and combine the facts and the law to reach a decision. State trial courts do the same but differ from inferior courts in two key ways. First, they are not governed by the subject-matter restrictions or the limits on civil damages or criminal penalties that govern courts of limited jurisdiction. Cases involving significant dollar amounts or major criminal penalties usually begin, therefore, at the trial court level. Second, trial courts are courts of record that keep detailed records of hearings, trials, and other proceedings. These records become important if a trial court decision is appealed. The trial court’s fact-finding function may be handled by the judge or by a jury. Determination of the applicable law, however, is always the judge’s responsibility. In cases pending in trial courts, the parties nearly always are represented by attorneys. States usually have at least one trial court for each county. It may be called a circuit, superior, district, county, chancery, or common pleas court. Most state trial courts can hear a wide range of civil and criminal cases, with little or no subject-matter restriction. They may, however, have civil and criminal divisions. If no court of limited jurisdiction deals with these matters, state trial courts may also contain other divisions such as domestic relations courts or probate courts.



Chapter Two The Resolution of Private Disputes

Appellate Courts State

appeals (or appellate) courts generally decide only legal questions. Instead of receiving new evidence or otherwise retrying the case, appellate courts review the record of the trial court proceedings. Although appellate courts correct legal errors made by the trial judge, they usually accept the trial court’s findings of fact. Appellate courts may also hear appeals from state administrative agency decisions. Some states have only one appeals court (usually called the Supreme Court), but most also have an intermediate appellate court. The U.S. Supreme Court sometimes hears appeals from decisions of the state’s highest court.

Jurisdiction and Venue LO2-2

Explain the difference between subject-matter jurisdiction and in personam jurisdiction.

The party who sues in a civil case (the plaintiff) cannot sue the defendant (the party being sued) in whatever court the plaintiff happens to prefer. Instead, the chosen court—whether a state court or a federal court—must have jurisdiction over the case. Jurisdiction is a court’s power to hear a case and to issue a decision binding on the parties. In order to render a binding decision in a civil case, a court must have not only subject-matter jurisdiction but also in personam jurisdiction or in rem jurisdiction. Even if a court has jurisdiction, applicable venue requirements must also be satisfied in order for the case to proceed in that court. Subject-Matter Jurisdiction Subject-matter jurisdiction is a court’s power to decide the type of dispute involved in the case. Criminal courts, for example, cannot hear civil matters. Similarly, a $500,000 claim for breach of contract cannot be pursued in a small claims court. In Personam Jurisdiction Identify the major legal issues courts must resolve when

LO2-3 deciding whether in personam jurisdiction exists with

regard to a defendant in a civil case.

Even a court with subject-matter jurisdiction cannot decide a civil case unless it also has either in personam jurisdiction or in rem jurisdiction. In personam jurisdiction is based on the residence, location, or activities of the defendant. A state court has in personam jurisdiction over defendants who are citizens or residents of the state (even if situated out-of-state), who are within the state’s borders when

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process is served on them (even if nonresidents),1 or who consent to the court’s authority (for instance, by entering the state to defend against the plaintiff’s claim).2 The same principle governs federal courts’ in personam jurisdiction over defendants. In addition, most states have enacted “long-arm” statutes that are designed to give their courts in personam jurisdiction over out-of-state defendants in certain instances. Under these statutes, nonresident individuals and businesses may become subject to the jurisdiction of the state’s courts by, for example, doing business within the state, contracting to supply goods or services within the state, committing a tort (a civil wrong) within the state, or committing a tort outside the state if it produces harm within the state. (Some long-arm statutes are phrased with even broader application in mind, so that in personam jurisdiction may extend as far as the U.S. Constitution’s Due Process clauses permit.) Federal law, moreover, permits federal courts to rely on state long-arm statutes as a basis for obtaining in personam jurisdiction over nonresident defendants. Even if a long-arm statute applies, however, a state or federal court’s assertion of in personam jurisdiction over a nonresident defendant must also meet due process standards. In International Shoe Co. v. Washington (1945), the U.S. Supreme Court held that in order for due process requirements to be satisfied when a state or federal court asserts in personam jurisdiction over a nonresident defendant, the defendant must be shown to have had the requisite “minimum contacts” with the forum state or federal district. These contacts must be significant enough that it would not offend “traditional notions of fair play and substantial justice” to require the nonresident defendant to defend the case in the forum state or federal district. After International Shoe, in personam jurisdiction cases involving nonresident defendants became divided into two categories: general jurisdiction and specific jurisdiction. In Abdouch v. Lopez, which follows, the Supreme Court of Nebraska explains each of these types of in personam jurisdiction and goes on to address the specific jurisdiction arguments made in the case. In Daimler AG v. Bauman, which serves as a basis of the Global Business Environment box that appears later in the chapter, the U.S. Supreme Court decides whether general jurisdiction exists regarding a German firm sued in the United States over actions that occurred outside the United States. Service of process is discussed later in the chapter. In many states, however, out-of-state defendants may make a special appearance to challenge the court’s jurisdiction without consenting to the court’s authority. 1 2

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Part One Foundations of American Law

Abdouch v. Lopez   829 N.W.2d 662 (Neb. 2013) Helen Abdouch, an Omaha, Nebraska, resident, served as executive secretary of the Nebraska presidential campaign of John F. ­Kennedy in 1960. Ken Lopez, a Massachusetts resident, and his Massachusetts-based company, Ken Lopez Bookseller (KLB), are engaged in the rare book business. In 1963, Abdouch received a copy of a book titled Revolutionary Road. Its author, Richard Yates, inscribed the copy with a note to Abdouch. The inscribed copy was later stolen from Abdouch. In 2009, Lopez and KLB bought the inscribed copy from a seller in Georgia. They sold it that same year to a customer from a state other than Nebraska. In 2011, Abdouch learned that Lopez had used the inscription and references to her in an advertisement on KLB’s website. The advertisement, which appeared on the website for more than three years after Lopez and KLB sold the inscribed copy, contained a picture of the inscription, the word “SOLD,” and this statement: This copy is inscribed by Yates: ‘For Helen Abdouch—with admiration and best wishes. Dick Yates. 8/19/63.’ Yates had worked as a speech writer for Robert Kennedy when Kennedy served as Attorney General; Abdouch was the executive secretary of the Nebraska (John F.) Kennedy organization when Robert Kennedy was campaign manager. . . . A scarce book, and it is extremely uncommon to find this advance issue of it signed. Given the date of the inscription—that is, during JFK’s Presidency—and the connection between writer and recipient, it’s reasonable to suppose this was an author’s copy, presented to Abdouch by Yates. Because Lopez and KLB did not obtain her permission before mentioning her and using the inscription in the advertisement, Abdouch filed an invasion-of-privacy lawsuit against Lopez and KLB in a Nebraska state district court. Contending that the Nebraska court lacked in personam jurisdiction, Lopez and KLB filed a motion to dismiss the case. The state district court granted the motion. Abdouch then appealed to the Supreme Court of Nebraska. (Further facts bearing upon the in personam jurisdiction issue appear in the following edited version of the Supreme Court’s opinion.)

McCormack, Judge Abdouch argues that the district court erred in finding that the State lacked in personam jurisdiction [, often referred to here as personal jurisdiction,] over Lopez and KLB. Abdouch argues that [the defendants’] active website deliberately targeted her with tortious conduct. She alleges these contacts are sufficient to create the necessary minimum contacts for specific jurisdiction. Personal jurisdiction is the power of a tribunal to subject and bind a particular entity to its decisions. Before a court can exercise personal jurisdiction over a nonresident defendant, the court must determine whether the long-arm statute is satisfied and, if the long-arm statute is satisfied, whether minimum contacts exist between the defendant and the forum state [for due process purposes]. Nebraska’s long-arm statute provides: “A court may exercise personal jurisdiction over a person . . . [w]ho has any other contact with or maintains any other relation to this state to afford a basis for the exercise of personal jurisdiction consistent with the Constitution of the United States.” Nebraska’s long-arm statute, therefore, extends Nebraska’s jurisdiction over nonresidents having any contact with or maintaining any relation to this state as far as the U.S. Constitution permits. [T]he issue is whether Lopez and KLB had sufficient contacts with Nebraska so that the exercise of personal jurisdiction would not offend federal principles of due process. To subject an out-of-state defendant to personal jurisdiction in a forum court, due process requires that the defendant have

minimum contacts with the forum state so as not to offend traditional notions of fair play and substantial justice. [See International Shoe Co. v. Washington, 326 U.S. 310, 316 (1945).] The benchmark . . . is whether the defendant’s minimum contacts with the forum state are such that the defendant should reasonably anticipate being haled into court there. Whether a forum state court has personal jurisdiction over a nonresident defendant depends on whether the defendant’s actions created substantial connections with the forum state, resulting in the defendant’s purposeful availment of the forum state’s benefits and protections. In analyzing personal jurisdiction, we consider the quality and type of the defendant’s activities in deciding whether the defendant has the necessary minimum contacts with the forum state. A court exercises two types of personal jurisdiction depending upon the facts and circumstances of the case: general personal jurisdiction or specific personal jurisdiction. In the exercise of general personal jurisdiction, the plaintiff’s claim does not have to arise directly out of the defendant’s contacts with the forum state if the defendant has engaged in continuous and systematic general business contacts with the forum state. But if the defendant’s contacts are neither substantial nor continuous and systematic, as Abdouch concedes is the case here, and instead the cause of action arises out of or is related to the defendant’s contacts with the forum, a court may assert specific jurisdiction over the defendant, depending upon the nature and quality of such contact.



Chapter Two The Resolution of Private Disputes

The Internet and its interaction with personal jurisdiction over a nonresident is an issue of first impression for this court. [However,] we take note that technological advances do not render impotent our longstanding principles. With this in mind, [most federal courts of appeal have] adopted the analytical framework set forth in Zippo Manufacturing Co. v. Zippo Dot Com, Inc., 952 F. Supp. 1119 (W.D. Pa. 1997), for Internet jurisdiction cases. In that case, Zippo Manufacturing filed a complaint in Pennsylvania against nonresident Zippo Dot Com, Inc., alleging causes of action under the federal Trademark Act of 1946. Zippo Dot Com’s contact with Pennsylvania consisted of over 3,000 Pennsylvania residents subscribing to its website. The court in Zippo Manufacturing famously created a “sliding scale” test that considers a website’s interactivity and the nature of the commercial activities conducted over the Internet to determine whether the courts have personal jurisdiction over nonresident defendants. The court explained the sliding scale as follows: At one end of the spectrum are situations where a defendant clearly does business over the Internet. If the defendant enters into contracts with residents of a foreign jurisdiction that involve the knowing and repeated transmission of computer files over the Internet, personal jurisdiction is proper. . . . At the opposite end are situations where a defendant has simply posted information on an Internet website which is accessible to users in foreign jurisdictions. A passive website that does little more than make information available to those who are interested in it is not grounds for the exercise [of] personal jurisdiction.  .  .  .  The middle ground is occupied by interactive websites where a user can exchange information with the host computer. In these cases, the exercise of jurisdiction is determined by examining the level of interactivity and commercial nature of the exchange of information that occurs on the website. The court in Zippo Manufacturing held that Pennsylvania had personal jurisdiction over Zippo Dot Com. In doing so, the court . . . found that the Zippo Dot Com website was a highly interactive commercial site [and] that the trademark infringement causes of action were related to the business contacts with customers in Pennsylvania. [Although Zippo Manufacturing’s test] is widely recognized and accepted, most circuits use it only as a starting point. As the Second Circuit noted, “it does not amount to a separate framework for analyzing Internet-based jurisdiction”; instead, “traditional statutory and constitutional principles remain the touchstone of the inquiry.” [Case citation omitted.] The Seventh Circuit has noted that “[c]ourts should be careful in resolving questions about personal jurisdiction involving online contacts to ensure that a defendant is not haled into court simply because the defendant owns or operates a website that is accessible in the forum state, even if that site is interactive.”

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[Citation omitted.] Many courts have held that even if the defendant operates a highly interactive website which is accessible from, but does not target, the forum state, then the defendant may not be haled into court in that state without offending the Constitution. Our precedent states that for there to be specific personal jurisdiction, the cause of action must arise out of or be related to the defendant’s contacts with the forum state. This is consistent with the U.S. Supreme Court’s precedent which has stated “mere purchases, even if occurring at regular intervals, are not enough to warrant a State’s assertion of in personam jurisdiction over a nonresident corporation in a cause of action not related to those purchase transactions.” Helicopteros Nacionales de Colombia v. Hall, 466 U.S. 408 (1984). In the case at hand, it is evident that the KLB website is interactive under the Zippo Manufacturing test. In his affidavit, Lopez admits that customers can browse and purchase books from the online inventory. Lopez admits that he has two customers in Nebraska who are on the mailing list for KLB’s catalogs. He admits that from 2009 through 2011, . . . $614.87 in sales from the website was made to Nebraska residents out of an estimated $3.9 million in total sales. But, beyond the minimal website sales to Nebraska residents and mailing catalogs to two Nebraska residents [who requested them], Lopez’s and KLB’s contacts with Nebraska are nonexistent. Lopez and KLB do not own, lease, or rent land in Nebraska. They have never advertised directly in Nebraska, participated in bookfairs in Nebraska [despite having participated in many bookfairs in other states], or attended meetings in Nebraska, and neither has paid sales tax in Nebraska. Furthermore, the Seventh Circuit has recently stated that when “the plaintiff’s claims are for intentional torts, the inquiry focuses on whether the conduct underlying the claims was purposely directed at the forum state.” [Citation omitted.] The reason for requiring purposeful direction is to “ensure that an out-of-state defendant is not bound to appear to account for merely ‘random, fortuitous, or attenuated contacts’ with the forum state.” Burger King Corp. v. Rudzewicz, 471 U.S. 462 (1985). Here, Abdouch’s cause of action is an intentional tort based on Nebraska’s privacy statute. There is no evidence that Lopez and KLB purposefully directed the advertisement at Nebraska. Further, there is no evidence that Lopez and KLB intended to invade Abdouch’s privacy in Nebraska. Rather, the limited Internet sales appear to be random, fortuitous, and attenuated contacts with Nebraska. Therefore, although KLB’s website is highly interactive, all of the contacts created by the site with Nebraska are unrelated to Abdouch’s cause of action. Abdouch argues that the effects test formulated by the U.S. Supreme Court in Calder v. Jones, 465 U.S. 783 (1984), creates personal jurisdiction over Lopez and KLB. In Calder, two Florida residents participated in the publication of [a National Enquirer]

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Part One Foundations of American Law

article about a California resident who brought a libel action in California against the Florida residents. Both defendants asserted that as Florida residents, they were not subject to the jurisdiction of the California court. The Supreme Court rejected the defendants’ argument and noted that the defendants [committed] intentional, and allegedly tortious, actions [that] were expressly aimed at California. [They] wrote and . . . edited an article that they knew would have a potentially devastating impact upon [the plaintiff]. And they knew that the brunt of that injury would be felt by [her] in the State in which she lives and works and in which the National Enquirer has its largest circulation. Under the circumstances, [the defendants] must reasonably anticipate being haled into court there to answer for the truth of the statements made in their article. [Calder, 465 U.S. at 789–90.] In coming to its holding, the U.S. Supreme Court created a test, now known as the Calder effects test, which has been explained by the Eighth Circuit: “[A] defendant’s tortious acts can serve as a source of personal jurisdiction only where the plaintiff makes a prima facie showing that the defendant’s acts (1) were intentional, (2) were uniquely or expressly aimed at the forum state, and (3) caused harm, the brunt of which was suffered—and which the defendant knew was likely to be suffered—[in the forum state].” Johnson v. Arden, 614 F.3d 785 (8th Cir. 2010). In the context of Internet intentional tort cases, the federal circuit courts have rejected the argument that [merely] posting defamatory or invasive material to the World Wide Web [is enough to satisfy the Calder effects test and give rise to in personam jurisdiction].

[Here,] Lopez’s and KLB’s placement of the advertisement online was directed at the entire world, without expressly aiming the posting at Nebraska. Abdouch pleaded in her complaint that the advertisement was “broadcast or sent out over the World Wide Web,” but Abdouch failed to plead facts that demonstrate that Nebraska residents were targeted with the advertisement. Although the advertisement does mention that “Abdouch was the executive secretary of the Nebraska (John F.) Kennedy organization,” the advertisement does not expressly direct its offer of sale to Nebraska. The mention of Nebraska here is incidental and was not included for the purposes of having the consequences felt in Nebraska. Lopez did not know that Abdouch was a resident of Nebraska [until he learned that fact in 2011]. He [initially] assumed that she had passed away and thus had no way of knowing that the brunt of harm would be suffered in Nebraska. We conclude that Abdouch’s complaint fails to plead facts to demonstrate that Lopez and KLB have sufficient minimum contacts with Nebraska. Although the website used to post the advertisement is interactive, the contacts created by the website are unrelated to Abdouch’s cause of action. Furthermore, . . . the pleadings fail to establish that Lopez and KLB expressly aimed their tortious conduct at Nebraska. For these reasons, Lopez and KLB could not have anticipated being haled into a Nebraska court for their online advertisement. Dismissal for lack of in personam jurisdiction affirmed.

The Global Business Environment Daimler AG v. Bauman  134 S. Ct. 746 (2014) In 2004, 22 residents of Argentina filed suit in the U.S. District Court for the Northern District of California against Daimler, a German company that manufactures Mercedes-Benz vehicles in Germany. The plaintiffs contended that during Argentina’s 1976–1983 “Dirty War,” Daimler’s subsidiary, Mercedes-Benz Argentina (MB Argentina), collaborated with state security forces to kidnap, detain, torture, and kill certain MB Argentina workers. These workers included the plaintiffs and deceased persons closely related to the plaintiffs. No part of MB Argentina’s alleged collaboration with Argentinian authorities took place in California or anywhere else in the United States. The plaintiffs maintained that Daimler should be held vicariously liable for MB Argentina’s actions. They brought claims under U.S. law as well as claims for wrongful death

and intentional infliction of emotional distress under the laws of California and Argentina. Relying on a California long-arm statute that applies to the full extent of what constitutional notions of due process will permit, the plaintiffs contended that in personam jurisdiction over Daimler should be predicated on the California contacts of Mercedes-Benz USA, LLC (MBUSA), another Daimler subsidiary. MBUSA, which is incorporated in Delaware and has its principal place of business in New Jersey, distributes Daimler-manufactured vehicles to dealerships in ­California and throughout the United States. MBUSA has multiple California-based facilities and is the largest supplier of luxury vehicles to the California market. Daimler sought dismissal of the case on the ground that the court lacked in personam jurisdiction over it. A federal district court granted Daimler’s request. The U.S. Court of Appeals for



Chapter Two The Resolution of Private Disputes

the Ninth Circuit reversed, concluding that in personam jurisdiction (personal jurisdiction) existed. The U.S. Supreme Court granted Daimler’s petition for a writ of certiorari. Writing for the Supreme Court in Daimler AG v. Bauman, Justice Ginsburg noted the landmark decision in International Shoe Co. v. Washington, 326 U.S. 310 (1945). That decision’s “minimum contacts” doctrine and “fair play and substantial justice” test continue to guide the due process inquiry when in personam jurisdiction over a nonresident defendant is at issue. (See the discussion of International Shoe earlier in the chapter.) Justice Ginsburg’s Daimler majority opinion also outlined the differences between general jurisdiction and specific jurisdiction. (For an explanation of these two types of in personam jurisdiction, see Abdouch v. Lopez, a case included earlier in the chapter.) The following excerpts from Daimler focus on the question of whether general jurisdiction existed. Ginsburg, Justice This case concerns the authority of a court in the United States to entertain a claim brought by foreign plaintiffs against a foreign defendant based on events occurring entirely outside the United States. The question presented is whether the Due Process Clause of the Fourteenth Amendment precludes the district court from exercising jurisdiction over Daimler, given the absence of any California connection to the atrocities, perpetrators, or victims described in the complaint. Plaintiffs invoked the court’s general or all-purpose jurisdiction. California, they urge, is a place where Daimler may be sued on any and all claims against it, wherever in the world the claims may arise. For example, as plaintiffs’ counsel affirmed, under the proffered jurisdictional theory, if a Daimler-­ manufactured vehicle overturned in Poland, injuring a Polish driver and passenger, the injured parties could maintain a design defect suit in California. [We must decide whether such] exercises of personal jurisdiction . . . are [permitted or, instead,] barred by due process constraints on the assertion of adjudicatory authority. In Goodyear Dunlop Tires Operations, S. A. v. Brown, 131 S. Ct. 2846 (2011), we addressed the distinction between general or all-purpose jurisdiction, and specific or conduct-linked jurisdiction. As to the former, we held that a court may assert jurisdiction over a foreign corporation “to hear any and all claims against [it]” only when the corporation’s affiliations with the State in which suit is brought are so constant and pervasive “as to render [it] essentially at home in the forum State.” Id. at 2851. Since [the 1945 decision in] International Shoe, “specific jurisdiction has become the centerpiece of modern jurisdiction theory, while general jurisdiction [has played] a reduced role.” Goodyear, 131 S. Ct. at 2854. Our post-International Shoe opinions on general jurisdiction  .  .  .  are few. [In] Perkins v. Benguet Consolidated Mining Co., 342 U.S. 437 (1952), an Ohio resident sued Benguet [in an Ohio court] on a claim that neither arose in Ohio nor related to the corporation’s activities

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in that State. [Benguet] was a company incorporated under the laws of the Philippines, where it operated gold and silver mines. [However,] Benguet ceased its mining operations during the Japanese occupation of the Philippines in World War II; its president moved to Ohio, where he kept an office, maintained the company’s files, and oversaw the company’s activities. We held that [because Ohio was the corporation’s principal, if temporary, place of business,] the Ohio courts could exercise general jurisdiction over Benguet without offending due process. Id. at 448. The next case on point, Helicopteros Nacionales de Colombia, S.A. v. Hall, 466 U.S. 408 (1984), arose from a helicopter crash in Peru. Four U.S. citizens perished in that accident; their survivors and representatives brought suit in Texas state court against the helicopter’s owner and operator, a Colombian corporation. That company’s contacts with Texas were confined to “sending its chief executive officer to Houston for a contract-negotiation session; accepting into its New York bank account checks drawn on a Houston bank; purchasing helicopters, equipment, and training services from a Texas-based helicopter company for substantial sums; and sending personnel to Texas for training.” Id. at 416. Notably, those contacts bore no apparent relationship to the accident that gave rise to the suit. We held that the company’s Texas connections did not resemble the “continuous and systematic general business contacts . . . found to exist in Perkins.” Id. “[M]ere purchases, even if occurring at regular intervals,” we clarified, “are not enough to warrant a State’s assertion of in personam jurisdiction over a nonresident corporation in a cause of action not related to those purchase transactions.” Id. at 418. Most recently, in Goodyear, we answered this question: “Are foreign subsidiaries of a United States parent corporation amenable to suit in state court on claims unrelated to any activity of the subsidiaries in the forum State?” 131 S. Ct. at 2850. That case arose from a bus accident outside Paris that killed two boys from North Carolina. The boys’ parents brought a wrongful-death suit in North Carolina state court alleging that the bus’s tire was defectively manufactured. The complaint named as defendants not only Goodyear, an Ohio corporation, but also Goodyear’s Turkish, French, and Luxembourgian subsidiaries. Those foreign subsidiaries, which manufactured tires for sale in Europe and Asia, lacked any affiliation with North Carolina. A small percentage of tires manufactured by the foreign subsidiaries were distributed in North Carolina, however, and on that ground, the North Carolina Court of Appeals held the subsidiaries amenable to the general jurisdiction of North Carolina courts. We reversed, observing that the North Carolina court’s analysis “elided the essential difference between case-specific and all-purpose (general) jurisdiction.” Id. at 2846. Although the placement of a product into the stream of commerce “may bolster an affiliation germane to specific jurisdiction,” we explained, such contacts “do not warrant a determination that, based on

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Part One Foundations of American Law

those ties, the forum has general jurisdiction over a defendant.” Id. As International Shoe itself teaches, a corporation’s “continuous activity of some sorts within a state is not enough to support the demand that the corporation be amenable to suits unrelated to that activity.” 326 U.S. at 318. Because Goodyear’s foreign subsidiaries were “in no sense at home in North Carolina,” we held, those subsidiaries could not be required to submit to the general jurisdiction of that State’s courts. 131 S. Ct. at 2854. With this background, we turn directly to the question whether Daimler’s affiliations with California are sufficient to subject it to the general (all-purpose) personal jurisdiction of that State’s courts. In sustaining the exercise of general jurisdiction over Daimler, the Ninth Circuit relied on an agency theory, determining that MBUSA acted as Daimler’s agent for jurisdictional purposes and then attributing MBUSA’s California contacts to Daimler. This Court has not yet addressed whether a foreign corporation may be subjected to a court’s general jurisdiction based on the contacts of its in-state subsidiary. But we need not pass judgment on invocation of an agency theory in the context of general jurisdiction, for in no event can the appeals court’s analysis be sustained. The Ninth Circuit’s agency finding rested primarily on its observation that MBUSA’s services were important to Daimler, as gauged by Daimler’s hypothetical readiness to perform those services itself if MBUSA did not exist. Formulated this way, the inquiry into importance stacks the deck, for it will always yield a pro-jurisdiction answer: “Anything a corporation does through an independent contractor, subsidiary, or distributor is presumably something that the corporation would do by other means if the independent contractor, subsidiary, or distributor did not exist.” [Citation omitted.] The Ninth Circuit’s agency theory thus appears to subject foreign corporations to general jurisdiction whenever they have an in-state subsidiary or affiliate, an outcome that would sweep beyond even the sprawling view of general jurisdiction we rejected in Goodyear. Goodyear made clear that only a limited set of affiliations with a forum will render a defendant amenable to all-purpose jurisdiction there. With respect to a corporation, the place of incorporation and principal place of business are paradigm

bases for general jurisdiction. Those affiliations have the virtue of being unique—that is, each ordinarily indicates only one place—as well as easily ascertainable. Cf. Hertz Corp. v. Friend, 559 U.S. 77 (2010). These bases afford plaintiffs recourse to at least one clear and certain forum in which a corporate defendant may be sued on any and all claims. Goodyear did not hold that a corporation may be subject to general jurisdiction only in a forum where it is incorporated or has its principal place of business; it simply typed those places paradigm all-purpose forums. Plaintiffs would have us look beyond the exemplar bases Goodyear identified, and approve the exercise of general jurisdiction in every State in which a corporation “engages in a substantial, continuous, and systematic course of business” [quoting the plaintiffs’ brief]. That formulation, we hold, is unacceptably grasping. [The relevant] inquiry under [International Shoe and] Goodyear is not whether a foreign corporation’s in-forum contacts can be said to be in some sense “continuous and systematic,” it is whether that corporation’s “affiliations with the State are so continuous and systematic as to render [it] essentially at home in the forum State.” Goodyear, 131 S. Ct. at 2851. Here, neither Daimler nor MBUSA is incorporated in California, nor does either entity have its principal place of business there. If Daimler’s California activities sufficed to allow adjudication of this Argentina-rooted case in California, the same global reach would presumably be available in every other State in which MBUSA’s sales are sizable. Such exorbitant exercises of all-­purpose jurisdiction would scarcely permit out-of-state defendants “to structure their primary conduct with some minimum assurance as to where that conduct will and will not render them liable to suit.” [Citation omitted.] It was therefore error for the Ninth Circuit to conclude that Daimler, even with MBUSA’s contacts attributed to it, was at home in California, and hence subject to suit there on claims by foreign plaintiffs having nothing to do with anything that occurred or had its principal impact in California. Ninth Circuit decision reversed; Daimler held not subject to court’s in personam jurisdiction.

In Rem Jurisdiction In rem jurisdiction is based on the presence of property within the state. It empowers state courts to determine rights in that property even if the persons whose rights are affected are outside the state’s in personam jurisdiction. For example, a state court’s decision regarding title to land within the state is said to bind the world.3

Venue Even if a court has jurisdiction, it may be unable to decide the case because venue requirements have not been met. Venue questions arise only after jurisdiction is established or assumed. In general, a court has venue if it is a territorially fair and convenient forum in which to hear the case. Venue requirements applicable to state

Another form of jurisdiction, quasi in rem jurisdiction or attachment jurisdiction, also is based on the presence of property within the state. Unlike cases based on in rem jurisdiction, cases based on quasi in rem jurisdiction do not necessarily determine rights in the property itself. Instead, the property is regarded as an extension of the out-of-state defendant—an extension

that sometimes enables the court to decide claims unrelated to the property. For example, a plaintiff might attach the defendant’s bank account in the state where the bank is located, sue the defendant on a tort or contract claim unrelated to the bank account, and recover the amount of the judgment from the account if the suit is successful.

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Chapter Two The Resolution of Private Disputes

courts typically are set by state statutes, which normally determine the county in which a case must be brought. For instance, the statute might say that a case concerning land must be filed in the county where the land is located, and that other suits must be brought in the county where the defendant resides or is doing business. If justice so requires, the defendant may be able to obtain a change of venue. This can occur when, for example, a fair trial would be impossible within a particular county. Role of Forum Selection Clauses Contracts sometimes contain a clause reciting that disputes between the parties regarding matters connected with the contract must be litigated in the courts of a particular state. Such a provision is known as a forum selection clause. Depending on its wording, a forum selection clause may have the effect of addressing both jurisdiction and venue issues. Although forum selection clauses may appear in agreements whose terms have been hammered out by the parties after extensive negotiation, they fairly often are found in form agreements whose terms were not the product of actual discussion or give-and-take. For example, an Internet access provider (IAP) may include a forum selection clause in a so-called clickwrap document that sets forth the terms of its Internet-related services—terms to which the IAP’s subscribers are deemed to have agreed by virtue of utilizing the IAP’s services. Forum selection clauses, whether expressly bargained for or included in a clickwrap agreement, are generally enforced by courts unless they are shown to be unreasonable in a given set of circumstances. Assume, for instance, that the IAP’s terms of service document calls for the courts of Virginia to have “exclusive jurisdiction” over its subscribers’ disputes with the company, but that a subscriber sues the IAP in a Pennsylvania court. Unless the subscriber performs the difficult task of demonstrating that application of the clickwrap agreement’s forum selection clause would be unreasonable, the Pennsylvania court will be likely to dismiss the case and to hold that if the subscriber wishes to litigate the claim, he or she must sue in an appropriate Virginia court.

Federal Courts and Their Jurisdiction Federal District Courts LO2-1

Describe the basic structures of state court systems and the federal court system.

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In the federal system, lawsuits usually begin in the federal district courts. As do state trial courts, the federal district courts determine both the facts and the law. The fact-­ finding function may be entrusted to either the judge or a jury, but determining the applicable law is the judge’s responsibility. Each state is designated as a separate district for purposes of the federal court system. Each district has at least one district court, and each district court has at least one judge. District Court Jurisdiction LO2-4

Explain what is necessary in order for a federal court to have subject-matter jurisdiction over a civil case.

There are various bases of federal district court civil jurisdiction. The two most important are diversity jurisdiction and federal question jurisdiction. One traditional justification for diversity jurisdiction is that it may help protect out-of-state defendants from potentially biased state courts. Diversity jurisdiction exists when (1) the case is between citizens of different states and (2) the amount in controversy exceeds $75,000. Diversity jurisdiction also exists in certain cases between citizens of a state and citizens or governments of foreign nations, if the amount in controversy exceeds $75,000. Under diversity jurisdiction, a corporation is a citizen of both the state where it has been incorporated and the state where it has its principal place of business. For an example of diversity jurisdiction and an explanation of how a corporation’s principal place of business is to be determined for diversity jurisdiction purposes, see the U.S. Supreme Court’s Hertz decision, which follows shortly. Federal question jurisdiction exists when the case arises under the Constitution, laws, or treaties of the United States. The “arises under” requirement normally is met when a right created by federal law is a basic part of the plaintiff’s case. There is no amount-in-controversy requirement for federal question jurisdiction. Diversity jurisdiction and federal question jurisdiction are forms of subject-matter jurisdiction. Even if one of the two forms exists, a federal district court must also have in personam jurisdiction in order to render a decision that is binding on the parties. As indicated earlier in the chapter, the analysis of in personam jurisdiction issues in the federal court system is essentially the same as in the state court systems. Further limiting the plaintiff’s choice of federal district courts are the federal system’s complex venue requirements, which are beyond the scope of this text.

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Part One Foundations of American Law

Concurrent Jurisdiction and Removal The federal district courts have exclusive jurisdiction over some matters. Patent cases, for example, must be litigated in the federal system. Often, however, federal district courts have concurrent jurisdiction with state courts—meaning that both state and federal courts have jurisdiction over the case. For example, a plaintiff might assert state court in personam jurisdiction over an out-of-state defendant or might sue in a federal district court under that court’s diversity

jurisdiction. A state court, moreover, may sometimes decide cases involving federal questions. Where concurrent jurisdiction exists and the plaintiff opts for a state court, the defendant has the option to remove the case to an appropriate federal district court, assuming the defendant acts promptly. The Hertz decision, which follows, provides an example of a defendant’s ability to have a case removed from state court to federal court in an instance of concurrent jurisdiction.

Hertz Corp. v. Friend   559 U.S. 77 (2010) Alleging violations of California’s wage and hour laws, California citizens Melinda Friend and John Nhieu sued Hertz Corporation in a California state court. Hertz filed a notice seeking removal of the case to a federal court on the basis of diversity-of-citizenship jurisdiction. The relevant federal statute provides that a federal court possesses diversity jurisdiction if the plaintiff and defendant are citizens of different states and the amount in controversy exceeds $75,000. The statute further provides that “a corporation shall be deemed to be a citizen of any State by which it has been incorporated and of the State where it has its principal place of business.” In seeking removal, Hertz argued that diversity jurisdiction was appropriate because the plaintiffs and the defendant were citizens of different states and more than $75,000 was in controversy. The plaintiffs contended, however, that Hertz was a California citizen (just as they were) and that the case should therefore remain in state court. Hertz submitted a declaration meant to demonstrate that its “principal place of business” was in New Jersey rather than in California. Besides stressing that Hertz was a national operation with car rental locations in 44 states, the declaration recited a series of statistics indicating that California accounted for approximately 20 percent of Hertz’s rental locations, full-time employees, annual revenue, and annual car rental transactions. The declaration also listed Park Ridge, New Jersey, as the location of Hertz’s corporate headquarters and stated that Hertz’s core executive and administrative functions are conducted there. In deciding whether Hertz was a California citizen for purposes of the diversity jurisdiction statute, the U.S. District Court for the Northern District of California applied Ninth Circuit Court of Appeals precedent instructing courts to identify a corporation’s principal place of business by first determining the amount of a corporation’s business activity state by state. Then, if the amount of activity was significantly larger or substantially predominated in one state, that state would be considered the corporation’s principal place of business. Applying the Ninth Circuit’s test to the relevant facts, the federal district court reasoned that the extent of Hertz’s business activities in California, as compared with its activities in other states, made California Hertz’s principal place of business. Because it concluded that Hertz was a California citizen and that diversity jurisdiction did not exist, the district court ordered that the case be remanded to state court. Hertz appealed this order to the Ninth Circuit Court of Appeals, which affirmed. The U.S. Supreme Court agreed to decide the case at Hertz’s request. Breyer, Justice The federal diversity jurisdiction statute provides that “a corporation shall be deemed to be a citizen of any State by which it has been incorporated and of the State where it has its principal place of business.” We seek here to resolve different interpretations that the [federal courts of appeal] have given this phrase. In doing so, we place primary weight upon the need for judicial administration of a jurisdictional statute to remain as simple as possible. The phrase “principal place of business” has proved . . . difficult to apply. [C]ourts were . . . uncertain as to where to look to determine a corporation’s “principal place of business” for diversity purposes. If a corporation’s headquarters and executive

offices were in the same state in which it did most of its business, the test seemed straightforward. The “principal place of business” was located in that state. But suppose those corporate headquarters, including executive offices, are in one state, while the corporation’s plants or other centers of business activity are located in other states? In 1959 a distinguished federal district judge, Edward Weinfeld, answer[ed] this question in part: Where a corporation is engaged in far-flung and varied activities which are carried on in different states, its principal place of business is the nerve center from which it radiates out to its constituent parts and from which its officers direct, control and coordinate all activities without regard to locale, in the furtherance of the corporate objective. The test . . . is



Chapter Two The Resolution of Private Disputes

that place where the corporation has an office from which its business was directed and controlled—the place where all of its business was under the supreme direction and control of its officers. Scot Typewriter Co. v. Underwood Corp., 170 F. Supp. 862, 865 (S.D.N.Y. 1959). Numerous [circuit courts of appeal] have since followed this rule, applying the “nerve center” test for corporations with “farflung” business activities. Scot’s analysis, however, did not go far enough. For it did not answer what courts should do when the operations of the corporation are not “far-flung” but rather limited to only a few states. When faced with this question, various courts have focused more heavily on where a corporation’s actual business activities are located. Perhaps because corporations come in many different forms, involve many different kinds of business activities, and locate offices and plants for different reasons in different ways in different regions, a general “business activities” approach has proved unusually difficult to apply. Courts must decide which factors are more important than others: for example, plant location, sales or servicing centers, transactions, payrolls, or revenue generation. The number of factors grew as courts explicitly combined aspects of the “nerve center” and “business activity” tests to look to a corporation’s “total activities,” sometimes to try to determine what treatises have described as the corporation’s “center of gravity.” Not surprisingly, different circuit courts of appeal (and sometimes different courts within a single circuit) have applied these highly general multifactor tests in different ways. This complexity . . . is at war with administrative simplicity. And it has failed to achieve a nationally uniform interpretation of federal law, an unfortunate consequence in a federal legal system. In an effort to find a single, more uniform interpretation of the statutory phrase, we have reviewed the courts of appeals’ divergent and increasingly complex interpretations. [W]e now return to, and expand, Judge Weinfeld’s approach [in Scot]. We conclude that “principal place of business” is best read as referring to the place where a corporation’s officers direct, control, and coordinate the corporation’s activities. It is the place that courts of appeals have called the corporation’s “nerve center.” And in practice it should normally be the place where the corporation maintains its headquarters—provided that the headquarters is the actual center of direction, control, and coordination, i.e., the “nerve center,” and not simply an office where the corporation holds its board meetings (for example, attended by directors and officers who have traveled there for the occasion). [Important considerations] convince us that this approach, while imperfect, is superior to other possibilities. First, the statute’s language supports the approach. The statute’s text deems a corporation a citizen of the “State where it has its principal place of business.” The word “place” is in the singular, not the plural.

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The word “principal” requires us to pick out the “main, prominent” or “leading” place. And the fact that the word “place” follows the words “State where” means that the “place” is a place within a state. It is not the state itself. A corporation’s “nerve center,” usually its main headquarters, is a single place. The public often (though not always) considers it the corporation’s main place of business. By contrast, the application of a more general business activities test has led some courts, as in the present case, to look, not at a particular place within a state, but incorrectly at the state itself, measuring the total amount of business activities that the corporation conducts there and determining whether they are significantly larger than in the next-ranking state. This approach invites greater litigation and can lead to strange results, as the Ninth Circuit has since recognized. Namely, if a “corporation may be deemed a citizen of California on th[e] basis” of “activities [that] roughly reflect California’s larger population . . . nearly every national retailer— no matter how far flung its operations—will be deemed a citizen of California for diversity purposes.” [Case citation omitted.] But why award or decline diversity jurisdiction on the basis of a state’s population, whether measured directly, indirectly (say proportionately), or with modifications? Second, administrative simplicity is a major virtue in a jurisdictional statute. Complex jurisdictional tests complicate a case, eating up time and money as the parties litigate, not the merits of their claims, but which court is the right court to decide those claims. [Moreover,] courts benefit from straightforward rules under which they can readily assure themselves of their power to hear a case. Simple jurisdictional rules also promote greater predictability. Predictability is valuable to corporations making business and investment decisions. Predictability also benefits plaintiffs deciding whether to file suit in a state or federal court. A “nerve center” approach, which ordinarily equates that “center” with a corporation’s headquarters, is simple to apply comparatively speaking. The metaphor of a corporate “brain,” while not precise, suggests a single location. By contrast, a corporation’s general business activities more often lack a single principal place where they take place. That is to say, the corporation may have several plants, many sales locations, and employees located in many different places. If so, it will not be as easy to determine which of these different business locales is the “principal” or most important “place.” We recognize that there may be no perfect test that satisfies all administrative and purposive criteria. We recognize as well that, under the “nerve center” test we adopt today, there will be hard cases. For example, in this era of telecommuting, some corporations may divide their command and coordinating functions among officers who work at several different locations, perhaps communicating over the Internet. That said, our test nonetheless

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points courts in a single direction, towards the center of overall direction, control, and coordination. Courts do not have to try to weigh corporate functions, assets, or revenues different in kind, one from the other. We also recognize that the use of a “nerve center” test may in some cases produce results that seem to cut against the basic rationale for [diversity jurisdiction]. For example, if the bulk of a company’s business activities visible to the public take place in New Jersey, while its top officers direct those activities just across the river in New York, the “principal place of business” is New York. One could argue that members of the public in New Jersey would be less likely to be prejudiced against the corporation than persons in New York—yet the corporation will still be entitled to remove a New Jersey state case to federal court. And note too that the same corporation would be unable to remove a

New York state case to federal court, despite the New York public’s presumed prejudice against the corporation. We understand that such seeming anomalies will arise. However, in view of the necessity of having a clearer rule, we must accept them. Accepting occasionally counterintuitive results is the price the legal system must pay to avoid overly complex jurisdictional administration while producing the benefits that accompany a more uniform legal system. [In this case, Hertz’s] unchallenged declaration suggests that Hertz’s center of direction, control, and coordination, its “nerve center,” and its corporate headquarters are one and the same, and they are located in New Jersey, not in California.

Specialized Federal Courts The federal court

The U.S. Supreme Court The United States Su-

system also includes certain specialized federal courts, including the Court of Federal Claims (which hears claims against the United States), the Court of International Trade (which is concerned with tariff, customs, import, and other trade matters), the bankruptcy courts (which operate as adjuncts of the district courts), and the Tax Court (which reviews certain IRS determinations). Usually, the decisions of these courts can be appealed to a federal court of appeals.

Federal Courts of Appeals The U.S. courts of

appeals do not engage in fact-finding. Instead, they review only the legal conclusions reached by lower federal courts. As Figure 2.1 shows, there are 13 circuit courts of appeals: 11 numbered circuits covering several states each; a District of Columbia circuit; and a separate federal circuit. Except for the Court of Appeals for the Federal Circuit, the most important function of the U.S. courts of appeals is to hear appeals from decisions of the federal district courts. Appeals from a district court ordinarily proceed to the court of appeals for that district court’s region. Appeals from the District Court for the Southern District of New York, for example, go to the Second Circuit Court of Appeals. The courts of appeals also hear appeals from the Tax Court, from many administrative agency decisions, and from some bankruptcy court decisions. The Court of Appeals for the Federal Circuit hears a wide variety of specialized appeals, including some patent and trademark matters, Court of Federal Claims decisions, and decisions by the Court of International Trade.

Ninth Circuit’s decision vacated, and case remanded for further proceedings in federal district court.

preme Court, the highest court in the land, is mainly an appellate court. It therefore considers only questions of law when it decides appeals from the federal courts of appeals and the highest state courts.4 Today, most appealable decisions from these courts fall within the Supreme Court’s certiorari jurisdiction, under which the Court has discretion whether to hear the appeal. The Court hears only a small percentage of the many appeals it is asked to decide under its certiorari jurisdiction. Nearly all appeals from the federal courts of appeals are within the Court’s certiorari jurisdiction. Appeals from the highest state courts are within the certiorari jurisdiction when (1) the validity of any treaty or federal statute has been questioned; (2) any state statute is challenged as repugnant to federal law; or (3) any title, right, privilege, or immunity is claimed under federal law. The Supreme Court usually defers to the states’ highest courts on questions of state law and does not hear appeals from those courts if the case involves only such questions. In certain rare situations, the U.S. Supreme Court has original jurisdiction, which means that it acts as a trial court. The Supreme Court has original and exclusive jurisdiction over all controversies between two or more states. It has original, but not exclusive, jurisdiction over cases involving foreign ambassadors, ministers, and like parties;

In special situations that do not often arise, the Supreme Court will hear appeals directly from the federal district courts. 4



Chapter Two The Resolution of Private Disputes

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Figure 2.1 The Thirteen Federal Judicial Circuits First Circuit (Boston, Mass.) Maine, Massachusetts, New Hampshire, Puerto Rico, Rhode Island

Second Circuit (New York, N.Y.) Connecticut, New York, Vermont

Third Circuit (Philadelphia, Pa.) Delaware, New Jersey, Pennsylvania, Virgin Islands

Fourth Circuit (Richmond, Va.) Maryland, North Carolina, South Carolina, Virginia, West Virginia

Fifth Circuit (New Orleans, La.) Louisiana, Mississippi, Texas

Sixth Circuit (Cincinnati, Ohio) Kentucky, Michigan, Ohio, Tennessee

Seventh Circuit (Chicago, Ill.) Illinois, Indiana, Wisconsin

Eighth Circuit (St. Louis, Mo.) Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, South Dakota

Ninth Circuit (San Francisco, Calif.) Alaska, Arizona, California, Guam, Hawaii, Idaho, Montana, Nevada, Northern Mariana Islands, Oregon, Washington

Tenth Circuit (Denver, Colo.) Colorado, Kansas, New Mexico, Oklahoma, Utah, Wyoming

Eleventh Circuit (Atlanta, Ga.) Alabama, Florida, Georgia

District of Columbia Circuit (Washington, D.C.)

Federal Circuit (Washington, D.C.)

controversies between the United States and a state; and cases in which a state proceeds against citizens of another state or against aliens.

Civil Procedure LO2-5

Identify the major steps in a civil lawsuit’s progression from beginning to end.

Civil procedure is the set of legal rules establishing how a civil lawsuit proceeds from beginning to end.5 Because civil procedure sometimes varies with the jurisdiction in question,6 the following presentation summarizes the most widely accepted rules governing civil cases in state and federal courts. Knowledge of these basic procedural matters will be useful if you become involved in a civil lawsuit and will help you understand the cases in this text. In any civil case, the adversary system is at work. Through their attorneys, the litigants take contrary Criminal procedure is discussed in Chapter 5. In the following discussion, the term jurisdiction refers to one of the 50 states, the District of Columbia, or the federal government. 5 6

positions before a judge and possibly a jury. To win a civil case, the plaintiff must prove each element of his, her, or its claim by a preponderance of the evidence.7 This standard of proof requires the plaintiff to show that the greater weight of the evidence—by credibility, not quantity—­supports the existence of each element. In other words, the plaintiff must convince the fact-finder that the existence of each element is more probable than its nonexistence. The attorney for each party presents his or her client’s version of the facts, tries to convince the judge or jury that this version is true, and attempts to rebut conflicting factual allegations by the other party. Each attorney also seeks to persuade the court that his or her reading of the law is correct.

Service of the Summons A summons notifies

the defendant that he, she, or it is being sued. The summons typically names the plaintiff and states the time within which the defendant must enter an appearance in court (usually through an attorney). In most jurisdictions, In a criminal case, however, the government must prove the elements of the alleged crime beyond a reasonable doubt. This standard of proof is discussed in Chapter 5. 7

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Part One Foundations of American Law

it is accompanied by a copy of the plaintiff’s complaint (which is described later). The summons is usually served on the defendant by an appropriate public official after the plaintiff has filed her case. To ensure that the defendant is properly notified, statutes, court rules, and constitutional due process guarantees set standards for proper service of the summons. For example, personal delivery to the defendant almost always meets these standards. Many jurisdictions also permit the summons to be left at the defendant’s home or place of business. Service to corporations often may be accomplished by delivery of the summons to the firm’s managing agent. Many state long-arm statutes permit out-of-state defendants to be served by registered mail. Although inadequate service of process may sometimes defeat the plaintiff’s claim, the defendant who participates in the case without making a prompt objection to the manner of service will be deemed to have waived the objection.

The Pleadings The pleadings are the documents the

parties file with the court when they first state their respective claims and defenses. They include the complaint, the answer, and, in some jurisdictions, the reply. Traditionally, the pleadings’ main function was to define and limit the issues to be decided by the court. Only those issues raised in the pleadings were considered part of the case, amendments to the pleadings were seldom permitted, and litigants were firmly bound by allegations or admissions contained in the pleadings. Although many jurisdictions retain some of these rules, most have relaxed them significantly. The main reason is the modern view of the purpose of pleading rules: that their aim is less to define the issues for trial than to give the parties general notice of each other’s claims and defenses. The Complaint The complaint states the plaintiff’s claim in separate, numbered paragraphs. It must allege sufficient facts to show that the plaintiff would be entitled to legal relief and to give the defendant reasonable notice of the nature of the plaintiff’s claim. The complaint also must state the remedy requested. The Answer Unless the defendant makes a successful motion to dismiss (described later), he must file an answer to the plaintiff’s complaint within a designated time after service of the complaint. The amount of time is set by applicable law, with 30 to 45 days being typical. The answer responds to the complaint paragraph by paragraph, with an admission or denial of each of the plaintiff’s allegations. An answer may also include an affirmative defense to the claim asserted in the complaint. A successful

affirmative defense enables the defendant to win the case even if all the allegations in the complaint are true and, by themselves, would have entitled the plaintiff to recover. For example, suppose that the plaintiff bases her lawsuit on a contract that she alleges the defendant has breached. The defendant’s answer may admit or deny the existence of the contract or the assertion that the defendant breached it. In addition, the answer may make assertions that, if proven, would provide the defendant an affirmative defense on the basis of fraud committed by the plaintiff during the contract negotiation phase. Furthermore, the answer may contain a counterclaim.8 A counterclaim is a new claim by the defendant arising from the matters stated in the complaint. Unlike an affirmative defense, it is not merely an attack on the plaintiff’s claim, but is the defendant’s attempt to obtain legal relief. In addition to using fraud as an affirmative defense to a plaintiff’s contract claim, for example, a defendant might counterclaim for damages caused by that fraud. The Reply In some jurisdictions, the plaintiff is allowed or required to respond to an affirmative defense or a counterclaim by making a reply. The reply is the plaintiff’s point-by-point response to the allegations in the answer or counterclaim. In jurisdictions that do not allow a reply to an answer, the defendant’s new allegations are automatically denied. Usually, however, a plaintiff who wishes to contest a counterclaim must file a reply to it.

Motion to Dismiss Sometimes it is evident from

the complaint or the pleadings that the plaintiff does not have a valid claim. In such a situation, it would be wasteful for the litigation to proceed further. The procedural device for ending the case at this early stage is commonly called the motion to dismiss. This motion often is made after the plaintiff has filed her complaint. A similar motion allowed by some jurisdictions, the motion for judgment on the pleadings, normally occurs after the pleadings have been completed. A successful motion to dismiss means that the defendant wins the case. If the motion fails, the case proceeds. The motion to dismiss may be made on various grounds—for example, inadequate service of process or lack of jurisdiction. The most important type of motion to dismiss, however, is the motion to dismiss for failure to state a claim upon which relief can be granted, sometimes In appropriate instances, a defendant also may file a cross claim against another defendant in the plaintiff’s suit, or a third-party complaint against a party who was not named as a defendant in the plaintiff’s complaint. 8



Chapter Two The Resolution of Private Disputes

called the demurrer. This motion basically says “So what?” to the factual allegations in the complaint. It asserts that the plaintiff cannot recover even if all of his allegations are true because no rule of law entitles him to win on those facts. Suppose that Potter sues Davis on the theory that Davis’s bad breath is a form of “olfactory pollution” entitling Potter to recover damages. Potter’s complaint describes Davis’s breath and the distress it causes Potter in great detail. Even if all of Potter’s factual allegations are true, Davis’s motion to dismiss almost certainly will succeed. There is no rule of law allowing the “victim” of another person’s bad breath to recover damages from that person.

Discovery LO2-6

Describe the different forms of discovery available to parties in civil cases.

When a civil case begins, litigants do not always possess all of the facts they need to prove their claims or establish their defenses. To help litigants obtain the facts and to narrow and clarify the issues for trial, the state and federal court systems permit each party to a civil case to exercise discovery rights. The discovery phase of a lawsuit normally begins when the pleadings have been completed. Each party is entitled to request information from the other party by utilizing the forms of discovery described in this section. Moreover, for civil cases pending in federal court, the Federal Rules of Civil Procedure require each party to provide the other party certain relevant information at an early point in the case without a formal discovery request by the other party. Discovery is available for information that is not subject to a recognized legal privilege and is relevant to the case or likely to lead to other information that may be relevant. Information may be subject to discovery even if it would not ultimately be admissible at trial under the legal rules of evidence. The scope of permissible discovery is thus extremely broad. The broad scope of discovery stems from a policy decision to minimize the surprise element in litigation and to give each party the opportunity to become fully informed regarding facts known by the opposing party. Each party may then formulate trial strategies on the basis of that knowledge. The deposition is one of the most frequently employed forms of discovery. In a deposition, one party’s attorney conducts an oral examination of the other party or of a likely witness (usually one identified with the other party). The questions asked by the examining attorney and the answers given by the deponent—the person being ­examined— are taken down by a court reporter. The deponent is under

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oath, just as he or she would be if testifying at trial, even though the deposition occurs on a pretrial basis and is likely to take place at an attorney’s office or at some location other than a courtroom. Some depositions are recorded in audiovisual form. Interrogatories and requests for admissions are among the other commonly utilized forms of discovery. Interrogatories are written questions directed by the plaintiff to the defendant, or vice versa. The litigant on whom interrogatories are served must provide written answers, under oath, within a time period prescribed by applicable law (30 days being typical). Requests for admissions are one party’s written demand that the other party admit or deny, in writing, certain statements of supposed fact or of the application of law to fact, within a time period prescribed by law (30 days again being typical). The other party’s failure to respond with an admission or denial during the legal time period is deemed an admission of the statements’ truth or accuracy. Requests for production of documents or other physical items (e.g., videos, photographs, and the like) are a discovery form employed by the parties in many civil cases. What about e-mail and other electronically stored information? For a discussion of the discoverability of such items, see the Cyberlaw in Action box that appears later in the chapter. When the issues in a case make the opposing litigant’s physical or mental condition relevant, a party may seek discovery in yet another way by filing a motion for a court order requiring that the opponent undergo a physical or mental examination. With the exception of the discovery form mentioned in the previous sentence, discovery generally takes place without a need for court orders or other judicial supervision. Courts become involved, however, if a party objects to a discovery request on the basis of privilege or other recognized legal ground, desires an order compelling a noncomplying litigant to respond to a discovery request, or seeks sanctions on a party who refused to comply with a legitimate discovery request or abusively invoked the discovery process. Documents and similar items obtained through the discovery process may be used at trial if they fall within the legal rules governing admissible evidence. The same is true of discovery material such as answers to interrogatories and responses to requests for admissions. If a party or other witness who testifies at trial offers testimony that differs from her statements during a deposition, the deposition may be used to impeach her—that is, to cast doubt on her trial testimony. A litigant may offer as evidence the deposition of a witness who died prior to trial or meets the legal standard of unavailability to testify in person.

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Part One Foundations of American Law

CYBERLAW IN ACTION In recent years, the widespread uses of e-mail and information presented and stored in electronic form have raised questions about whether, in civil litigation, an opposing party’s e-mails and electronic information are discoverable to the same extent as conventional written or printed documents. With the Federal Rules of Civil Procedure and comparable discovery rules applicable in state courts having been devised prior to the explosion in e-mail use and online activities, the rules’ references to “documents” contemplated traditional on-paper items. Courts, however, frequently interpreted “documents” broadly, so as to include e-mails and certain electronic communications within the scope of discoverable items. Even so, greater clarity regarding discoverability seemed warranted—especially as to electronic material that might be less readily classifiable than e-mails as “documents.” Various states responded by updating their discovery rules to include electronic communications within the list of discoverable items. So did the Federal Judicial Conference. In Federal Rules of Civil Procedure amendments proposed by the Judicial Conference and ratified by Congress in 2006, “electronically stored information” became a separate category of discoverable material. The electronically stored information (ESI) category is broad enough to include e-mails and similar communications as well as electronic business records, web pages, dynamic databases, and a host of other material existing in electronic form. So-called e-discovery has become a standard feature of civil litigation because of the obvious value of having access to the opposing party’s e-mails and other electronic communications. Discovery regarding ESI occurs in largely the same manner as discovery regarding conventional documents. The party seeking discovery of ESI serves a specific request for production on the other. The served party must provide the requested ESI if it is relevant, is not protected by a legal privilege (e.g., the attorney–client privilege), and is reasonably accessible. Court involvement becomes necessary only if the party from whom discovery is sought fails to comply or objects on lack of relevance, privilege, or burdensomeness grounds. The Federal Rules allow the party seeking discovery of ESI to specify the form in which the requested copies should appear (e.g., hard copies, electronic files, searchable CD, direct access to database, etc.). The party from whom discovery is sought may object to the specified form, in which event the court may have to resolve the dispute. If the requesting party does not specify a form, the other party must provide the requested electronic material in a form that is reasonably usable. The Federal Rules provide that if the requested electronic material is “not reasonably accessible because of undue burden or cost,” the party from whom discovery is sought need not provide it. When an objection along those lines is filed, the court decides whether the

objection is valid in light of the particular facts and circumstances. For instance, if requested e-mails appear only on backup tapes and searching those tapes would require the expenditures of significant time, money, and effort, are the requested e-mails “not reasonably accessible because of undue burden or costs”? Perhaps, but perhaps not. The court will rule, based on the relevant situation. The court may deny the discovery request, uphold it, or condition the upholding of it on the requesting party’s covering part or all of the costs incurred by the other party in retrieving the ESI and making it available. When a party fails or refuses to comply with a legitimate discovery request and the party seeking discovery of ESI has to secure a court order compelling the release of it, the court may order the noncompliant party to pay the attorney fees incurred by the requesting party in seeking the court order. If a recalcitrant party disregards a court order compelling discovery, the court may assess attorney fees against that party and/or impose evidentiary or procedural sanctions such as barring that party from using certain evidence or from raising certain claims or defenses at trial. The discussion suggests that discovery requests regarding ESI may be extensive and broad-ranging, with logistical issues often attending those requests. In recognition of these realities, the Federal Rules seek to head off disputes by requiring the parties to civil litigation to meet, at least through their attorneys, soon after the case is filed. The meeting’s goal is development of a discovery plan that outlines the parties’ intentions regarding ESI discovery and sets forth an agreement on such matters as the form in which the requested ESI will be provided. If the parties cannot agree on certain ESI discovery issues, the court will become involved to resolve the disputes. The discoverability of ESI makes it incumbent upon businesses to retain and preserve such material not only when litigation to which the material may be related has already been instituted, but also when potential litigation might reasonably be anticipated. Failure to preserve the electronic communications could give rise to allegations of evidence destruction and, potentially, sanctions imposed by a court. (For further discussion of related legal and ethical issues, see this chapter’s Ethics and Compliance in Action box.) Finally, given the now-standard requests of plaintiffs and defendants that the opposing party provide access to relevant e-mails, one should not forget this important piece of advice: Do not say anything in an e-mail that you would not say in a formal written memo or in a conversation with someone. There is a toofrequent tendency to think that because e-mails often tend to be informal in nature, one is somehow free to say things in an e-mail that he or she would not say in another setting. Many individuals and companies have learned the hard way that comments made in their e-mails or those of their employees proved to be damning evidence against them in litigation and thus helped the opposing parties win the cases.



Chapter Two The Resolution of Private Disputes

In addition, selected parts or all of the deposition of the opposing party or of certain persons affiliated with the opposing party may be used as evidence at trial, regardless of whether such a deponent is available to testify “live.” Participation in the discovery process may require significant expenditures of time and effort, not only by the attorneys but also by the parties and their employees. Parties who see themselves as too busy to comply with discovery requests may need to think seriously about whether they should remain a party to pending litigation. The discovery process may also trigger significant ethical issues, such as those associated with uses of discovery requests simply to harass or cause expense to the other party, or the issues faced by one who does not wish to hand over legitimately sought material that may prove to be damaging to him or to his employer.

Summary Judgment Summary judgment is a de-

vice for disposing of relatively clear cases without a trial. It differs from a demurrer because it involves factual determinations. To prevail, the party moving for a summary judgment must show that (1) there is no genuine issue of material (legally significant) fact and (2) she is entitled to judgment as a matter of law. A moving party satisfies the first element of the test by using the pleadings, relevant discovery information, and affidavits (signed and sworn statements regarding matters of fact) to show that there is no real question about any significant fact. She satisfies the second element by showing that, given the established facts, the applicable law clearly mandates that she win. Either or both parties may move for a summary judgment. If the court rules in favor of either party, that party wins the case. (The losing party may appeal, however.) If the parties’ summary judgment motions are denied, the case proceeds to trial. The judge may also grant a partial summary judgment, which settles some issues in the case but leaves others to be decided at trial.

The Pretrial Conference Depending

on the jurisdiction, a pretrial conference is either mandatory or held at the discretion of the trial judge. At this conference, the judge meets informally with the attorneys for both litigants. He or she may try to get the attorneys to stipulate, or agree to, the resolution of certain issues in order to simplify the trial. The judge may also urge them to convince their clients to settle the case by coming to an agreement that eliminates the need for a trial. If the case is not settled, the judge enters a pretrial order that includes the attorneys’ stipulations and any other agreements. Ordinarily, this order binds the parties for the remainder of the case.

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The Trial Once the case has been through discovery

and has survived any pretrial motions, it is set for trial. The trial may be before a judge alone (i.e., a bench trial), in which case the judge makes findings of fact and reaches conclusions of law before issuing the court’s judgment. If the right to a jury trial exists and either party demands one, the jury finds the facts. The judge, however, continues to determine legal questions.9 During a pretrial jury screening process known as voir dire, biased potential jurors may be removed for cause. In addition, the attorney for each party is allowed a limited number of peremptory challenges, which allow him to remove potential jurors without having to show bias or other cause. Trial Procedure At either a bench trial or a jury trial, the attorneys for each party make opening statements that outline what they expect to prove. The plaintiff’s attorney then presents her client’s case-in-chief by calling witnesses and introducing documentary evidence (relevant documents and written records, e-mails, videos, and other evidence having a physical form). The plaintiff’s attorney asks questions of her client’s witnesses in a process known as direct examination. If the plaintiff is an individual person rather than a corporation, he is very likely to testify. The plaintiff’s attorney may choose to call the defendant to testify. In this respect, civil cases differ from criminal cases, in which the Fifth Amendment’s privilege against self-incrimination bars the government from compelling the defendant to testify. After the plaintiff’s attorney completes direct examination of a witness, the defendant’s lawyer cross-examines the witness. This may be followed by redirect examination by the plaintiff’s attorney and recross examination by the defendant’s lawyer. Once the plaintiff’s attorney has completed the presentation of her client’s case, defense counsel presents his client’s case-in-chief by offering documentary evidence and the testimony of witnesses. The same process of direct, cross-, redirect, and recross-examination is followed, except that the examination roles of the respective lawyers are reversed. After the plaintiff and defendant have presented their casesin-chief, each party is allowed to present evidence rebutting the showing made by the other party. Throughout each side’s presentations of evidence, the opposing attorney may object, on specified legal grounds, to certain questions asked of The rules governing availability of a jury trial are largely beyond the scope of this text. The U.S. Constitution guarantees a jury trial in federal court cases “at common law” whose amount exceeds $20. Most states have similar constitutional provisions, often with a higher dollar amount. Also, Congress and the state legislatures have chosen to allow jury trials in various other cases. 9

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Part One Foundations of American Law

Ethics and Compliance in Action The broad scope of discovery rights in a civil case will often entitle a party to seek and obtain copies of e-mails, records, memos, and other documents and electronically stored information from the opposing party’s files. In many cases, some of the most favorable evidence for the plaintiff will have come from the defendant’s files, and vice versa. If your firm is, or is likely to be, a party to civil litigation and you know that the firm’s files contain materials that may be damaging to the firm in the litigation, you may be faced with the temptation to alter or destroy the potentially damaging items. This temptation poses serious ethical dilemmas. Is it morally defensible to change the content of records or documents on an after-the-fact basis, in order to lessen the adverse effect on your firm in pending or probable litigation? Is document destruction or e-mail deletion ethically justifiable when you seek to protect your firm’s interests in a lawsuit? If the ethical concerns are not sufficient by themselves to make you leery of involvement in document alteration or destruction, consider the potential legal consequences for yourself and your firm. The much-publicized collapse of the Enron Corporation in 2001 led to considerable scrutiny of the actions of the Arthur Andersen firm, which had provided auditing and consulting services to Enron. An Andersen partner, David Duncan, pleaded guilty to a criminal obstruction of justice charge that accused him of having destroyed, or having instructed Andersen employees to destroy, certain Enron-related records in order to thwart a Securities and Exchange Commission (SEC) investigation of Andersen. The U.S. Justice Department also launched an obstruction of justice prosecution against Andersen on the theory that the firm altered or destroyed records pertaining to Enron in order to impede the SEC investigation. A jury found Andersen guilty of obstruction of justice. Although the Andersen conviction was later overturned by the U.S. ­Supreme Court because the trial judge’s instructions to the jury on relevant principles of law had been impermissibly vague regarding the critical issue of criminal intent, a devastating effect on the firm had already taken place. Of course, not all instances of document alteration or destruction will lead to criminal prosecution for obstruction of justice. Other consequences of a noncriminal but clearly severe nature may result, however, from document destruction that interferes with legitimate discovery requests in a civil case. In such instances, courts have broad discretionary authority

witnesses or to certain evidence that has been offered for admission. The trial judge utilizes the legal rules of evidence to determine whether to sustain the objection (meaning that the objected-to question cannot be answered by the witness or that the offered evidence will be disallowed) or, instead,

to impose appropriate sanctions on the document-destroying party. These sanctions may include such remedies as court orders prohibiting the document-destroyer from raising certain claims or defenses in the lawsuit, instructions to the jury regarding the wrongful destruction of the documents, and court orders that the document-destroyer pay certain attorney fees to the opposing party. What about the temptation to refuse to cooperate regarding an opposing party’s lawful request for discovery regarding material in one’s possession? Although a refusal to cooperate seems less blameworthy than destruction or alteration of documents, extreme instances of recalcitrance during the discovery process may cause a party to experience adverse consequences similar to those imposed on parties who destroy or alter documents. Litigation involving Ronald Perelman and the Morgan Stanley firm provides an illustration. Perelman had sued Morgan Stanley on the theory that the investment bank participated with Sunbeam Corp. in a fraudulent scheme that supposedly induced him to sell Sunbeam his stake in another firm in return for Sunbeam shares whose value plummeted when Sunbeam collapsed. During the discovery phase of the case, Perelman had sought certain potentially relevant e-mails from Morgan Stanley’s files. Morgan Stanley repeatedly failed and refused to provide this discoverable material and, in the process, ignored court orders to provide the e-mails. Eventually, a fed-up trial judge decided to impose sanctions for Morgan Stanley’s wrongful conduct during the discovery process. The judge ordered that Perelman’s contentions would be presumed to be correct and that the burden of proof would be shifted to Morgan Stanley so that Morgan Stanley would have to disprove Perelman’s allegations. In addition, the trial judge prohibited Morgan Stanley from contesting certain allegations made by Perelman. The jury later returned a verdict in favor of Perelman and against Morgan Stanley for $604 million in compensatory damages and $850 million in punitive damages. The court orders sanctioning Morgan Stanley for its discovery misconduct undoubtedly played a key role in Perelman’s victory, effectively turning a case that was not a sure-fire winner for Perelman into just that. The case illustrates that a party to litigation may be playing with fire if he, she, or it insists on refusing to comply with legitimate discovery requests.

overrule it (meaning that the question may be answered or that the offered evidence will be allowed). The witnesses that plaintiffs and defendants call to testify at trial may include those who can testify as to relevant facts of which they have personal knowledge (often called



Chapter Two The Resolution of Private Disputes

lay witnesses) and, sometimes, so-called expert witnesses. If the court agrees that someone a plaintiff or defendant wishes to use as an expert witness possesses relevant scientific, technical, or other specialized knowledge, skill, experience, or educational background and could provide testimony potentially useful to the judge or jury, the court may permit the expert witness to provide opinion testimony or other insights regarding matters of importance in the case. (Lay witnesses, on the other hand, normally are not permitted to offer opinions in their testimony.) Before allowing such opinion testimony, however, the court must be satisfied not only that the witness qualifies as an expert by virtue of knowledge, skill, experience, or background, but also that his or her opinion testimony would be based on sufficient facts and would result from reasoned application of principles and methods considered reliable in the relevant field. In a significant number of cases, there may be “dueling experts” on a given matter—one expert witness called by the plaintiff and another by the defendant. After all of the evidence has been presented by the parties, each party’s attorney makes a closing argument summarizing his or her client’s position. In bench trials, the judge then usually takes the case under advisement rather than issuing a decision immediately. The judge later makes findings of fact and reaches conclusions of law, renders judgment, and, if the plaintiff is the winning party, states the relief to which the plaintiff is entitled. Jury Trials At the close of a jury trial, the judge ordinarily submits the case to the jury after issuing instructions that set forth the legal rules applicable to the case. The jury then deliberates, makes the necessary determinations of the facts, applies the applicable legal rules to the facts, and arrives at a verdict on which the court’s judgment will be based. The verdict form used the majority of the time is the general verdict, which requires only that the jury declare which party wins and, if the plaintiff wins, the money damages awarded. The jury neither states its findings of fact nor explains its application of the law to the facts. Although the nature of the general verdict may permit a jury, if it is so inclined, to render a decision that is based on bias, sympathy, or some basis other than the probable facts and the law, one’s belief regarding the extent to which juries engage in so-called jury nullification  of the facts and law is likely to be heavily influenced by one’s attitude toward the jury system. Most proponents of the jury system may be inclined to believe that “renegade” juries, though regrettable, are an aberration, and that the vast majority of juries make a good-faith effort to decide cases on the basis of

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the facts and controlling legal principles. Some jury system proponents, however, take a different view, asserting that juries should engage in jury nullification when they believe it is necessary to accomplish “rough justice.” Those who take a dim view of the jury system perceive it as fundamentally flawed and as offering juries too much opportunity to make decisions that stray from a reasonable view of the evidence and the law. Critics of the jury system have little hope of abolishing it, however. Doing so would require amendments to the U.S. Constitution and many state constitutions, as well as the repeal of numerous federal and state statutes. Another verdict form known as the special verdict may serve to minimize concerns that some observers have about jury decisions. When a special verdict is employed, the jury makes specific, written findings of fact in response to questions posed by the trial judge. The judge then applies the law to those findings. Whether a special verdict is utilized is a matter largely within the discretion of the trial judge. The special verdict is not as frequently employed, however, as the general verdict. Directed Verdict Although the general verdict gives the jury considerable power, the American legal system also has devices for limiting that power. One device, the directed verdict, takes the case away from the jury and provides a judgment to one party before the jury gets a chance to decide the case. The motion for a directed verdict may be made by either party; it usually occurs after the other (nonmoving) party has presented her evidence. The moving party asserts that the evidence, even when viewed favorably to the other party, leads to only one result and need not be considered by the jury. Courts differ on the test governing a motion for a directed verdict. Some deny the motion if there is any evidence favoring the nonmoving party, whereas others deny the motion only if there is substantial evidence favoring the nonmoving party. More often than not, trial judges deny motions for a directed verdict. Judgment Notwithstanding the Verdict On occasion, one party wins a judgment even after the jury has reached a verdict against that party. The device for doing so is the judgment notwithstanding the verdict (also known as the judgment non obstante veredicto or judgment n.o.v.). Some jurisdictions provide that a motion for judgment n.o.v. cannot be made unless the moving party previously moved for a directed verdict. In any event, the standard used to decide the motion for judgment n.o.v. usually is the same standard used to decide the motion for a directed verdict.

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Part One Foundations of American Law

Motion for a New Trial In a wide range of situations that vary among jurisdictions, the losing party can successfully move for a new trial. Acceptable reasons for granting a new trial include legal errors by the judge during the trial, jury or attorney misconduct, the discovery of new evidence, or an award of excessive damages to the plaintiff. Most motions for a new trial are unsuccessful, however.

Appeal A

final judgment generally prevents the parties from relitigating the same claim. One or more parties still may appeal the trial court’s decision, however. Normally, appellate courts consider only alleged errors of law made by the trial court. The matters ordinarily considered “legal” and thus appealable include the trial judge’s decisions on motions to dismiss, for summary judgment, for directed verdict or judgment notwithstanding the verdict, and for a new trial. Other matters typically considered appealable include trial court rulings on service of process and admission of evidence at trial, as well as the court’s legal conclusions in a nonjury trial, instructions to the jury in a jury case, and decision regarding damages or other relief. Appellate courts may affirm the trial court’s decision, reverse it, or affirm parts of the decision and reverse other parts. One of three things ordinarily results from an appellate court’s disposition of an appeal: (1) the plaintiff wins the case, (2) the defendant wins the case, or (3) the case is remanded (returned) to the trial court for further proceedings if the trial court’s decision is reversed in whole or in part. For example, if the plaintiff appeals a trial court decision granting the defendant’s motion to dismiss and the appellate courts affirm that decision, the plaintiff loses. On the other hand, if an appellate court reverses a trial court judgment in the plaintiff’s favor, the defendant could win outright, or the case might be returned to the trial court for further proceedings consistent with the appellate decision.

Enforcing a Judgment In this text, you may oc-

casionally see cases in which someone was not sued even though he probably would have been liable to the plaintiff, who sued another party instead. One explanation is that the first party was “judgment-proof”—so lacking in assets as to make a civil lawsuit for damages a waste of time and money. The defendant’s financial condition also affects a winning plaintiff’s ability to collect whatever damages she has been awarded. When the defendant fails to pay as required after losing a civil case, the winning plaintiff must enforce the judgment. Ordinarily, the plaintiff will obtain a writ of execution enabling the sheriff or federal marshal to seize designated property of the defendant and sell it at a judicial

sale to help satisfy the judgment. A judgment winner may also use a procedure known as garnishment to seize property, money, and wages that belong to the defendant but are in the hands of a third party such as a bank or employer. Legal limits exist, however, concerning the portion of wages that may be garnished. If the property needed to satisfy the judgment is located in another state, the plaintiff must use that state’s execution or garnishment procedures. Under the U.S. Constitution, the second state must give “full faith and credit” to the judgment of the state in which the plaintiff originally sued. Finally, when the court has awarded an equitable remedy such as an injunction, the defendant may be found in contempt of court and subjected to a fine or a jail term if he fails to obey the court’s order.

Class Actions So far, our civil procedure discussion

has proceeded as if the plaintiff and the defendant were single parties. Various plaintiffs and defendants, however, may be parties to one lawsuit. In addition, each jurisdiction has procedural rules stating when other parties can be joined to a suit that begins without them. One special type of multiparty case, the class action, allows one or more persons to sue on behalf of themselves and all others who have suffered similar harm from substantially the same wrong. Class action suits by consumers, environmentalists, and other groups now are reasonably common events. The usual justifications for the class action are that (1) it allows legal wrongs causing losses to a large number of widely dispersed parties to be fully compensated and (2) it promotes economy of judicial effort by combining many similar claims into one suit. The requirements for a class action vary among jurisdictions. The issues addressed by state and federal class action rules include the following: whether there are questions of law and fact common to all members of the alleged class; whether those common questions predominate over other questions; whether the class is small enough to allow all of its members to join the case as parties, rather than use a class action; and whether the plaintiff(s) and their attorney(s) can adequately represent the class without conflicts of interest or other forms of unfairness. To protect the individual class members’ right to be heard, some jurisdictions have required that unnamed or absent class members be given notice of the case if this is reasonably possible. The damages awarded in a successful class action usually are apportioned among the entire class. Establishing the total recovery and distributing it to the class, however, pose problems when the class is large, the class members’ injuries are indefinite, or some members cannot be identified.



Chapter Two The Resolution of Private Disputes

In 2005, Congress moved to restrict the filing of class actions in state courts by enacting a statute giving the federal district courts original jurisdiction over class actions in which the amount in controversy exceeds $5 million and any member of the plaintiff class resides in a state different from the state of any defendant. Proponents of the measure describe it as being designed to curtail “forum shopping” by multistate plaintiffs for “friendly” state courts that might be especially likely to favor the claims of the plaintiffs. Critics assert that the 2005 enactment is too protective of corporate defendants and likely to curtail the bringing of legitimate civil rights, consumer-protection, and environmental-harm claims. Those criticisms have been countered by assertions from other quarters that the 2005 law did not go far enough in restricting class actions. These critics contend that some proposed classes are simply “too big”—meaning that a corporate defendant could face ruinous financial consequences if the court allowed the case to proceed as a class action and liability was established. In such instances, the argument goes, the court should refuse to certify the case as a class action and thereby force individual plaintiffs to sue on a case-bycase basis. Over the last decade, the Supreme Court has issued important decisions dealing with class action certification issues. In Wal-Mart Stores, Inc. v. Dukes, 564 U.S. 338 (2011), the Court rejected class status for a group of 1.5 million females employed, or formerly employed, by Walmart. All 1.5 million claimed to have been the victims of sex discrimination during their Walmart employment as a result of a company practice that allowed local store managers very broad discretion in making salary and promotion decisions regarding store employees. The plaintiffs who sought class recognition alleged that in exercising this discretion, store managers made salary and promotion decisions that discriminated against them on the basis of their sex. In ruling that the case could not go forward as a class action, the Court concluded that even though the plaintiffs all

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claimed to have experienced sex discrimination as a result of a supposed corporate practice, this surface similarity in the discrimination allegations was not enough to satisfy a key class action certification requirement: the need for the plaintiffs’ claims to reflect common questions of law and fact. According to the Court, this “commonality” requirement called for the plaintiffs to show that they “suffered the same injury” in a specific sense. The Court reasoned that they could not do so, given the large number of store managers who exercised discretion in making decisions regarding individual employees and given the variability in the particular harms—and extent of harms—experienced by the employees. Although the Court did not invoke the “too big” argument referred to in an earlier paragraph, it seems possible that such a concern may have lurked in the background. Of course, the decision in Wal-Mart did not mean that the plaintiffs were automatically deprived of legal recourse for the alleged wrongs they claimed. They could still pursue their cases individually. As might be expected, however, only a small percentage of the employees and former employees opted to pursue their own individual cases once the Court denied them the opportunity to band together as a class. Wal-Mart appeared to suggest that courts should closely scrutinize class action requests and that class action certification would likely become more difficult for plaintiffs to obtain. A 2016 Supreme Court decision, however, reveals that class actions are not necessarily a dying breed after Wal-Mart. In Tyson Foods, Inc. v. Bouaphakeo, which follows, the Court affirms the lower court’s grant of class action certification. Besides concluding that the commonality element held lacking in WalMart was present in Bouaphakeo, the Court focuses on the related yet separate question of whether the common questions in the dispute predominate over the individual ones. In addition, the Court addresses an important evidentiary question. 

Tyson Foods, Inc. v. Bouaphakeo   136 S. Ct. 1036 (2016) A federal law, the Fair Labor Standards Act (FLSA), requires that if employees covered by the statute work more than 40 hours during a week, their employers must pay them overtime compensation. For those excess hours, employees are to be paid one and one-half times their regular hourly rate. The FLSA also requires employers to pay employees for activities that are integral and indispensable to their regular work, even if those activities do not occur at the employees’ workstations. In addition, the FLSA requires employers to keep records of employees’ wages, hours worked, and employment conditions. Peg Bouaphakeo and numerous other employees of Tyson Foods Inc. were covered by the FLSA. They worked in the kill, cut, and re-trim departments of a Tyson pork processing plant. Safety considerations associated with the nature of their work necessitated that these employees wear protective gear. The exact composition of the gear depended on the tasks they were assigned to perform on a given

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Part One Foundations of American Law

day. Tyson compensated some of the employees for the time spent in donning and doffing the protective gear. These employees were paid for an extra four minutes each day because Tyson estimated that four minutes was the time necessary to put on and take off the protective gear. For certain other employees, Tyson estimated that eight minutes was the relevant amount of time. Tyson, therefore, paid those employees for an extra eight minutes per day. Still other Tyson employees, though required to wear protective gear, were not paid for the donning-and-doffing time. Although Tyson recorded the amount of time each employee spent at his or her actual workstation, it did not record the time each employee spent in putting on and taking off the required protective gear. The employees took the position that this time significantly exceeded the four- and eight-minute estimates Tyson used. Bouaphakeo and the other employees sued Tyson in a federal district court, alleging that in either not including or not accurately including the donning-and-doffing time in hours the employees worked, Tyson had denied the employees overtime compensation required by the FLSA. The employees contended that wearing the protective gear was integral and indispensable to their work and that if their time spent putting on and taking off the required protective gear had been included in hours worked, they would have exceeded the 40-hours-per-week threshold for overtime pay. The employees sought to have their claims against Tyson certified as a class action under a collective action provision in the FLSA. Tyson argued that because of the variance in protective gear the respective employees wore, the employees’ claims were not sufficiently similar to be resolved in a class action. The district court concluded, however, that class action certification was warranted because common questions, such as whether putting on and taking off required protective gear was compensable under the FLSA, were present even if not all of the workers wore the same gear. Because Tyson did not keep records of the donning-and-doffing time, the employees relied on evidence stemming from a study by an industrial relations expert. The expert conducted more than 700 videotaped observations of how long various donning-and-doffing activities took and then averaged the time taken. This process yielded an estimate of 18 minutes per day for the cut and re-trim departments and 21.25 minutes per day for the kill department. These estimates were then added to the timesheets of each employee to ascertain which class members worked more than 40 hours in a week and to shed light on a possible class-wide recovery. The jury awarded the class approximately $2.9 million in unpaid wages. Before that amount was paid by Tyson and distributed to class members, Tyson appealed to the U.S. Court of Appeals for the Eighth Circuit. Tyson argued that the district court erred in certifying the case as a class action. After the Eighth Circuit affirmed the lower court’s decision, the U.S. Supreme Court agreed to decide the case.

Kennedy, Justice Tyson challenges the certification of the FLSA collective action. The parties do not dispute that the standard for certifying a collective action under the FLSA is no more stringent than the standard for certifying a class under the Federal Rules of Civil Procedure. This opinion assumes, without deciding, that this is correct. For purposes of this case, then, if certification of respondents’ class action under the Federal Rules was proper, certification of the collective action was proper as well. Federal Rule of Civil Procedure 23(b)(3) requires that, before a class is certified under that subsection, a district court must find that “questions of law or fact common to class members predominate over any questions affecting only individual members.” The “predominance inquiry tests whether proposed classes are sufficiently cohesive to warrant adjudication by representation.” Amchem Products, Inc. v. Windsor, 521 U.S. 591, 623 (1997). This calls upon courts to give careful scrutiny to the relation between common and individual questions in a case. An individual question is one where “members of a proposed class will need to present evidence that varies from member to member,” while a common question is one where “the same evidence will suffice for each member to make a prima facie showing [or] the issue is

susceptible to generalized, class-wide proof.” [Citation omitted.] The predominance inquiry “asks whether the common, aggregation-enabling, issues in the case are more prevalent or important than the non-common, aggregation-defeating, individual issues.” [Citation omitted.] When “one or more of the central issues in the action are common to the class and can be said to predominate, the action may be considered proper under Rule 23(b)(3) even though other important matters will have to be tried separately, such as damages or some affirmative defenses peculiar to some individual class members.” [Citation omitted.] Here, the parties do not dispute that there are important questions common to all class members, the most significant of which is whether time spent donning and doffing the required protective gear is compensable work under the FLSA. To be entitled to recovery, however, each employee must prove that the amount of time spent donning and doffing, when added to his or her regular hours, amounted to more than 40 hours in a given week. Tyson argues that these necessarily person-specific inquiries into individual work time predominate over the common questions raised by the employees’ claims, making class certification improper. The employees counter that these individual inquiries are unnecessary because it can be assumed each employee donned and



Chapter Two The Resolution of Private Disputes

doffed for the same average time observed [by the industrial relations expert in his review of videotapes of employees putting on protective gear]. Whether this inference is permissible becomes the central dispute in this case. Tyson contends that [the expert’s] study manufactures predominance by assuming away the very differences that make the case inappropriate for classwide resolution. Reliance on a representative sample, Tyson argues, absolves each employee of the responsibility to prove personal injury, and thus deprives petitioner of any ability to litigate its defenses to individual claims. Calling this unfair, Tyson maintains that the Court should announce a broad rule against the use in class actions of what the parties call representative evidence. A categorical exclusion of that sort, however, would make little sense. A representative or statistical sample, like all evidence, is a means to establish or defend against liability. Its permissibility turns not on the form a proceeding takes—be it a class or individual action—but on the degree to which the evidence is reliable in proving or disproving the elements of the relevant cause of action. It follows that the Court would reach too far were it to establish general rules governing the use of statistical evidence, or so-called representative evidence, in all class-action cases. Evidence of this type is used in various substantive realms of the law. Whether and when statistical evidence can be used to establish classwide liability will depend on the purpose for which the evidence is being introduced and on the elements of the underlying cause of action. In many cases, a representative sample is the only practicable means to collect and present relevant data establishing a defendant’s liability. In a case where representative evidence is relevant in proving a plaintiff’s individual claim, that evidence cannot be deemed improper  merely because the claim is brought on behalf of a class. One way for the employees to show, then, that the sample relied upon here is a permissible method of proving classwide liability is by showing that each class member could have relied on that sample to establish liability if he or she had brought an individual action. If the sample could have sustained a reasonable jury finding as to hours worked in each employee’s individual action, that sample is a permissible means of establishing the employees’ hours worked in a class action. In this suit, the employees sought to introduce a representative sample to fill an evidentiary gap created by the employer’s failure to keep adequate records. If the employees had proceeded with 3,344 individual lawsuits, each employee likely would have had to introduce [the expert’s] study to prove the hours he or she worked. Rather than absolving the employees from proving individual injury, the representative evidence here was a permissible means of making that very showing. Reliance on [the expert’s] study did not deprive Tyson of its ability to litigate individual

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defenses. Since there were no alternative means for the employees to establish their hours worked, Tyson’s primary defense was to show that [the expert’s] study was unrepresentative or inaccurate. That defense is itself common to the claims made by all class members. Tyson’s reliance on Wal-Mart Stores, Inc. v. Dukes, 564 U.S. 338 (2011), is misplaced. Wal-Mart does not stand for the broad proposition that a representative sample is an impermissible means of establishing classwide liability. Wal-Mart involved a nationwide Title VII class of over 1½ million employees. In reversing class certification, this Court did not reach Rule 23(b)(3)’s predominance prong, holding instead that the class failed to meet even Rule 23(a)’s more basic requirement that class members share a common question of fact or law. The plaintiffs in Wal-Mart did not provide significant proof of a common policy of discrimination to which each employee was subject. “The only corporate policy that the plaintiffs’ evidence convincingly establishe[d was] Wal-Mart’s ‘policy’ of allowing discretion by local supervisors over employment matters”; and even then, the plaintiffs could not identify “a common mode of exercising discretion that pervade[d] the entire company.”   Id. at 355–56. The plaintiffs in Wal-Mart proposed to use representative evidence as a means of overcoming this absence of a common policy. Under their proposed methodology, a “sample set of the class members would be selected, as to whom liability for sex discrimination and the backpay owing as a result would be determined in depositions supervised by a master.” Id. at 367. The aggregate damages award was to be derived by taking the percentage of claims determined to be valid from this sample and applying it to the rest of the class, and then multiplying the number of presumptively valid claims by the average backpay award in the sample set. The Court held that this “Trial By Formula” was [improper] because it enlarged the class members’ substantive right[s] and deprived defendants of their right to litigate statutory defenses to individual claims. The Court’s holding in the instant case is in accord with WalMart. The underlying question in Wal-Mart, as here, was whether the sample at issue could have been used to establish liability in an individual action. Since the Court held that the employees were not similarly situated, none of them could have prevailed in an individual suit by relying on depositions detailing the ways in which other employees were discriminated against by their particular store managers. By extension, if the employees had brought 1½ million individual suits, there would be little or no role for representative evidence. Permitting the use of that sample in a class action, therefore, would have [been inappropriate because it would have given] plaintiffs and defendants different rights in a class proceeding than they could have asserted in an individual action.

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Part One Foundations of American Law

In contrast, the study here could have been sufficient to sustain a jury finding as to hours worked if it were introduced in each employee’s individual action. While the experiences of the employees in Wal-Mart bore little relationship to one another, in this case each employee worked in the same facility, did similar work, and was paid under the same policy. [U]nder these circumstances the experiences of a subset of employees can be probative as to the experiences of all of them. This is not to say that all inferences drawn from representative evidence in an FLSA case are just and reasonable. Representative evidence that is statistically inadequate or based on implausible assumptions  could not lead to a fair or accurate estimate of the uncompensated hours an employee has worked. Tyson, however, did not raise a challenge to the methodology [used by the employees’ expert]. As a result, there is

no basis in the record to conclude it was legal error to admit that evidence. Once a district court finds evidence to be admissible, its persuasiveness is, in general, a matter for the jury. Reasonable minds may differ as to whether the average time [the expert] calculated is probative as to the time actually worked by each employee. Resolving that question, however, is the near-exclusive province of the jury. The district court could have denied class certification on this ground only if it concluded that no reasonable juror could have believed that the employees spent roughly equal time donning and doffing. The district court made no such finding, and the record here provides no basis for this Court to second-guess that conclusion.

Alternative Dispute Resolution

parties. Most cases settle at some stage in the proceedings described previously. The usual settlement agreement is a contract whereby the defendant, without admitting liability, agrees to pay the plaintiff a sum of money in exchange for the plaintiff’s promise to drop the claim against the defendant. Such agreements must satisfy the requirements of contract law discussed later in this text. In some cases, moreover, the court must approve the settlement in order for it to be enforceable. Examples include class actions and litigation involving minors.

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Explain the differences among the major forms of alternative dispute resolution.

Lawsuits are not the only devices for resolving civil disputes. Nor are they always the best means of doing so. Settling private disputes through the courts can be a cumbersome, lengthy, and expensive process for litigants. With the advent of a litigious society and the increasing caseloads it has produced, handling disputes in this fashion also imposes ever-greater social costs. For these reasons and others, various forms of alternative dispute resolution (ADR) have assumed increasing importance in recent years. Proponents of ADR cite many considerations in its favor. These include ADR’s (1) quicker resolution of disputes; (2) lower costs in time, money, and aggravation for the parties; (3) lessening of the strain on an overloaded court system; (4) use of decision makers with specialized expertise; and (5) potential for compromise decisions that promote and reflect consensus between the parties. As will be seen in later discussion, however, there are ADR skeptics.

Common Forms of ADR Settlement The settlement of a civil lawsuit is not everyone’s idea of an alternative dispute resolution mechanism. It is an important means, however, of avoiding protracted litigation—one that often is a sensible compromise for the

Judgment of Eighth Circuit Court of Appeals affirmed.

Arbitration Arbitration is the submission of a dispute to a neutral, nonjudicial third party (the arbitrator) who issues a binding decision resolving the dispute. Arbitration usually results from the parties’ agreement. That agreement normally is made before the dispute arises (most often through an arbitration clause in a contract). As noted in the Concepcion case, which follows shortly, the Federal Arbitration Act requires judicial enforcement of a wide range of agreements to arbitrate claims. This means that if a contract contains a clause requiring arbitration of certain claims but one of the parties attempts to litigate such a claim in court, the court is very likely to dismiss the case and compel arbitration of the dispute. Arbitration may also be compelled by other statutes. One example is the compulsory arbitration many states require as part of the collective bargaining process for certain public employees. Finally, parties who have not agreed in advance to submit future disputes to arbitration may agree upon arbitration after the dispute arises.



Chapter Two The Resolution of Private Disputes

Arbitration usually is less formal than regular court proceedings. The arbitrator may or may not be an attorney. Often, she is a professional with expertise in the subject matter of the dispute. Although arbitration hearings often resemble civil trials, the applicable procedures, the rules for admission of evidence, and the record-keeping requirements typically are not as rigorous as those governing courts. Arbitrators sometimes have freedom to ignore rules of substantive law that would bind a court. The arbitrator’s decision, called an award, is filed with a court, which will enforce it if necessary. The losing party may object to the arbitrator’s award, but judicial review of arbitration proceedings is limited. According to the Federal Arbitration Act (FAA), grounds for overturning an arbitration award include (1) a party’s use of fraud, (2) the arbitrator’s partiality or corruption, and (3) other misconduct by the arbitrator. The previously noted advantages of arbitration and the enforceability of arbitration clauses in contracts have combined in recent years to make such clauses common features in various types of contracts. Skeptics of arbitration, however, worry about this development, particularly when the relevant contract is one drafted entirely or almost entirely by the party with greater economic power and business sophistication. These critics point to arbitration’s potential for unfairness to ordinary consumers or employees of, say, a large corporation when they find that their dispute with the corporation cannot be resolved in court but must instead be submitted to arbitration because of an arbitration clause in the parties’ contract. In such situations, the contract’s terms probably would have been dictated by the corporation rather than having been arrived at through a genuine bargaining process. Although most arbitrators almost certainly strive to be fair, critics cite the supposed danger that some arbitrators may tend to favor parties with greater economic clout because, as the old saying goes, “they know which side their bread is buttered on.” These arguments about the potential for second-class justice, whether accurate or overblown, have led to calls in

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some quarters for legislative action in which Congress would tinker with the FAA by denying or restricting the ability of business organizations to include binding arbitration clauses in their contracts with ordinary consumers or employees (as opposed to contracts with other business entities). In 2019 the U.S. House of Representatives passed the Forced Arbitration Injustice Repeal Act (FAIR Act), which prohibits a forced arbitration agreement from being enforced if it requires forced arbitration of an employment, consumer, or civil rights claim against a corporation. As this book went to press, passage in the Senate and enactment of this legislation was uncertain. During recent years, this further question about arbitration has arisen: If state law permits the creation of a classwide arbitration that combines individual arbitrations presenting the same issues, is an arbitration clause enforceable under the FAA if it not only requires individual arbitration but also bans classwide arbitration? The two Supreme Court decisions discussed below address that question. AT&T Mobility LLC v. Concepcion, which follows shortly, addresses the FAA’s purposes and emphasizes that the FAA’s provision requiring enforcement of agreements to arbitrate controls over nearly all state laws that would stand in the way of enforcement of such an agreement. The Supreme Court goes on to hold that contract provisions requiring arbitration of claims on an individual basis—and prohibiting joinder of those claims with others in a class action–type arbitration—are both permissible and enforceable under the FAA, notwithstanding any state law to the contrary. In American Express Co. v. Italian Colors Restaurant, 133 S. Ct. 2304 (2013), the Supreme Court followed the lead of Concepcion and held that a court must respect a contractual waiver of class arbitration even if plaintiffs seeking to bring a class action in court contend that the plaintiffs’ costs of individually arbitrating claims for an alleged violation of federal law would exceed the potential recovery. Taken together, the two decisions probably will make class arbitration an increasingly rare species, as corporations seem likely to draft arbitration clauses so that they not only

AT&T Mobility LLC v. Concepcion   563 U.S. 333 (2011) Vincent and Liza Concepcion entered into a contract for the sale and servicing of cellular phones with AT&T Mobility LLC (AT&T). AT&T used the same contract in its dealings with other customers. The agreement called for arbitration of all disputes between the parties but required that claims be brought in the parties’ “individual capacity, and not as a plaintiff or class member in any purported class or representative proceeding.” AT&T advertised the service that the Concepcions purchased as including the provision of free phones. Although the Concepcions were not charged for the phones, they were charged $30.22 in sales tax based on the phones’ retail value. The Concepcions later sued AT&T in the U.S. District Court for the Southern District of California. Their complaint was consolidated with a class action case alleging, among other things, that AT&T had engaged in false advertising and fraud by charging sales tax on phones it advertised as free.

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AT&T filed a motion asking the court to compel arbitration under the terms of its contract with the Concepcions. The Concepcions opposed the motion, contending that the arbitration agreement was unconscionable and otherwise objectionable under California law because it disallowed classwide procedures. Finding the arbitration provision unconscionable because AT&T had not shown that arbitration of individual disputes adequately substituted for the deterrent effects of class actions, the district court denied AT&T’s motion. In so ruling, the court relied on the California Supreme Court’s decision in Discover Bank v. Superior Court, 113 P.3d 1100 (Cal. 2005). The U.S. Court of Appeals for the Ninth Circuit affirmed on the same ground. The Ninth Circuit also held that the Federal Arbitration Act (FAA) did not preempt the California rule stemming from Discover Bank. The U.S. Supreme Court granted AT&T’s request that it decide the case. Scalia, Justice Section 2 of the FAA makes agreements to arbitrate “valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” We consider whether the FAA prohibits states from conditioning the enforceability of certain arbitration agreements on the availability of classwide arbitration procedures. The FAA was enacted in 1925 in response to widespread judicial hostility to arbitration agreements. We have described [§ 2 of the FAA] as reflecting both a “liberal federal policy favoring arbitration” and the “fundamental principle that arbitration is a matter of contract.” [Case citations omitted.] In line with these principles, courts must place arbitration agreements on an equal footing with other contracts, and enforce them according to their terms. The final phrase of § 2, however, permits arbitration agreements to be declared unenforceable “upon such grounds as exist at law or in equity for the revocation of any contract.” This saving clause permits agreements to arbitrate to be invalidated by “generally applicable contract defenses, such as fraud, duress, or unconscionability,” but not by defenses that apply only to arbitration or that derive their meaning from the fact that an agreement to arbitrate is at issue. [Case citations omitted.] The question in this case is whether § 2 preempts California’s rule classifying most collective-arbitration waivers in consumer contracts as unconscionable. We refer to this rule as the Discover Bank rule. Under California law, courts may refuse to enforce any contract found “to have been unconscionable at the time it was made,” or may “limit the application of any unconscionable clause.” [Statutory citation omitted.] A finding of unconscionability requires “a ‘procedural’ and a ‘substantive’ element, the former focusing on ‘oppression’ or ‘surprise’ due to unequal bargaining power, the latter on ‘overly harsh’ or ‘one-sided’ results.” [Case citation omitted.] In Discover Bank, the California Supreme Court applied this framework to class-action waivers in arbitration agreements and held as follows: [W]hen the waiver is found in a consumer contract of adhesion in a setting in which disputes between the contracting parties predictably involve small amounts of damages, and when it is alleged that the party with the superior bargaining power has carried out a scheme to deliberately cheat

large numbers of consumers out of individually small sums of money, then . . . the waiver becomes in practice the exemption of the party from responsibility for [its] own fraud, or willful injury to the person or property of another. Under these circumstances, such waivers are unconscionable under California law and should not be enforced. California courts have frequently applied this rule to find arbitration agreements unconscionable. The Concepcions argue that the Discover Bank rule, given its origins in California’s unconscionability doctrine and California’s policy against exculpat[ory] [agreements] is a ground that “exist[s] at law or in equity for the revocation of any contract” under FAA § 2. Moreover, they argue that even if we construe the Discover Bank rule as a prohibition on collective-action waivers rather than simply an application of unconscionability, the rule would still be applicable to all dispute-resolution contracts, since California prohibits waivers of class litigation as well. When state law prohibits outright the arbitration of a particular type of claim, the analysis is straightforward: The conflicting rule is displaced by the FAA. Preston v. Ferrer, 552 U.S. 346, 353 (2008). But the inquiry becomes more complex when a doctrine normally thought to be generally applicable, such as duress or, as relevant here, unconscionability, is alleged to have been applied in a fashion that disfavors arbitration. In Perry v. Thomas, 482 U.S. 483 (1987), for example, we noted that the FAA’s preemptive effect might extend even to grounds traditionally thought to exist “‘at law or in equity for the revocation of any contract.’” We said that a court may not “rely on the uniqueness of an agreement to arbitrate as a basis for a state-law holding that enforcement would be unconscionable, for this would enable the court to effect what . . . the state legislature cannot.” An obvious illustration of this point would be a case finding unconscionable or unenforceable as against public policy consumer arbitration agreements that fail to provide for judicially monitored discovery. The rationalizations for such a holding are neither difficult to imagine nor different in kind from those articulated in Discover Bank. A court might reason that no consumer would knowingly waive his right to full discovery, as this would enable companies to hide their wrongdoing [and possibly evade legal responsibility]. And, the reasoning would continue, because such a rule applies the general principle of



Chapter Two The Resolution of Private Disputes

unconscionability or public-policy disapproval of exculpatory agreements, it is applicable to “any” contract and thus preserved by § 2 of the FAA. In practice, of course, the rule would have a disproportionate impact on arbitration agreements, but it would presumably apply to contracts purporting to restrict discovery in litigation as well. Although § 2’s saving clause preserves generally applicable contract defenses, nothing in it suggests an intent to preserve state-law rules that stand as an obstacle to the accomplishment of the FAA’s objectives. The “principal purpose” of the FAA is to “ensur[e] that private arbitration agreements are enforced according to their terms.” [Case citation omitted.] [Accordingly,] we have held that parties may agree to limit the issues subject to arbitration, to arbitrate according to specific rules, and to limit with whom a party will arbitrate its disputes. [Case citations omitted.] The point of affording parties discretion in designing arbitration processes is to allow for efficient, streamlined procedures tailored to the type of dispute. It can be specified, for example, that the decision-maker be a specialist in the relevant field, or that proceedings be kept confidential to protect trade secrets. And the informality of arbitral proceedings is itself desirable, reducing the cost and increasing the speed of dispute resolution. [O]ur cases  .  .  .  have repeatedly described the FAA as “embod[ying] [a] national policy favoring arbitration,” and “a liberal federal policy favoring arbitration agreements, notwithstanding any state substantive or procedural policies to the contrary.” [Case citations omitted.] Thus, in Preston v. Ferrer, holding preempted a state-law rule requiring exhaustion of administrative remedies before arbitration, we said: “A prime objective of an agreement to arbitrate is to achieve ‘streamlined proceedings and expeditious results,’” which objective would be “frustrated” by requiring a dispute to be heard by an agency first. That rule, we said, would “at the least, hinder speedy resolution of the controversy.” California’s Discover Bank rule similarly interferes with arbitration. Although the rule does not require classwide arbitration, it allows any party to a consumer contract to demand it ex post. The rule also requires that damages be predictably small, and that the consumer allege a scheme to cheat consumers. The former requirement, however, is toothless and malleable, and the latter has no limiting effect, as all that is required is an allegation. Consumers remain free to bring and resolve their disputes on a bilateral basis under Discover Bank, and some may well do so; but there is little incentive for lawyers to arbitrate on behalf of individuals when they may do so for a class and reap far higher fees in the process. And faced with inevitable class arbitration, companies would have less incentive to continue resolving potentially duplicative claims on an individual basis. Although we have had little occasion to examine classwide arbitration, our decision in Stolt-Nielsen S.A. v. Animal Feeds Int’l

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Corp., 130 S. Ct. 1758 (2010), is instructive. In that case we held that an arbitration panel exceeded its power under . . . the FAA by imposing class procedures based on policy judgments rather than the arbitration agreement itself or some background principle of contract law that would affect its interpretation. We then held that the agreement at issue, which was silent on the question of class procedures, could not be interpreted to allow them because the “changes brought about by the shift from bilateral arbitration to class-action arbitration” are “fundamental.” Classwide arbitration includes absent parties, necessitating additional and different procedures and involving higher stakes. Confidentiality becomes more difficult. And while it is theoretically possible to select an arbitrator with some expertise relevant to the classcertification question, arbitrators are not generally knowledgeable in the often-dominant procedural aspects of certification, such as the protection of absent parties. The conclusion follows that class arbitration, to the extent it is manufactured by Discover Bank rather than consensual, [interferes with fundamental attributions of arbitration and] is inconsistent with the FAA. First, the switch from bilateral to class arbitration sacrifices the principal advantage of arbitration—its informality—and makes the process slower, more costly, and more likely to generate procedural morass than final judgment. [B]efore an arbitrator may decide the merits of a claim in classwide procedures, he must first decide, for example, whether the class itself may be certified, whether the named parties are sufficiently representative and typical, and how discovery for the class should be conducted. A cursory comparison of bilateral and class arbitration illustrates the difference. According to the American Arbitration Association (AAA), the average consumer arbitration between January and August 2007 resulted in a disposition on the merits in six months. As of September 2009, the AAA had opened 283 class arbitrations. Of those, 121 remained active, and 162 had been settled, withdrawn, or dismissed. Not a single one, however, had resulted in a final award on the merits. For those cases that were no longer active, the [mean] time from filing to settlement, withdrawal, or dismissal—not judgment on the merits—was . . . 630 days. Second, class arbitration requires procedural formality. The AAA’s rules governing class arbitrations mimic the Federal Rules of Civil Procedure for class litigation. And while parties can alter those procedures by contract, an alternative is not obvious. If procedures are too informal, absent class members would not be bound by the arbitration. For a class-action money judgment to bind absentees in litigation, class representatives must at all times adequately represent absent class members, and absent members must be afforded notice, an opportunity to be heard, and a right to opt out of the class. At least this amount of process would presumably be required for absent parties to be bound by the results of arbitration. We find it unlikely that in passing the FAA, Congress meant to leave the disposition of

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these procedural requirements to an arbitrator. Indeed, class arbitration was not even envisioned by Congress when it passed the FAA in 1925. Third, class arbitration greatly increases risks to defendants. Informal procedures do of course have a cost: The absence of multilayered review makes it more likely that errors will go uncorrected. Defendants are willing to accept the costs of these errors in arbitration, since their impact is limited to the size of individual disputes, and presumably outweighed by savings from avoiding the courts. But when damages allegedly owed to tens of thousands of potential claimants are aggregated and decided at once, the risk of an error will often become unacceptable.

Faced with even a small chance of a devastating loss, defendants will be pressured into settling questionable claims. The dissent claims that class proceedings are necessary to prosecute small-dollar claims that might otherwise slip through the legal system. But states cannot require a procedure that is inconsistent with the FAA, even if it is desirable for unrelated reasons. Because it “stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress,” [case citation omitted,] California’s Discover Bank rule is preempted by the FAA.

mandate arbitration but require it to be of the individual claim variety.

mock jury trial that does not bind the parties. If the parties do not settle after completion of the summary jury trial, they still are entitled to a regular court trial. There is some disagreement over whether courts can compel the parties to take part in a summary jury trial.

Court-Annexed Arbitration In this form of ADR, certain civil lawsuits are diverted into arbitration. One example might be cases in which less than a specified dollar amount is at issue. Most often, court-annexed arbitration is mandatory and is ordered by the judge, but some jurisdictions merely offer litigants the option of arbitration. The losing party in a court-annexed arbitration still has the right to a regular trial. Mediation In mediation, a neutral third party called a mediator helps the parties reach a cooperative resolution of their dispute by facilitating communication between them, clarifying their areas of agreement and disagreement, helping them see each other’s viewpoints, and suggesting settlement options. Mediators, unlike arbitrators, cannot make decisions that bind the parties. Instead, a successful mediation process results in a mediation agreement. Such agreements normally are enforced under regular contract law principles. Mediation is used in a wide range of situations, including labor, commercial, family, and environmental disputes. It may occur by agreement of the parties after a dispute has arisen. It may also result from a previous contractual agreement by the parties. Increasingly, court-annexed mediation is either compelled or made available by courts in certain cases. Summary Jury Trial Sometimes settlement of civil litigation is impeded because the litigants have vastly different perceptions about the merits of their cases. In such cases, the summary jury trial may give the parties a needed dose of reality. The summary jury trial is an abbreviated, nonpublic

Decision of Ninth Circuit Court of Appeals reversed, and case remanded for further proceedings.

Minitrial A minitrial is an informal, abbreviated private “trial” whose aim is to promote settlement of disputes. Normally, it arises out of a private agreement that also describes the procedures to be followed. In the typical minitrial, counsel for the parties present their cases to a panel composed of senior management from each side. Sometimes a neutral advisor such as an attorney or  a retired judge presides. This advisor may also offer an  opinion about the case’s likely outcome in court. After the presentations, the managers attempt to negotiate a settlement.

Other ADR Devices Other ADR devices include

(1) med/arb (a hybrid of mediation and arbitration in which a third party first acts as a mediator, and then as an arbitrator), (2) the use of magistrates and special masters to perform various tasks during complex litigation in the federal courts, (3) early neutral evaluation (ENE) (a courtannexed procedure involving early, objective evaluation of the case by a neutral private attorney with experience in its subject matter), (4) private judging (in which litigants hire a private referee to issue a decision that may be binding but that usually does not preclude recourse to the courts), and (5) private panels instituted by an industry or an organization to handle claims of certain kinds (e.g., the Better Business Bureau). In addition, some formal legal processes are sometimes called ADR devices. Examples include small claims courts and the administrative procedures used to handle claims for veterans’ benefits or Social Security benefits.



Chapter Two The Resolution of Private Disputes

Problems and Problem Cases 1. Victoria Wilson, a resident of Illinois, wishes to bring an invasion of privacy lawsuit against XYZ Co. because XYZ used a photograph of her, without her consent, in an advertisement for one of the company’s products. Wilson will seek money damages of $150,000 from XYZ, whose principal offices are located in New Jersey. A New Jersey newspaper was the only print media outlet in which the advertisement was published. However, XYZ also placed the advertisement on the firm’s website. This website may be viewed by anyone with Internet access, regardless of the viewer’s geographic location. Where, in a geographic sense, may Wilson properly file and pursue her lawsuit against XYZ? Must Wilson pursue her case in a state court, or does she have the option of litigating in federal court? Assuming that Wilson files her case in state court, what strategic option may XYZ exercise if it acts promptly? 2. Alex Ferrer, a former judge who appeared as “Judge Alex” on a television program, entered into a contract with Arnold Preston, a California attorney who rendered services to persons in the entertainment industry. Seeking fees allegedly due under the contract, Preston invoked the clause setting forth the parties’ agreement to arbitrate “any dispute . . .  relating to the terms of [the contract] or the breach, validity, or legality thereof . . .  in accordance with the rules [of the American Arbitration Association].” Ferrer countered Preston’s demand for arbitration by filing, with the California Labor Commissioner, a petition in which he contended that the contract was unenforceable under the California Talent Agencies Act (CTAA) because Preston supposedly acted as a talent agent without the license required by the CTAA. In addition, Ferrer sued Preston in a California court, seeking a declaration that the dispute between the parties regarding the contract and its validity was not subject to arbitration. Ferrer also sought an injunction restraining Preston from proceeding before the arbitrator unless and until the Labor Commissioner concluded that she did not have authority to rule on the parties’ dispute. Preston responded by moving to compel arbitration, in reliance on the Federal Arbitration Act. The California court denied Preston’s motion to compel arbitration and issued the injunction sought by Ferrer. Was the court correct in doing so? 3. Dog-breeders Ron and Catherine Bombliss lived in Illinois. They bred Tibetan mastiffs, as did Oklahoma

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residents Anne and Jim Cornelsen. When Anne Cornelson telephoned the Bomblisses and said she was ready to sell two litters of Tibetan mastiff puppies, Ron Bombliss expressed interest in purchasing two females of breeding quality. The Cornelsens had a website that allowed communications regarding dogs available for purchase but did not permit actual sales via the website. The Bomblisses traveled to Oklahoma to see the Cornelsens’ puppies and ended up purchasing two of them. The Cornelsens provided a guarantee that the puppies were suitable for breeding purposes. Following the sale, the Cornelsens mailed, to the Bomblisses’ home in Illinois, American Kennel Club registration papers for the puppies. Around this same time, Anne Cornelsen posted comments in an Internet chat room frequented by persons interested in Tibetan mastiffs. These comments suggested that the mother of certain Tibetan mastiff puppies (including one the Bomblisses had purchased) may have had a genetic disorder. The comments were made in the context of an apparent dispute between the Cornelsens and Richard Eichhorn, who owned the mother mastiff and had made it available to the Cornelsens for breeding purposes. The Bomblisses believed that the comments would have been seen by other persons in Illinois and elsewhere and would have impaired the Bomblisses’ ability to sell their puppies even though, when tested, their puppies were healthy. The Bomblisses therefore sued the Cornelsens in an Illinois court on various legal theories. The Cornelsens asked the Illinois court to dismiss the case on the ground that the court lacked in personam jurisdiction over them. Did the Illinois court lack in personam jurisdiction? 4. Hall Street Associates was the landlord and Mattel Inc. was the tenant under various leases for property that Mattel used as a manufacturing site for many years. The leases provided that the tenant would indemnify the landlord for any costs resulting from the tenant’s failure to follow environmental laws while using the premises. Tests of the property’s well water in 1998 showed high levels of trichloroethylene (TCE), the apparent residue of manufacturing discharges connected with Mattel’s operations on the site between 1951 and 1980. After the Oregon Department of Environmental Quality (DEQ) discovered even more pollutants, Mattel signed a consent order with the DEQ providing for cleanup of the site. After Mattel gave notice of intent to terminate the lease in 2001, Hall Street sued, contesting Mattel’s right to vacate on the date it gave and claiming that the leases obliged Mattel to

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indemnify Hall Street for the costs of cleaning up the TCE. A federal district court ruled in Mattel’s favor on the termination issue. The parties then proposed that they be permitted to submit the indemnification issue to arbitration rather than having the court rule on it. The court was amenable. The parties drew up an arbitration agreement, which the court approved and entered as an order. One paragraph of the agreement provided that [t]he United States District Court for the District of Oregon may enter judgment upon any [arbitration] award, either by confirming the award or by vacating, modifying or correcting the award. The court shall vacate, modify or correct any award: (i) where the arbitrator’s findings of facts are not supported by substantial evidence, or (ii) where the  arbitrator’s conclusions of law are erroneous.

The arbitrator initially decided in Mattel’s favor on the indemnification question, but the federal district court vacated the arbitrator’s decision on the ground of legal error (the basis set forth in the parties’ arbitration agreement). On remand, the arbitrator ruled in favor of Hall Street. The district court upheld this ruling. Mattel then appealed to the U.S. Court of Appeals for the Ninth Circuit, arguing that the arbitrator’s initial decision in Mattel’s favor should be reinstated. In particular, Mattel argued that the agreement calling for the district court to vacate the arbitrator’s decision in the event of legal error amounted to an unenforceable attempt to expand the legally permitted grounds for setting aside an arbitrator’s decision (as set forth in the Federal Arbitration Act). How did the Ninth Circuit rule? 5. WWP Inc. (WWP) is a charitable organization that furnishes assistance to injured military veterans and their families. WWP conducts its operations under the name “Wounded Warrior Project.” After WWP had been in existence for approximately a year, a separate, unaffiliated charitable organization, Wounded Warriors Family Support Inc. (WWFS), began providing assistance to injured veterans and their families. WWFS operated outside the United States as of 2002 but later became active within the United States. WWFS also launched a website whose domain name, “wounded warriors.org,” was similar to a domain name used by WWP. In addition, WWFS’s website included content referring to a “Wounded Warriors Hospital Fund.” Through use of this website, WWFS received large amounts of donated funds. WWP sued WWFS in the U.S. District Court for the District of

Nebraska. Relying on various legal theories, WWP alleged that WWFS created confusion through its website as to whether WWP and WWFS were affiliated and that WWFS had been unjustly enriched through receipt and retention of donations actually meant for WWP. After a jury trial, the district court awarded WWP approximately $1.7 million in damages and issued an injunction meant to curb further instances of confusion. WWFS appealed to the U.S. Court of Appeals for the Eighth Circuit. In its appeal, WWFS argued (among other things) that the district court had erred in denying WWFS’s motion to compel WWP to produce “[a]ll documents relating to or evidencing any donations received by [WWP] from January 1, 2002 to the present” after WWP refused to provide the documents. WWFS also argued on appeal that the district court erred in allowing a forensic accountant to testify as an expert witness who offered an opinion regarding the amount of damages allegedly sustained by WWP. WWFS argued that the forensic accountant should not have been permitted to testify as an expert because he utilized what WWFS regarded as simple mathematical calculations and because his opinion on damages was insufficiently connected with the facts of the case. Did the district court err in denying the motion to compel production of the requested documents? Did the district court err in permitting the forensic accountant to offer an expert opinion? 6. Jerrie Gray worked at a Tyson Foods plant where she was exposed to comments, gestures, and physical contact that, she alleged, constituted sexual harassment. Tyson disputed the allegation, arguing that the behavior was not unwelcome; that the complained-about conduct was not based on sex; that the conduct did not affect a term, condition, or privilege of employment; and that proper remedial action was taken in response to any complaint by Gray of sexual harassment. During the trial in federal court, a witness for Gray repeatedly volunteered inadmissible testimony that the judge had to tell the jury to disregard. At one point, upon an objection from the defendant’s counsel, the witness asked, “May I say something here?” The judge told her she could not. Finally, after the jury left the courtroom, the witness had an angry outburst that continued into the hallway, in view of some of the jurors. The jury awarded Gray $185,000 in compensatory and $800,000 in punitive damages. Tyson believed that it should not have been liable, that the awards of damages were excessive and unsupported by evidence, and



Chapter Two The Resolution of Private Disputes

that the inadmissible evidence and improper conduct had tainted the proceedings. What courses of action may Tyson pursue? 7. Oklahoma resident Samantha Guffey purchased a used 2009 Volvo XC90 (Volvo) from Odil Ostonakulov and Motorcars of Nashville Inc. (MNI). Ostonakulov resides in Tennessee. MNI is a Tennessee corporation with its principal place of business in Nashville, Tennessee. Ostonakulov and MNI operate a used car lot in Nashville. The sale occurred after Guffey was the winning bidder for the car in an auction by MNI on eBay. After receiving the Volvo, Guffey determined that it was not in the condition advertised. She later sued Ostonakulov and MNI in an Oklahoma state trial court for alleged fraud and alleged violations of an Oklahoma consumer protection law. The defendants moved to dismiss for lack of in personam jurisdiction. In an affidavit Guffey provided for the court as it considered the defendants’ jurisdiction objection, Guffey stated that she bid on the Volvo listed on eBay based, in part, on the representation of a 30-day limited warranty on the car. The affidavit also stated that after she submitted her bid, but several days before the closing date of the auction, she received an e-mail solicitation from Ostonakulov suggesting that she contact him by phone and negotiate a “buy-it-now” price for the vehicle. She chose not to do so, but only after calling and speaking with him personally about the matter. After Gulley learned that she had won the auction with the highest bid, she had her father call and speak to Ostonakulov about final details and payment instructions. Ostonakulov mailed a purchase agreement to Gulley’s father’s office in Oklahoma City. Gulley signed the agreement and returned it to Tennessee. Ostonakulov also helped arrange shipping of the vehicle to Oklahoma, where Guffey took delivery. According to Guffey’s affidavit, the eBay sale to her was not an isolated transaction for the defendants and that they have between 12 and 35 cars listed for sale every day on eBay. The affidavit also asserted that the defendants had sold at least three cars in Oklahoma and that they have sold more than 30 cars to Oklahoma residents. Oklahoma has a long-arm statute that applies to the full extent permitted by due process principles. The Oklahoma trial court dismissed the case after concluding that it did not have in personam jurisdiction over the defendants. Guffey appealed to the Supreme Court of Oklahoma. How did that court rule on the jurisdiction question?

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8. Abbott Laboratories manufactured and sold the Life Care PCA, a pump that delivers medication into a person intravenously at specific time intervals. Beverly Lewis sued Abbott in a Mississippi state court, alleging that a defective Life Care PCA had injured her by delivering an excessive quantity of morphine. Abbott served Lewis with a request for admission calling for her to admit that her damages did not exceed $75,000. Lewis did not answer the request for admission. Abbott removed the case to the U.S. District Court for the Southern District of Mississippi, predicating the court’s subject-matter jurisdiction on diversity of citizenship and an amount in controversy exceeding $75,000. Contending that her silence had amounted to an admission that her damages were less than $75,000, Lewis filed a motion asking that the federal court remand the case to the state court. Did the federal court have subject-matter jurisdiction? How did the federal court rule on Lewis’s motion to send the case back to the state court? 9. The state of New Jersey says it is sovereign over certain landfilled portions of Ellis Island. The state of New York disagrees, asserting that it is sovereign over the whole of the island. New Jersey brings an action in the U.S. District Court for the Southern District of New York. Should the court hear the case? 10. Florian Hinrichs, a citizen of Germany and a member of the German military, had been assigned to Fort Rucker for flight training. Fort Rucker is located in Alabama. Hinrichs and Daniel Vinson were in the same training program. On June 24, 2007 (during the time of his assignment to Fort Rucker), Hinrichs was riding in the front passenger seat of Vinson’s 2004 GMC Sierra 1500 pickup truck (the Sierra). Vinson was driving the Sierra. As the vehicle proceeded down an Alabama roadway, it was struck by a vehicle whose intoxicated driver (Kenneth Earl Smith) caused it to run a stop sign. The Sierra rolled over twice, and Hinrichs suffered a spinal-cord injury that left him paralyzed. In the litigation referred to below, Hinrichs alleged that his injuries were caused by the defective design of the Sierra’s roof. This design, Hinrichs contended, allowed the roof over the passenger compartment to collapse during the rollover. Hinrichs also alleged that Sierra’s seatbelt, which he was wearing at the time of the accident, was defectively designed because it failed to restrain him. General Motors Corp. designed the Sierra. General Motors of Canada Ltd. (GM Canada), whose principal place of business is in Ontario, Canada, is a separate legal entity from

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GM. GM Canada was incorporated under Canadian law and has its principal place of business in Ontario, Canada. It does not do business directly in the United States. GM Canada manufactured certain parts of the Sierra eventually purchased by Vinson, assembled the vehicle in Canada, and sold it to GM. The transfer of title to the vehicle (i.e., from GM Canada to GM) occurred in Canada. GM then distributed the Sierra for sale in the United States through a dealer located in Pennsylvania. Vinson purchased the Sierra from the Pennsylvania dealer in 2003. He drove it to Alabama in 2006 when he was assigned to Fort Rucker. Besides suing Smith (the intoxicated driver) for negligence, Hinrichs brought product liability claims

against both GM and GM Canada in an Alabama trial court. Arguing that the Alabama court lacked in personam jurisdiction over it, GM Canada moved for dismissal. In opposition to the motion, Hinrichs stressed that even if GM Canada does not do business directly in the United States, it anticipates that almost all of the vehicles it assembles in Canada will end up in the stream of commerce in the United States and that Alabama is among the states in which the vehicles will be sold or driven. The Alabama trial court dismissed the claim against GM Canada on the ground that in personam jurisdiction was lacking. Hinrichs appealed the dismissal. Was the trial court’s ruling correct?

CHAPTER 3

Business and the Constitution

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federal statute and related regulations prohibited producers of beer from listing, on a product label, the alcohol content of the beer in the container on which the label appeared. The regulation existed because the U.S.  government believed that if alcohol content could be disclosed on labels, certain producers of beer might begin marketing their brand as having a higher alcohol content than competing beers. The government was concerned that “strength wars” among producers could then develop, that consumers would seek out beers with higher alcohol content, and that adverse public health consequences would follow. Because it wished to include alcohol content information on container labels for its beers, Coors Brewing Co. filed suit against the U.S. government and asked the court to rule that the statute and regulations violated Coors’s constitutional right to freedom of speech. Consider the following questions as you read Chapter 3: ••On which provision in the U.S. Constitution was Coors relying in its challenge of the statute and regulations? ••Does a corporation such as Coors possess the same constitutional right to freedom of speech possessed by an individual human being, or does the government have greater latitude to restrict the content of a corporation’s speech? ••The alcohol content disclosures that Coors wished to make with regard to its product would be classified as commercial speech. Does commercial speech receive the same degree of constitutional protection that political or other noncommercial speech receives? ••Which party—Coors or the federal government—won the case, and why? • Do producers and other sellers of alcoholic beverages have, in connection with the sale of their products, special ethical obligations that sellers of other products might not have? If so, what are those obligations and why do they exist?

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LEARNING OBJECTIVES After studying this chapter, you should be able to: 3-1 Describe the role of courts in interpreting constitutions and in determining whether statutes or other government actions are constitutional. 3-2 Explain the key role of the U.S. Constitution’s Commerce Clause in authorizing action by Congress. 3-3 Explain the burden-on-commerce doctrine’s role in making certain state government actions unconstitutional.

3-4 Describe the incorporation doctrine’s role in making most guarantees of the Bill of Rights operate to protect persons not only against certain federal government actions, but also against certain state and local government actions. 3-5 Explain the differences among the means-ends tests used by courts when the constitutionality of government action is being determined (strict scrutiny, intermediate scrutiny, and rational basis).

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3-6 Describe the differences between noncommercial speech and commercial speech and the respective levels of First Amendment protection they receive. 3-7 Explain the difference between procedural due process and substantive due process. 3-8 Identify the instances when an Equal Protection Clause–based challenge to government action

CONSTITUTIONS SERVE TWO general functions. First, they set up the structure of government, allocating power among its various branches and subdivisions. Second, they prevent government from taking certain actions— especially actions that restrict individual or, as suggested by the Coors scenario that opened this chapter, corporate rights. This chapter examines the U.S. Constitution’s performance of these functions and considers how that performance affects government regulation of business.

An Overview of the U.S. Constitution The U.S. Constitution exhibits the principle of separation of powers by giving distinct powers to Congress, the president, and the federal courts. Article I of the Constitution establishes a Congress composed of a Senate and a House of Representatives, gives it sole power to legislate at the federal level, and sets out rules for the enactment of legislation. Article I, § 8 also defines when Congress can make law by stating its legislative powers. Three of those powers— the commerce, tax, and spending powers—are discussed later in the chapter. Article II gives the president the executive power—the power to execute or enforce the laws passed by Congress. Section 2 of that article lists other presidential powers, including the powers to command the nation’s armed forces and to make treaties. Article III gives the judicial power of the United States to the Supreme Court and the other federal courts later established by Congress. Article III also determines the types of cases the federal courts may decide. Besides creating a separation of powers, Articles I, II, and III set up a system of checks and balances among Congress, the president, and the courts. For example, Article I gives the president the power to veto legislation passed by Congress, but allows Congress to override such a veto by a two-thirds vote of each House. Articles I and II provide that the president, the vice president, and other federal officials may be removed from office if, following an impeachment trial in the Senate, two-thirds of

triggers more rigorous scrutiny than the rational basis test. 3-9 Identify the major circumstances in which federal law will preempt state law. 3-10 Explain the power granted to the government by the Takings Clause, as well as the limits on that power.

the Senate concludes that the impeached office-holder committed “Treason, Bribery, or other high Crimes and Misdemeanors.” Article II states that treaties agreed to by the president must be approved by a two-thirds vote of the Senate. Article III gives Congress some control over the Supreme Court’s appellate jurisdiction. The Constitution recognizes the principle of federalism in the way it structures power relations between the federal government and the states. After listing the powers Congress holds, Article I lists certain powers that Congress cannot exercise. The Tenth Amendment provides that those powers the Constitution neither gives to the federal government nor denies to the states are reserved to the states or the people. Article VI, however, makes the Constitution, laws, and treaties of the United States supreme over state law. As will be seen, this principle of federal supremacy may cause federal statutes to preempt inconsistent state laws. The Constitution also puts limits on the states’ lawmaking powers. One example is Article I’s command that states shall not pass laws impairing the obligation of contracts. Of course, there is sometimes disagreement (between state and federal officials, for example) about whether a particular branch of government has overreached. For example, in 2020, President Trump challenged a subpoena (issued as part of a state criminal investigation) for financial records related to his personal and business financial records. The president argued that a sitting president is absolutely immune from such a process; among other things, he argued that the criminal subpoenas would divert him from his duties and impose an intolerable burden on a president’s ability to perform his Article II functions. The Supreme Court found that distraction was not sufficient to confer absolute immunity and held that Article II and the Supremacy Clause do not preclude or require a heightened standard for the issuance of a state criminal subpoena to a sitting president. Trump v. Vance, 140 S. Ct. 2412 (2020). Article V sets forth the procedures for amending the Constitution. The Constitution has been amended 27 times. The first 10 of these amendments comprise the Bill of Rights. Although the rights guaranteed in the first



Chapter Three Business and the Constitution

10  amendments once restricted only federal government action, most of them now limit state government action as well. As you will learn, this results from their incorporation within the Due Process Clause of the Fourteenth Amendment.

The Evolution of the Constitution and the Role of the Supreme Court Describe the role of courts in interpreting constitutions

LO3-1 and in determining whether statutes or other government

actions are constitutional.

According to the legal realists discussed in Chapter 1, written “book law” is less important than what public decision makers actually do. Using this approach, we discover a Constitution that differs from the written Constitution just described. The actual powers of today’s presidency, for instance, exceed anything one would expect from reading Article II. As you will see, moreover, some constitutional provisions have acquired a meaning different from their meaning when first enacted. American constitutional law has evolved rather than being static. Many of these changes result from the way one public decision maker—the nine-member U.S. Supreme Court— has interpreted the Constitution over time. Formal constitutional change can be accomplished only through the amendment process. Because this process is difficult to employ, however, amendments to the Constitution have been relatively infrequent. As a practical matter, the Supreme Court has become the Constitution’s main “amender” through its many interpretations of constitutional provisions. Various factors help explain the Supreme Court’s ability and willingness to play this role. Because of their vagueness, some key constitutional provisions invite diverse interpretations. “Due process of law” and “equal protection of the laws” are examples. In addition, the history surrounding the enactment of constitutional provisions sometimes is sketchy, confused, or contradictory. Under the power of judicial review, courts can declare the actions of other government bodies unconstitutional. How courts exercise this power depends on how they choose to read the Constitution. Courts thus have political power—a conclusion especially applicable to the Supreme Court. Indeed, the Supreme Court’s justices are, to a considerable extent, public policy makers. Their beliefs are important in the determination of how the United States is governed. This is why the justices’

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nomination and confirmation often involve so much political controversy. Yet even though the Constitution frequently is what the courts say it is, judicial power to shape the Constitution has limits. Certain limits spring from the Constitution’s language, which sometimes is quite clear. Others result from the judges’ adherence to the stare decisis doctrine discussed in Chapter 1. Perhaps the most significant limits on judges’ power, however, stem from the tension between modern judicial review and democracy. Legislators are chosen by the people, whereas judges—especially appellate level judges—often are appointed, not elected. Today, judges exercise political power by declaring the actions of legislatures unconstitutional under standards largely of the judiciary’s own devising. This sometimes leads to charges that courts are undemocratic, elitist institutions. Such charges put political constraints on judges because courts depend on the other branches of government—and ultimately on public belief in judges’ fidelity to the rule of law—to make their decisions effective. Therefore, judges sometimes may be reluctant to declare statutes unconstitutional because they are wary of power struggles with a more representative body such as Congress.

LOG ON For a great deal of information about the U.S. Supreme Court and access to the Court’s opinions in recent cases, see the Court’s website at http://www.supremecourtus.gov.

The Coverage and Structure of This Chapter This chapter examines certain constitutional provisions that are important to business; it does not discuss constitutional law in its entirety. These provisions help define federal and state power to regulate the economy. The U.S. Constitution limits government regulatory power in two general ways. First, it restricts federal legislative authority by listing the powers Congress can exercise. These are known as the enumerated powers. Federal legislation cannot be constitutional if it is not based on a power specifically stated in the Constitution. Second, the U.S. Constitution limits both state and federal power by placing certain independent checks in the path of each. In effect, the independent checks establish that even if Congress has an enumerated power to legislate on a particular matter or a state constitution authorizes a state to take certain actions, there still are certain protected spheres into which neither the federal government nor the state government may reach.

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Part One Foundations of American Law

Accordingly, a federal law must meet two general tests in order to be constitutional: (1) it must be based on an enumerated power of Congress and (2) it must not collide with any of the independent checks. For example, Congress has the power to regulate commerce among the states. This power might seem to allow Congress to pass legislation forbidding women from crossing state lines to buy or sell goods. Yet such a law, though arguably based on an enumerated power, surely would be unconstitutional because it conflicts with an independent check—the equal protection guarantee discussed later in the chapter. Today, the independent checks are the main limitations on congressional power. The most important reason for the decline of the enumerated powers limitation is the perceived need for active federal regulation of economic and social life. Recently, however, the enumerated powers limitation has begun to assume somewhat more importance, as will be seen. After discussion of the most important state and federal powers to regulate economic matters, the chapter explores certain independent checks that apply to the federal government and the states. The chapter then examines some independent checks that affect the states alone. It concludes by discussing a provision—the Takings Clause of the Fifth Amendment—that both recognizes a governmental power and limits its exercise.

State and Federal Power to Regulate State Regulatory Power Although

state constitutions may do so, the U.S. Constitution does not list the powers state legislatures can exercise. The U.S. Constitution does place certain independent checks in the path of state lawmaking, however. It also declares that certain powers (e.g., creating currency and taxing imports) can be exercised only by Congress. In many other areas, though, Congress and the state legislatures have concurrent powers. Both can make law within those areas unless Congress preempts state regulation under the Supremacy Clause. A very important state legislative power that operates concurrently with many congressional powers is the police power, a broad state power to regulate for the public health, safety, morals, and welfare.

Federal Regulatory Power Article

I, § 8 of the U.S. Constitution specifies a number of ways in which Congress may legislate concerning business and commercial matters. For example, it empowers Congress to coin and borrow money, regulate interstate commerce, establish uniform laws regarding bankruptcies, create post offices,

and enact copyright and patent laws. The most important congressional powers contained in Article I, § 8, however, are the powers to regulate commerce among the states, to lay and collect taxes, and to spend for the general welfare. Because they now are read broadly, these three powers are the main constitutional bases for the extensive federal social and economic regulation that exists today. The Commerce Power LO3-2

Explain the key role of the U.S. Constitution’s Commerce Clause in authorizing action by Congress.

Article I, § 8 states that “The Congress shall have Power . . . . To regulate Commerce . . . among the several States.” The original reason for giving Congress this power to regulate interstate commerce (that is, commerce between or among multiple states) was to nationalize economic matters by blocking the protectionist state restrictions on interstate trade that were common after the Revolution. As discussed later in the chapter, the Commerce Clause serves as an independent check on state regulation that unduly restricts interstate commerce. Our present concern, however, is the Commerce Clause’s role as a source of congressional regulatory power. The literal language of the Commerce Clause simply empowers Congress to regulate commerce that occurs among the states. Supreme Court decisions interpreting the Commerce Clause have held, however, that it sets up three categories of actions in which Congress may engage: first, regulating the channels of interstate commerce; second, regulating and protecting the instrumentalities of interstate commerce, as well as persons or things in interstate commerce; and third, regulating activities that substantially affect interstate commerce. Largely because of judicial decisions regarding congressional action falling within the third category, the Commerce Clause has become a federal power with an extensive regulatory reach. How has this transformation occurred? The most important step in the transformation was the Supreme Court’s conclusion that the power to regulate interstate commerce includes the power to regulate intrastate (that is, commerce within a state) activities that affect interstate commerce. For example, in a 1914 decision, the Supreme Court upheld the Interstate Commerce Commission’s regulation of railroad rates within Texas (an intrastate matter outside the language of the Commerce Clause) because those rates affected rail traffic between Texas and Louisiana (an interstate matter within the clause’s language). This “affecting commerce” doctrine eventually was used to justify federal police power measures with significant intrastate reach. For instance, the Supreme Court



Chapter Three Business and the Constitution

upheld the application of the 1964 Civil Rights Act’s “public accommodations” section to a family-owned restaurant in Birmingham, Alabama. It did so because the restaurant’s racial discrimination affected interstate commerce by reducing the restaurant’s business and limiting its purchases of out-of-state meat and by restricting the ability of Blacks to travel among the states. By the early 1990s, broad judicial interpretations of the Commerce Clause led many observers to conclude that the clause established a federal power with almost unlimited reach. Then two Supreme Court decisions, United States v. Lopez, 514 U.S. 549 (1995), and United States v. ­Morrison, 529 U.S. 598 (2000), offered clear reminders that the power to regulate interstate commerce is not without limits. Those cases struck down laws that made possessing a

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gun in a school zone a federal crime (Lopez) and addressed gender-motivated violent crimes (Morrison). In both cases, the Court held that Congress had exceeded its power. One area that has tested Congress’s Commerce Clause power is the federal ban on marijuana. Though many states and cities have made it legal as a matter of state law, it remains (at least at the time of this writing) illegal under federal law. The Supreme Court has found that Congress has the power to prohibit its use under federal law, finding that there exists an interstate market for the drug and that such a law regulates economic activity. Gonzales v. Raich, 545 U.S. 1 (2005). In the case below, the Court considered whether a state law was an unconstitutional burden on interstate commerce.

South Dakota v. Wayfair, Inc.   138 S. Ct. 2080 (2018) The State of South Dakota (like most states) requires companies to collect a sales tax on goods and services sold in the state and remit the money to the state. That practice is fairly straightforward for businesses that sell their products through physical locations in the state (brick-and-mortar stores, for example), when a customer pays at the point of sale. But online retailers with no physical location in the state had argued that states could not force them to collect the tax. The U.S. Supreme Court had ruled in the past, most recently in a case called Quill Corp. v. North Dakota (504 U.S. 298 (1992)), that states could not require a business to collect the state’s sales tax if that business had no physical presence in the state. That ruling was based on the Commerce Clause: Without a strong connection between the business and the state (such as a physical presence), the tax collection requirement imposed an undue burden on the free flow of interstate commerce. South Dakota sued Wayfair and other online retailers, seeking to require them to collect its sales tax from online sales to customers in South Dakota. It argued that the “physical presence” rule was depriving them of needed tax dollars and should be overturned. Because of binding precedent from the U.S. Supreme Court (i.e., the Quill case and a case before it called Bellas Hess), the retailers won on their motions for summary judgment in the trial court and the South Dakota Supreme Court. The U.S. Supreme Court granted certiorari to hear South Dakota’s appeal. Kennedy, Justice All concede that taxing the sales in question here is lawful. The question is whether the out-of-state seller can be held responsible for its payment, and this turns on a proper interpretation of the Commerce Clause, U.S. Const., Art. I, § 8, cl. 3. Under this Court’s decisions in Bellas Hess and Quill, South Dakota may not require a business to collect its sales tax if the business lacks a physical presence in the State. Without that physical presence, South Dakota instead must rely on its residents to pay the use tax owed on their purchases from out-of-state sellers. “[T]he impracticability of [this] collection from the multitude of individual purchasers is obvious.” National Geographic Soc. v. California Bd. of Equalization, 430 U.S. 551, 555 (1977). And consumer compliance rates are notoriously low. . . . It is estimated that Bellas Hess and Quill cause the States to lose between $8 and $33 billion every year.  .  .  . In South Dakota alone, the Department of Revenue estimates revenue loss at $48 to $58 million

annually. Particularly because South Dakota has no state income tax, it must put substantial reliance on its sales and use taxes for the revenue necessary to fund essential services. Those taxes account for over 60 percent of its general fund. In 2016, South Dakota confronted the serious inequity Quill imposes by enacting S. 106—“An Act to provide for the collection of sales taxes from certain remote sellers, to establish certain Legislative findings, and to declare an emergency.” The legislature found that the inability to collect sales tax from remote sellers was “seriously eroding the sales tax base” and “causing revenue losses and imminent harm . . . through the loss of critical funding for state and local services.” § 8(1). . . . The Act applies only to sellers that, on an annual basis, deliver more than $100,000 of goods or services into the State or engage in 200 or more separate transactions for the delivery of goods or services into the State. Respondents Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc., are merchants with no employees or real estate in South

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Dakota. . . . Each easily meets the minimum sales or transactions requirement of the Act, but none collects South Dakota sales tax. II. The Constitution grants Congress the power “[t]o regulate Commerce . . . among the several States.” Art. I, § 8, cl. 3. . . . Although the Commerce Clause is written as an affirmative grant of authority to Congress, this Court has long held that in some instances it imposes limitations on the States absent congressional action. Modern precedents rest upon two primary principles that mark the boundaries of a State’s authority to regulate interstate commerce. First, state regulations may not discriminate against interstate commerce; and second, States may not impose undue burdens on interstate commerce. [A] State “may tax exclusively interstate commerce so long as the tax does not create any effect forbidden by the Commerce Clause.” [Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 285 (1977)]. After all, “interstate commerce may be required to pay its fair share of state taxes.” D. H. Holmes Co. v. McNamara, 486 U.S. 24, 31 (1988). In National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753, 754–55 (1967),] . . . [t]he Court held that . . . [unless a] retailer maintained a physical presence such as “retail outlets, solicitors, or property within a State,” the State lacked the power to require that retailer to collect a local use tax. Ibid. In 1992, the Court reexamined the physical presence rule in Quill. III The physical presence rule has “been the target of criticism over many years from many quarters.” Direct Marketing Assn. v. Brohl, 814 F.3d 1129, 1148, 1150–1151 (10th Cir. 2016) (Gorsuch, J., concurring). . . . Quill created an inefficient “online sales tax loophole” that gives out-of-state businesses an advantage. And “while nexus rules are clearly necessary,” the Court “should focus on rules that are appropriate to the twenty-first century, not the nineteenth.” Hellerstein, Deconstructing the Debate Over State Taxation of Electronic Commerce, 13 Harv. J. L. & Tech. 549, 553 (2000). Each year, the physical presence rule becomes further removed from economic reality and results in significant revenue losses to the States. These critiques underscore that the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause. All agree that South Dakota has the authority to tax these transactions.  .  .  . The central dispute is whether South Dakota may require remote sellers to collect and remit the tax without some additional connection to the State. . . . There just must be “a substantial nexus with the taxing State.” Physical presence is not necessary to create a substantial nexus. The Quill majority expressed concern that without the

physical presence rule “a state tax might unduly burden interstate commerce” by subjecting retailers to tax collection obligations in thousands of different taxing jurisdictions. But the administrative costs of compliance, especially in the modern economy with its Internet technology, are largely unrelated to whether a company happens to have a physical presence in a State. For example, a business with one salesperson in each State must collect sales taxes in every jurisdiction in which goods are delivered; but a business with 500 salespersons in one central location and a website accessible in every State need not collect sales taxes on otherwise identical nationwide sales. Quill puts both local businesses and many interstate businesses with physical presence at a competitive disadvantage relative to remote sellers. Remote sellers can avoid the regulatory burdens of tax collection and can offer de facto lower prices caused by the widespread failure of consumers to pay the tax on their own. . . . In effect, Quill has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers—something that has become easier and more prevalent as technology has advanced. Worse still, the rule produces an incentive to avoid physical presence in multiple States. . . . Rejecting the physical presence rule is necessary to ensure that artificial competitive advantages are not created by this Court’s precedents. Modern e-commerce does not align analytically with a test that relies on the sort of physical presence defined in Quill. Between targeted advertising and instant access to most consumers via any internet-enabled device, “a business may be present in a State in a meaningful way without” that presence “being physical in the traditional sense of the term.” Quill’s physical presence rule intrudes on States’ reasonable choices in enacting their tax systems. And that it allows remote sellers to escape an obligation to remit a lawful state tax is unfair and unjust. It is unfair and unjust to those competitors, both local and out of State, who must remit the tax; to the consumers who pay the tax; and to the States that seek fair enforcement of the sales tax, a tax many States for many years have considered an indispensable source for raising revenue. In essence, respondents ask this Court to retain a rule that allows their customers to escape payment of sales taxes—taxes that are essential to create and secure the active market they supply with goods and services. An example may suffice. Wayfair offers to sell a vast selection of furnishings. Its advertising seeks to create an image of beautiful, peaceful homes, but it also says that “[o]ne of the best things about buying through Wayfair is that we do not have to charge sales tax.” Brief for Petitioner 55. What Wayfair ignores in its subtle offer to assist in tax evasion is that creating a dream home assumes solvent state and local governments. State taxes fund the police and fire departments that protect the homes containing their customers’ furniture and



Chapter Three Business and the Constitution

ensure goods are safely delivered; maintain the public roads and municipal services that allow communication with and access to customers; support the “sound local banking institutions to support credit transactions [and] courts to ensure collection of the purchase price,” Quill, 504 U.S., at 328 (opinion of White, J.); and help create the “climate of consumer confidence” that facilitates sales. IV *** Though Quill was wrong on its own terms when it was decided in 1992, since then the Internet revolution has made its earlier error all the more egregious and harmful. . . . In 1992, less than 2 percent of Americans had Internet access. Today that number is about 89 percent. When it decided Quill, the Court could not have envisioned a world in which the world’s largest retailer would be a remote seller. The Internet’s prevalence and power have changed the dynamics of the national economy. In 1992, mail-order sales in the United States totaled $180 billion. Last year, e-commerce retail sales alone were estimated at $453.5 billion. This expansion has also increased the revenue shortfall faced by States seeking to collect their sales and use taxes. In 1992, it was estimated that the States were losing between $694 million and $3 billion per year in sales tax revenues as a result of the physical presence rule. Now estimates range from $8 to $33 billion. Here, the tax distortion created by Quill exists in large part because consumers regularly fail to comply with lawful use taxes. Some remote retailers go so far as to advertise sales as tax free.

The Taxing Power Article I, § 8 of the Constitution states that “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises.” The main purpose of this taxing power is to provide a means of raising revenue for the federal government. The taxing power, however, may also serve as a regulatory device. Congress may choose to regulate a disfavored activity by taxing it heavily or may opt to encourage a favored activity by lowering or eliminating a tax on it. Today, the reach of the taxing power is seen as very broad, as evidenced by National Federation of Independent Business v. Sebelius, which follows shortly. The Spending Power If taxing-power regulation uses a federal club, congressional spending-power regulation employs a federal carrot. Article I, § 8 also gives Congress a broad ability to spend for the general welfare. By basing the receipt of federal money on the performance of certain

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For these reasons, the Court concludes that the physical presence rule of Quill is unsound and incorrect. The Court’s decisions in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), and National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967), should be, and now are, overruled. V In the absence of Quill and Bellas Hess, the first prong of the Complete Auto test simply asks whether the tax applies to an activity with a substantial nexus with the taxing State. “[S]uch a nexus is established when the taxpayer [or collector] ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.” Polar Tankers, Inc. v. City of Valdez, 557 U.S. 1, 11 (2009). Here, the nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the State. The Act applies only to sellers that deliver more than $100,000 of goods or services into South Dakota or engage in 200 or more separate transactions for the delivery of goods and services into the State on an annual basis. This quantity of business could not have occurred unless the seller availed itself of the substantial privilege of carrying on business in South Dakota. And respondents are large, national companies that undoubtedly maintain an extensive virtual presence. Thus, the substantial nexus requirement of Complete Auto is satisfied in this case. The judgment of the Supreme Court of South Dakota is vacated, and the case is remanded for further proceedings not inconsistent with this opinion.

conditions, Congress can use the spending power to encourage states to take certain actions and thereby advance specific regulatory ends. Conditional federal grants to the states, for instance, are common today. Over the past several decades, congressional spending-power regulation routinely has been upheld. There are limits, however, on its use. First, an exercise of the spending power must serve general public purposes rather than particular interests. Second, when Congress conditions the receipt of federal money on certain conditions, it must do so clearly. Third, the condition must be reasonably related to the purpose underlying the federal expenditure. This means, for instance, that Congress probably could not condition a state’s receipt of federal highway money on the state’s adoption of a one-house legislature. Fourth, though Congress may use conditional grants of funding to states to encourage them to

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take certain regulatory actions, Congress can neither compel states to enact a desired regulatory program nor otherwise coerce them into doing so. For an example of issues arising under this last limit on Congress’s spending power, see the National Federation case, which follows shortly. The Necessary and Proper Clause After listing the commerce power, the taxing and spending powers, and

various other powers extended to Congress, Article I, § 8 concludes with a provision granting Congress the further power to “make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers. . . .” The Necessary and Proper Clause is dependent upon Article I, § 8’s previously listed powers but augments them by permitting Congress to enact laws that are useful or conducive to the exercise of those enumerated powers.

Figure 3.1 A Note on the Affordable Care Act Decision Congress enacted the Patient Protection and Affordable Care Act (hereinafter, Affordable Care Act or ACA) in 2010. Several cases filed shortly thereafter in federal courts presented constitutional challenges to two provisions in the statute: (1) the requirement, applicable to most Americans, that they have health insurance in force by a certain date specified in the law or, instead, pay what the statute termed a “[s]hared responsibility payment” (a provision that has come to be known as the individual mandate and will be referred to by that designation here) and (2) the requirement that states participate in an expansion of Medicaid, the long-standing federally created program under which the federal government and the states act together to fund health care for low-income persons and others with special needs. After the lower courts issued conflicting decisions, the Supreme Court agreed to decide the constitutionality of the challenged provisions. National Federation of Independent Business v. Sebelius (hereinafter, NFIB) proved to be not only an important Commerce Clause case, but also a major decision regarding two other enumerated powers, the taxing power and the spending power. This note focuses on NFIB’s treatment of the Commerce Clause issue triggered by the individual mandate referred to above. An edited version of NFIB appears in the chapter. It focuses on the 2012 decision’s taxing-power and spending-power analyses, which dealt, respectively, with the individual mandate and the Medicaid expansion provision. When Congress enacted the Affordable Care Act, it relied chiefly on the Commerce Clause as the source of power to enact the law. The federal government, accordingly, placed primary emphasis on the Commerce Clause when it sought to defend the individual mandate in the courts. The government invoked its taxing power as an alternative justification. Although there was no true majority opinion for the Supreme Court on the commerce-power question in NFIB, five justices concluded that the individual mandate exceeded the regulatory authority Congress possesses under the Commerce Clause. Chief Justice Roberts, who wrote for a majority of the Court on the taxing-power question, garnered no official votes for the portion of his opinion dealing with the commerce power. However, the four dissenting justices—Scalia, Kennedy, Thomas, and Alito—joined in an opinion adopting a commerce-power analysis that closely resembled the Chief Justice’s analysis. (The dissenters’ extreme dissatisfaction with the Chief Justice’s treatment of the taxing-power issue probably kept them from joining any part of the Roberts opinion despite their apparent agreement with his Commerce Clause analysis.) Chief Justice Roberts and the four dissenters separately acknowledged that the Court’s precedents contemplated expansive authority for Congress under the Commerce Clause. They concluded, however, that the individual mandate went beyond what those precedents would authorize. The Chief Justice stressed that in giving Congress the power to “regulate” commerce, the Commerce Clause presupposes the existence of relevant activity to be regulated. The individual mandate, he observed, sought to compel persons not otherwise inclined to engage in commercial activity to do so by purchasing insurance. Noting the seemingly unprecedented nature of a congressional requirement that persons make a purchase from a private party, the Chief Justice asserted that the Court’s precedents dealing with activities substantially affecting interstate commerce could not be stretched far enough to let Congress reach the absence of commercial activity and regulate it by requiring such activity. The four dissenters took a similar tack, emphasizing that the individual mandate amounted to an impermissible attempt to regulate inactivity rather than the activity necessary, in their view, to make the Commerce Clause a potential source of regulatory authority. (The other four justices—Ginsburg, Breyer, Sotomayor, and Kagan—regarded the Court’s “affecting commerce” precedents as leading logically to the conclusion that the individual mandate should be seen as authorized under the Commerce Clause, given the inevitability that everyone will need health care at some point and the notion that the insurance requirement was largely a payment mechanism designed to help control health care costs. Their Commerce Clause arguments failed, however.) With five justices concluding that the Commerce Clause did not authorize the individual mandate, it became necessary for the Court to determine whether a separate enumerated power—the taxing power—would provide the necessary constitutional foundation for the provision (which, as noted earlier, required that an individual make a “[s]hared responsibility payment” if



Chapter Three Business and the Constitution

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he or she did not obtain health insurance). Although the taxing-power argument was its backup argument, the government succeeded with it. Chief Justice Roberts, joined by Justices Ginsburg, Breyer, Sotomayor, and Kagan, determined that the congressional power to tax justified the provision. (See the later edited version of NFIB, which focuses on the taxing-power issue as well as the spending-power issue raised by the Affordable Care Act’s Medicaid expansion provision.) Critics of the Affordable Care Act and of the notion that the Commerce Clause permits expansive federal power likely were heartened by the government’s failure to succeed with its commerce-power argument in NFIB. But if critics won the Commerce Clause battle, they lost the constitutional war. The government’s success with the taxing-power argument meant that the individual mandate—often described as the centerpiece of the Affordable Care Act—was every bit as constitutional as it would have been if the government had succeeded with the Commerce Clause argument. At the time of this writing, the Supreme Court was preparing to consider another challenge to the ACA. In cases brought by a group of states, some plaintiffs claim the entire law should be struck down because of changes that Congress had made to the law. Specifically, Congress changed the penalty for not buying health insurance, making the penalty zero. A legal question the cases present is whether the change to the law means that the entire ACA is now unconstitutional.

National Federation of Independent Business v. Sebelius    567 U.S. 519 (2012) Congress enacted the Patient Protection and Affordable Care Act in 2010 (hereinafter, ACA) in an effort to increase the number of Americans covered by health insurance and decrease the cost of health care. As noted in Figure 3.1, one key ACA provision has come to be known as the individual mandate. That provision requires most Americans to maintain “minimum essential” health insurance coverage. For persons who are not exempt, and who do not receive health insurance through an employer or government program, the means of satisfying the requirement is to purchase insurance from a private company. The ACA further requires that those who do not comply with the mandate to have insurance in force must make a “[s]hared responsibility payment” to the federal government. That payment, which the ACA describes as a “penalty,” is calculated as a percentage of household income, subject to a floor based on a specified dollar amount and a ceiling based on the average annual premium the individual would have to pay for qualifying private health insurance. The ACA states that this “penalty” will be paid to the Internal Revenue Service (IRS) with an individual’s taxes, and “shall be assessed and collected in the same manner” as tax penalties. Some individuals who are subject to the insurance mandate are nonetheless exempt from the shared responsibility payment if their income is below a certain threshold. As noted in Figure 3.1, the ACA also features a provision calling for an expansion of the Medicaid program, which offers federal funding to states to assist low-income families, children, pregnant women, the blind, the elderly, and the disabled in obtaining medical care. The ACA provision at issue expands Medicaid’s scope and increases the number of individuals the states must cover. For example, the ACA calls for state programs to provide Medicaid coverage to adults with incomes up to 133 percent of the federal poverty level, whereas many states historically have covered adults with children only if their income is considerably lower and have not covered childless adults at all. The ACA’s Medicaid provision increases federal funding to cover all of the states’ costs in expanding Medicaid coverage in early years of the expansion and most of those costs in succeeding years. However, the ACA also provides that if a state does not comply with the new Medicaid coverage requirements, the state could lose not merely the federal funding for those requirements, but potentially all of its federal Medicaid funds. In various federal court cases, plaintiffs challenged the above-referred-to ACA provisions on constitutional grounds. The cases yielded conflicting results. Included among the cases was one filed by 26 states, several individuals, and the National Federation of Independent Business. In that case, the U.S. Court of Appeals for the Eleventh Circuit concluded that Congress lacked constitutional authority to enact the individual mandate. However, the Eleventh Circuit upheld the Medicaid expansion as a valid exercise of Congress’s spending power. The U.S. Supreme Court agreed to decide the case. As explained in Figure 3.1, five justices concluded in National Federation of Independent Business v. Sebelius that the Commerce Clause could not be interpreted as authorizing the individual mandate. The following edited version of the opinion authored by Chief Justice Roberts focuses on whether Congress’s taxing power authorizes the individual mandate and on whether Congress’s spending

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Part One Foundations of American Law

power justifies the Medicaid expansion. Justices Ginsburg, Breyer, Sotomayor, and Kagan joined the Chief Justice to form a majority on the taxing-power question. On the spending-power question, Justices Breyer and Kagan subscribed to the Chief Justice’s analysis. Justices Ginsburg and Sotomayor provided the fourth and fifth votes for the outcome reached by the Chief Justice’s opinion on the Medicaid expansion, though they otherwise disagreed with his analysis.  Roberts, Chief Justice Today we resolve constitutional challenges to two provisions of the ACA: the individual mandate, which requires individuals to purchase a health insurance policy providing a minimum level of coverage [or, instead, make a “[s]hared responsibility payment”]; and the Medicaid expansion, which gives funds to the states on the condition that they provide specified health care to all citizens whose income falls below a certain threshold. [R]ather than granting general authority to perform all the conceivable functions of government, the Constitution lists, or enumerates, the federal government’s powers. The same does not apply to the states, because the Constitution is not the source of their power. The Constitution may restrict state governments—as it does, for example, by forbidding them to deny any person the equal protection of the laws. But where such prohibitions do not apply, state governments do not need constitutional authorization to act. The states thus can and do perform many of the vital functions of modern government—punishing street crime, running public schools, and zoning property for development, to name but a few. Our cases refer to this general power, possessed by the states but not by the federal government, as the police power. This case concerns . . . powers that the Constitution does grant the federal government, but which must be read carefully to avoid creating a general federal authority akin to the police power. The Constitution authorizes Congress to “regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” Art. I, § 8, cl. 3. Congress may also “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.” Art. I, § 8, cl. 1. Put simply, Congress may tax and spend. This grant gives the federal government considerable influence even in areas where it cannot directly regulate. The federal government may enact a tax on an activity that it cannot authorize, forbid, or otherwise control. And in exercising its spending power, Congress may offer funds to the states, and may condition those offers on compliance with specified conditions. These offers may well induce the states to adopt policies that the federal government itself could not impose. The reach of the federal government’s enumerated powers is broader still because the Constitution authorizes Congress to “make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers.” Art. I, § 8, cl. 18. We have long read this provision to give Congress great latitude

in exercising its powers. Our respect for Congress’s policy judgments [, however,] can never extend so far as to disavow restraints on federal power that the Constitution carefully constructed.  The Individual Mandate and the Taxing Power The government advances two theories for the proposition that Congress had constitutional authority to enact the ACA’s individual mandate. First, the government argues that Congress had the power to enact the mandate under the Commerce Clause. [Alternatively], the government argues that if the commerce power does not support the mandate, we should nonetheless uphold it as an exercise of Congress’s power to tax. [Authors’ note: As explained earlier, the government failed to succeed with its Commerce Clause argument. For discussion of the Court’s Commerce Clause analysis, see Figure 3.1.] Because the Commerce Clause does not support the individual mandate, it is necessary to turn to the government’s second argument: that the mandate may be upheld as within Congress’s enumerated power to “lay and collect Taxes.” Under the mandate, if an individual does not maintain health insurance, the only consequence is that he must make an additional payment to the IRS when he pays his taxes. That, according to the government, means the mandate can be regarded as establishing a condition—not owning health insurance—that triggers a tax—the required payment to the IRS. Under that theory, the mandate is not a legal command to buy insurance. Rather, it makes going without insurance just another thing the government taxes, like buying gasoline or earning income. And if the mandate is in effect just a tax hike on . . . taxpayers who do not have health insurance, it may be within Congress’s constitutional power to tax. Granting the ACA the full measure of deference owed to federal statutes, it can be so read. The exaction the Affordable Care Act imposes on those without health insurance looks like a tax in many respects. The “[s]hared responsibility payment,” as the statute entitles it, is paid into the Treasury by “taxpayer[s]” when they file their tax returns. It does not apply to individuals who do not pay federal income taxes because their household income is less than the filing threshold in the Internal Revenue Code. For taxpayers who do owe the payment, its amount is determined by such familiar factors as taxable income, number of dependents, and joint filing status. The requirement to pay is found in the Internal Revenue Code and enforced by the IRS, which . . . must assess and collect it “in the same manner as taxes.” This process yields the essential feature of any tax: it produces at least some revenue for



Chapter Three Business and the Constitution

the government. Indeed, the payment is expected to raise about $4 billion per year by 2017. It is of course true that the Act describes the payment as a “penalty,” not a “tax.” But . . . that label . . . does not determine whether the payment may be viewed as an exercise of Congress’s taxing power. [We have decided cases in which something labeled as a “penalty” was nevertheless a tax, and other cases in which something labeled a “tax” was nevertheless a penalty.] The [use of a functional analysis that is not tied to labels] suggests that the shared responsibility payment may for constitutional purposes be considered a tax, not a penalty. First, for most Americans the amount due will be far less than the price of insurance, and, by statute, it can never be more. In 2016, for example, individuals making $35,000 a year are expected to owe the IRS about $60 for any month in which they do not have health insurance. Someone with an annual income of $100,000 a year would likely owe about $200. The price of a qualifying insurance policy is projected to be around $400 per month. It may often be a reasonable financial decision to make the payment rather than purchase insurance, unlike [a situation in which there would be a large] financial punishment. Second, the individual mandate contains no . . . requirement [of knowing wrongdoing or other corrupt intent]. Third, the payment is collected solely by the IRS through the normal means of taxation—except that the IRS is not allowed to use those means most suggestive of a punitive sanction, such as criminal prosecution. The [types of] reasons the Court [has used in previous cases for concluding that] what was called a “tax” . . . was a penalty support the conclusion that what is called a “penalty” here may be viewed as a tax. None of this is to say that the payment is not intended to affect individual conduct. Although the payment will raise considerable revenue, it is plainly designed to expand health insurance coverage. But taxes that seek to influence conduct are nothing new. Some of our earliest federal taxes sought to deter the purchase of imported manufactured goods in order to foster the growth of domestic industry. Today, federal and state taxes can compose more than half the retail price of cigarettes, not just to raise more money, but to encourage people to quit smoking. And we have upheld such obviously regulatory measures as taxes on selling marijuana and sawed-off shotguns.  Indeed, “[e]very tax is in some measure regulatory. To some extent it interposes an economic impediment to the activity taxed as compared with others not taxed.” [Citation omitted.] That [the challenged ACA provision] seeks to shape decisions about whether to buy health insurance does not mean that it cannot be a valid exercise of the taxing power. Because the Constitution permits such a tax, it is not our role to forbid it, or to pass upon its wisdom or fairness.

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The Medicaid Expansion and the Spending Power The states also contend that the Medicaid expansion exceeds Congress’s authority under [its spending power]. They claim that Congress is coercing the states to adopt the changes it wants by threatening to withhold all of a state’s Medicaid grants, unless the state accepts the new expanded funding and complies with the conditions that come with it. This, they argue, violates the basic principle that the “federal government may not compel the states to enact or administer a federal regulatory program.” New York v. United States, 505 U.S. 144, 188 (1992). There is no doubt that the ACA [calls for] dramatic[] increases [in] state obligations under Medicaid. The current Medicaid program requires states to cover only certain discrete categories of needy individuals—pregnant women, children, needy families, the blind, the elderly, and the disabled. There is no mandatory coverage for most childless adults, and the states typically do not offer any such coverage. The states also enjoy considerable flexibility with respect to the coverage levels for parents of needy families. On average states cover only those unemployed parents who make less than 37 percent of the federal poverty level, and only those employed parents who make less than 63 percent of the poverty line. The Medicaid provisions of the ACA, in contrast, require states to expand their Medicaid programs by 2014 to cover all individuals under the age of 65 with incomes below 133 ­percent of the federal poverty line. The ACA provides that the federal government will pay 100 percent of the costs of covering these newly eligible individuals through 2016. In the following years, the federal payment level gradually decreases, to a minimum of 90 percent. In light of the expansion in coverage mandated by the ACA, the federal government estimates that its Medicaid spending will increase by approximately $100 billion per year. The [Constitution’s] Spending Clause grants Congress the power “to pay the Debts and provide for the . . . general Welfare of the United States.” Art. I, § 8, cl. 1. We have long recognized that Congress may use this power to grant federal funds to the states, and may condition such a grant upon the states’ “taking certain actions that Congress could not require them to take.” [Citation omitted.] Such measures “encourage a state to regulate in a particular way, [and] influenc[e] a state’s policy choices.” [Citation omitted.]  At the same time, our cases have recognized limits on Congress’s power under the Spending Clause to secure state compliance with federal objectives. We have repeatedly characterized . . . Spending Clause legislation as “much in the nature of a contract.” [Citations omitted.] The legitimacy of Congress’s exercise of the spending power “thus rests on whether the State voluntarily and knowingly accepts the terms of the contract.”

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Part One Foundations of American Law

[Citation omitted.] Respecting this limitation is critical to ensuring that Spending Clause legislation does not undermine the status of the states as independent sovereigns in our federal system. That insight has led this Court to strike down federal legislation that commandeers a state’s legislative or administrative apparatus for federal purposes. It has also led us to scrutinize Spending Clause legislation to ensure that Congress is not using financial inducements to exert a “power akin to undue influence.” [Citation omitted.] Congress may use its spending power to create incentives for states to act in accordance with federal policies. But when pressure turns into compulsion, the legislation runs contrary to our system of federalism. Spending Clause programs do not pose this danger when a state has a legitimate choice whether to accept the federal conditions in exchange for federal funds. In such a situation, state officials can fairly be held politically accountable for choosing to accept or refuse the federal offer. But when the state has no choice, the federal government can achieve its objectives without accountability. Congress may attach appropriate conditions to federal taxing and spending programs to preserve its control over the use of federal funds. In the typical case we look to the states to defend their prerogatives by adopting “the simple expedient of not yielding” to federal blandishments when they do not want to embrace the federal policies as their own. [Citation omitted.] The states, however, argue that the Medicaid expansion is far from the typical case. They object that [instead] of simply refusing to grant the new funds to states that will not accept the new conditions, Congress has also threatened to withhold those states’ existing Medicaid funds. The states claim that this threat serves no purpose other than to force unwilling states to sign up for the dramatic expansion in health care coverage effected by the ACA. Given the nature of the threat and the programs at issue here, we must agree. In South Dakota v. Dole, 483 U.S. 203 (1987), we considered a challenge to a federal law that threatened to withhold five percent of a State’s federal highway funds if the State did not raise its drinking age to 21. The Court found that the condition was “directly related to one of the main purposes for which highway funds are expended—safe interstate travel.” [Id.] at 208. At the same time, the condition was not a restriction on how the highway funds—set aside for specific highway improvement and maintenance efforts—were to be used. We accordingly asked whether “the financial inducement offered by Congress” was “so coercive as to pass the point at which pressure turns into compulsion.” Id. at 211. By “financial inducement” the Court meant the threat of losing 5 percent of highway funds; no new money was offered to the states to raise their drinking ages. We found that the inducement was not impermissibly

coercive, because Congress was offering only “relatively mild encouragement to the States.” Id. We observed that “all South Dakota would lose if she adheres to her chosen course as to a suitable minimum drinking age is 5 percent” of her highway funds. Id. In fact, the federal funds at stake constituted less than half of one percent of South Dakota’s budget at the time. In consequence, “we conclude[d] that [the] encouragement to state action [was] a valid use of the spending power.” Id. at 212. Whether to accept the drinking age change “remain[ed] the prerogative of the states not merely in theory but in fact.” Id. at 211–212. In this case, the financial “inducement” Congress has chosen is much more than “relatively mild encouragement”—it is a gun to the head. A state that opts out of the ACA’s expansion in health care coverage . . . stands to lose not merely “a relatively small percentage” of its existing Medicaid funding, but all of it. Medicaid spending accounts for over 20 percent of the average state’s total budget, with federal funds covering 50 to 83 percent of those costs. It is easy to see how the Dole Court could conclude that the threatened loss of less than half of one percent of South Dakota’s budget left that state a “prerogative” to reject Congress’s desired policy, “not merely in theory but in fact.” The threatened loss of over 10 percent of a state’s overall budget, in contrast, is economic dragooning that leaves the states with no real option but to acquiesce in the Medicaid expansion. Nothing in our opinion precludes Congress from offering funds under the ACA to expand the availability of health care, and requiring that states [agreeing to accept] such funds comply with the conditions on their use. What Congress is not free to do is to penalize states that choose not to participate in that new program by taking away their existing Medicaid funding. In light of the Court’s holding, the [federal government] cannot . . . withdraw existing Medicaid funds [from states] for failure to comply with the requirements set out in the [ACA’s Medicaid] expansion. The Court today limits the financial pressure the [federal government] may apply to induce states to accept the terms of the Medicaid expansion. As a practical matter, that means states may now choose to reject the expansion. Some states may indeed decline to participate. Other states, however, may voluntarily sign up, finding the idea of expanding Medicaid coverage attractive, particularly given the level of federal funding the ACA offers at the outset.  Judgment of Eleventh Circuit affirmed insofar as it held that individual mandate exceeded commerce power, reversed insofar as it held that individual mandate was not authorized by taxing power, and reversed insofar as it held that Medicaid expansion was justified under spending power.



Chapter Three Business and the Constitution

Burden on, or Discrimination against, Interstate Commerce LO3-3

Explain the burden-on-commerce doctrine’s role in making certain state government actions unconstitutional.

In addition to empowering Congress to regulate interstate commerce, the Commerce Clause limits the states’ ability to burden or discriminate against such commerce. This limitation is not expressly stated in the Constitution. Instead, it arises by implication from the Commerce Clause and reflects that clause’s original purpose of blocking state protectionism and ensuring free interstate trade. (Because this limitation arises by implication, it is often referred to as the “dormant” Commerce Clause.) The burden-on-commerce limitation and the nondiscrimination principle operate independently of congressional legislation under the commerce power or other federal powers. If appropriate federal regulation is present, the preemption questions discussed in the next section may also arise. Many different state laws can raise burden-on-commerce problems. For example, state regulation of transportation (e.g., limits on train or truck lengths) has been a prolific source of litigation. The same is true of state restrictions on the importation of goods or resources, such as laws forbidding the sale of out-of-state food products unless they meet certain standards. Such restrictions sometimes benefit local economic interests and reflect their political influence. Burden-on-commerce issues also arise if states try to aid their own residents by blocking the export of scarce or valuable products, thus denying out-of-state buyers access to those products. In part because of the variety of state regulations it has had to consider, the Supreme Court has not adhered to one consistent test for determining when such regulations impermissibly burden interstate commerce. In a 1994 case, the Court said that if a state law discriminates against interstate commerce, the strictest scrutiny will be applied in the determination of the law’s constitutionality. Discrimination is express when state laws treat local and interstate commerce unequally on their face. State laws might also discriminate even though on their face, they seem neutral regarding interstate commerce. This occurs when their effect is to burden or hinder such commerce. In one case, for example, the Supreme Court considered a North Carolina statute that required all closed containers of apples sold within the state to bear only the applicable U.S. grade or standard. The State of Washington, the nation’s largest apple producer, had its own inspection and grading system for Washington apples. This system generally was regarded

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as superior to the federal system. The Court struck down the North Carolina statute because it benefited local apple producers by forcing Washington sellers to regrade apples sold in North Carolina (thus raising their costs of doing business) and by undermining the competitive advantage provided by Washington’s superior grading system. On the other hand, state laws that regulate evenhandedly and have only incidental effects on interstate commerce are constitutional if they serve legitimate state interests and their local benefits exceed the burden they place on interstate commerce. There is no sharp line between such regulations and those that are almost always unconstitutional under the tests discussed above. In a 1981 Supreme Court case, a state truck-length limitation that differed from the limitations imposed by neighboring states failed to satisfy the tests for constitutionality. The Court concluded that the measure did not further the state’s legitimate interest in highway safety because the trucks banned by the state generally were as safe as those it allowed. In addition, whatever marginal safety advantage the law provided was outweighed by the numerous problems it posed for interstate trucking companies. Laws may also unconstitutionally burden interstate commerce when they directly regulate that commerce. This can occur, for example, when state price regulations require firms to post the prices at which they will sell within the state and to promise that they will not sell below those prices in other states. Because they affect prices in other states, such regulations directly regulate interstate commerce and usually are unconstitutional.

Independent Checks on the Federal Government and the States Even if a regulation is within Congress’s enumerated powers or a state’s police power, it still is unconstitutional if it collides with one of the Constitution’s independent checks. This section discusses three checks that limit federal and state regulation of the economy: freedom of speech, due process, and equal protection. Before discussing these guarantees, however, we must consider three foundational matters.

Incorporation Describe the incorporation doctrine’s role in making most guarantees of the Bill of Rights operate to protect persons LO3-4 not only against certain federal government actions, but also against certain state and local government actions.

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Part One Foundations of American Law

The Fifth Amendment prevents the federal government from depriving “any person . . . of life, liberty, or property, without due process of law.” The Fourteenth Amendment creates the same prohibition with regard to the states. The literal language of the First Amendment, however, restricts only federal government action. Moreover, the Fourteenth Amendment says that no state shall “deny to any person . . . the equal protection of the laws.” Thus, although the due process guarantees clearly apply to both the federal government and the states, the First Amendment seems to apply only to the federal government and the Equal Protection Clause only to the states. The First Amendment’s free speech guarantee, however, has been included within the “liberty” protected by Fourteenth Amendment due process as a result of Supreme Court decisions. The free speech guarantee, therefore, restricts state governments as well as the federal government. This is an example of the process of incorporation, by which almost all Bill of Rights provisions now apply to the states. The criminal procedure–related provisions in the Fourth, Fifth, and Sixth Amendments (examined in Chapter 5 of this text) are further examples of Bill of Rights protections that the federal government must honor but that state and local governments must respect as well because of the incorporation doctrine. The Fourteenth Amendment’s equal protection guarantee, on the other hand, has been made applicable to federal government action through incorporation of it within the Fifth Amendment’s Due Process Clause.

Government Action People

often talk as if the Constitution protects them against anyone who might threaten their rights. However, most of the Constitution’s individual rights provisions block only the actions of government bodies, federal, state, and local.1 Private behavior that denies individual rights, while perhaps forbidden by statute, is very seldom a constitutional matter. This government action or state action requirement forces courts to distinguish between governmental behavior and private behavior. Judicial approaches to this problem have varied over time. Before World War II, only formal arms of government such as legislatures, administrative agencies, municipalities, courts, prosecutors, and state universities were deemed state actors. After the war, however, the scope of government action increased considerably, with various sorts of traditionally private behavior being subjected to individual rights limitations. The Supreme Court, in Marsh However, the Thirteenth Amendment, which bans slavery and involuntary servitude throughout the United States, does not have a government action requirement. Some state constitutions, moreover, have individual rights provisions that lack a state action requirement. 1

v. Alabama, 326 U.S. 501 (1946), treated a privately owned company town’s restriction of free expression as government action under the public function theory because the town was nearly identical to a regular municipality in most respects. In Shelley v. Kraemer, 334 U.S. 1 (1948), the Court held that when state courts enforced certain white homeowners’ private agreements not to sell their homes to Blacks, there was state action that violated the Equal Protection Clause. Later, in Burton v. Wilmington Parking Authority, 365 U.S. 715 (1961), the Court concluded that racial discrimination by a privately owned restaurant located in a state-owned and state-operated parking garage was unconstitutional state action, in part because the garage and the restaurant were intertwined in a mutually beneficial “symbiotic” relationship. Among the other factors leading courts to find state action during the 1960s and 1970s were extensive government regulation of private activity and government financial aid to a private actor. The Court, however, severely restricted the reach of state action during the 1970s and 1980s. Since then, private behavior generally has not been held to constitute state action unless a regular unit of government is directly responsible for the challenged private behavior because it has coerced or encouraged such behavior. The public function doctrine, moreover, has been limited to situations in which a private entity exercises powers that have traditionally been exclusively reserved to the state; private police protection is a possible example. In addition, government regulation and government funding have become somewhat less important factors in state action determinations.

Means-Ends Tests Explain the differences among the means-ends tests used LO3-5 by courts when the constitutionality of government action is being determined (strict scrutiny, intermediate scrutiny, and rational basis).

Throughout this chapter, you will see tests of constitutionality that may seem strange at first glance. One example is the test for determining whether laws that discriminate on the basis of sex violate equal protection. This test says that to be constitutional, such laws must be substantially related to the achievement of an important government purpose. The Equal Protection Clause does not contain such language. It simply says that “No State shall . . . deny to any person . . . the equal protection of the laws.” What is going on here? The sex discrimination test just stated is a means-ends test developed by the Supreme Court. Such tests are judicially created because no constitutional right is absolute and because judges, therefore, must weigh individual rights against the



Chapter Three Business and the Constitution

social purposes served by laws that restrict those rights. In other words, means-ends tests determine how courts strike the balance between individual rights and the social needs that may justify their suppression. The “ends” component of a means-ends test specifies how significant a social purpose must be in order to justify the restriction of a right. The “means” component states how effectively the challenged law must promote that purpose in order to be constitutional. In the sex discrimination test, for example, the challenged law must serve an “important” government purpose (the significance of the end) and must be “substantially” related to the achievement of that purpose (the effectiveness of the means). Some constitutional rights are deemed more important than others. Accordingly, courts use tougher tests of constitutionality in certain cases and more lenient tests in other situations. Sometimes these tests are lengthy and complicated. Throughout the chapter, therefore, we will simplify by referring to three general kinds of means-ends tests: 1. The rational basis test. This is a very relaxed test of constitutionality that challenged laws usually pass with ease. A typical formulation of the rational basis test might say that government action need only have a reasonable relation to the achievement of a legitimate government purpose to be constitutional. 2. Intermediate scrutiny. This comes in many forms; the sex discrimination test discussed above is an example. 3. Full strict scrutiny. Here, the court might say that the challenged law must be necessary to the fulfillment of a compelling government purpose. (Sometimes a court might choose different phrasing, such as by saying that the challenged law must be narrowly tailored to fulfillment of the government’s compelling purpose. Despite the different phrasing, the test is substantively the same.) Government action that is subjected to this rigorous test of constitutionality is usually struck down.

Business and the First Amendment Describe the differences between noncommercial speech

LO3-6 and commercial speech and the respective levels of the

First Amendment protection they receive.

The First Amendment provides that “Congress shall make no law . . . abridging the freedom of speech.” Despite its absolute language (“no law”), the First Amendment does not prohibit every law that restricts speech. Although the First Amendment’s free speech guarantee is not absolute, government action restricting the content of speech usually receives close scrutiny from the courts. One justification

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for this high level of protection is the “marketplace” rationale, under which the free competition of ideas is seen as the surest means of attaining truth. The marketplace of ideas operates most effectively, according to this rationale, when restrictions on speech are kept to a minimum and all viewpoints can be considered. During recent decades, the First Amendment has been applied to a wide variety of government restrictions on the expression of individuals and organizations, including corporations. This chapter does not attempt a comprehensive discussion of the many applications of the freedom of speech guarantee. Instead, it explores basic First Amendment concepts before turning to an examination of the free speech rights of corporations.  The religion portions of the First Amendment are mostly beyond the scope of this text. Two issues related to business, though, bear mention here. First, in 2017, a company called Hobby Lobby argued that its religious beliefs should exempt it from having to comply with certain Affordable Care Act regulations that it found objectionable—specifically, a rule requiring it to cover the cost of contraceptives for its employees. The Court did not consider the First Amendment implications but instead ruled in Hobby Lobby’s favor on the ground that the company had religious beliefs under a statute called the Religious Freedom Restoration Act. Burwell v. Hobby Lobby Stores, 573 U.S. 682 (2014). Second, in one well-publicized case, a baker in Colorado declined to bake a cake for a same-sex wedding, claiming that it violated his religious beliefs. He argued that the cakes he baked, though for a business, were expressive activity protected by the First Amendment. The U.S. Supreme Court ruled in his favor but not on First Amendment grounds (instead, it found that the state administrative agency had acted improperly when considering his claim). It seems inevitable that the Court will address the First Amendment arguments in some similar case in the future, eventually deciding whether a business has such a right. See Masterpiece Cakeshop, Ltd. v. Colorado Civil Rights Commission, 138 S. Ct. 1719 (2018). Restrictions on Content of Speech For constitutional purposes, there is a fundamental distinction between conduct and speech (or, to use a frequently employed alternative term, expression). Because conduct usually does not receive constitutional protection, the government typically has considerable latitude to regulate it. Speech, on the other hand, enjoys First Amendment protection. The line between unprotected conduct and potentially protected speech may seem distinct, but that is not always the case in actual practice. Consider the cases involving so-called expressive conduct—conduct so inherently expressive that it is treated for First Amendment

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Part One Foundations of American Law

purposes the same as speech uttered verbally or communicated in writing. As the Supreme Court has held, flag-burning is an example of expressive conduct. Most conduct is not considered to be inherently expressive, however, and thus does not receive First Amendment protection. In a recent Supreme Court decision, Expressions Hair Design v. Schneiderman, 137 S. Ct. 1144 (2017), the conductversus-speech issue came to the forefront. A New York statute barred merchants from imposing, on customers who paid by credit card, a surcharge in addition to the price charged to cash-paying customers. Expressions Hair Design (EHD) wished to post notices that announced a price for cash-paying customers and that an added fee would be tacked on for creditcard-paying customers. Because it feared that posting such notices could leave it vulnerable to legal proceedings for alleged violations of the statute, EHD challenged the statute on First Amendment grounds. The State of New York argued that the statute merely regulated price and was therefore a conduct regulation undeserving of the First Amendment. The Supreme Court disagreed, classifying the statute as a speech restriction— and hence potentially a violation of the First Amendment— because it had the effect of prohibiting the communication of the price information that EHD wished to convey. If speech stands to be affected by a law or other government action speech, the next key question is whether the government action restricts the content of speech, as opposed to operating in a content-neutral way by regulating such matters as time, place, or manner of speech. Whereas content-neutral restrictions are evaluated under a looser test for First Amendment purposes, content restrictions strike at the heart of the freedom of speech guarantee and are reviewed with strict scrutiny. An example comes from Reed v. Town of Gilbert, 576 U.S. 155 (2015), which pertained to an Arizona town’s sign code that prohibited the display of outdoor signs without a permit but set forth various exemptions from the prohibition. One exemption was for “Ideological Signs,” another was for “Political Signs,” and another was for “Temporary Directional Signs.” Signs in the first two categories could be much larger than those in the Temporary Directional Signs category, and either had no placement or time-of-display restrictions (Ideological Signs) or could be displayed during a time period of significant length (Political Signs, which could be displayed during an election season). Temporary Directional Signs, however, had to be much smaller. Moreover, they could only be displayed not more than 12 hours before a qualifying event and not more than one hour afterward. A church that was cited for violating the Temporary Directional Signs time restrictions challenged the town code provisions as a violation of the First Amendment. Rejecting the town’s argument that the code’s sign provisions were content-neutral because they

did not single out particular viewpoints for adverse treatment, the Supreme Court emphasized that the provisions still were content restrictions because their application depended completely on the communicative content of the signs. The Court concluded that the code provisions could not withstand strict scrutiny because even if it were assumed that the town possessed compelling interests in aesthetics and public safety, there were content-neutral ways of furthering those objectives (such as by consistently regulating such matters as sign size, materials, lighting, and portability). Therefore, the sign provisions violated the First Amendment. The Court also noted in Reed that viewpointdiscrimination, though not present in the case and not necessary for a content restriction to be identified, is a particularly egregious type of content restriction. Matal v. Tam, which appears later in the chapter, provides an example of viewpoint discrimination and the role it plays in First Amendment analysis. Political and Other Noncommercial Speech Political speech—expression that deals in some fashion with government, government issues or policies, public officials, or political candidates—is often described as being at the “core” of the First Amendment. Various Supreme Court decisions have held, however, that the freedom of speech guarantee applies not only to political speech, but also to noncommercial expression that does not have a political content or flavor. According to these decisions, the First Amendment protects speech of a literary or artistic nature; speech dealing with scientific, economic, educational, and ethical issues; and expression on many other matters of public interest or concern. Government attempts to restrict the content of political or other noncommercial speech normally receive full strict scrutiny when challenged in court. Unless the government is able to meet the exceedingly difficult burden of proving that the speech restriction is necessary to the fulfillment of a compelling government purpose, a First Amendment violation will be found. Because government restrictions on political or other noncommercial speech trigger the full strict scrutiny test, such speech is referred to as carrying “full” First Amendment protection. Do corporations, however, have the same First Amendment rights that individual human beings possess? The Supreme Court has consistently provided a “yes” answer to this question. Therefore, if a corporation engages in political or other noncommercial expression, it is entitled to full First Amendment protection, just as an individual would be if he or she engaged in such speech. In the much-publicized Citizens United case, which follows shortly, the Supreme Court ruled on a First Amendment–based challenge to a federal statute that restricted uses of corporate funds for “electioneering



Chapter Three Business and the Constitution

communications” close to the time of an election and for advertisements amounting to express advocacy for or against a candidate who was seeking office. Treating the funding restrictions as speech restrictions, a five-justice majority of the Court held that they violated the First Amendment because they could not withstand strict scrutiny. Figure 3.2, which follows the case, describes some observed impacts of the Citizens United decision on subsequent election cycles. Although corporate speakers have First Amendment rights, not all speech of a corporation is fully protected. Some corporate speech is classified as commercial speech, a category of expression examined later in the chapter. As

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will be seen, commercial speech receives First Amendment protection but not the full variety extended to political or noncommercial speech. The mere fact, however, that a profit motive underlies speech does not make the speech commercial in nature. Books, movies, television programs, musical works, works of visual art, and newspaper, magazine, and journal articles are normally classified as noncommercial speech—and are thus fully protected—despite the typical existence of an underlying profit motive. Their informational, educational, artistic, or entertainment components are thought to outweigh, for First Amendment purposes, the profit motive.

Citizens United v. Federal Election Commission    558 U.S. 310 (2010) Citizens United, a nonprofit corporation with a $12 million annual budget, receives most of its funds in the form of donations by individuals. A small portion comes from for-profit corporations. In January 2008, Citizens United released a film titled Hillary: The Movie (hereinafter Hillary). It is a 90-minute documentary about then-senator Hillary Clinton, a candidate in the Democratic Party’s 2008 presidential primary elections. Hillary depicts interviews with political commentators and other persons, most of them quite critical of Senator Clinton. Hillary was released in theaters and on DVD, but Citizens United wanted to increase distribution by making it available through video-on-demand. Although video-on-demand services often require viewers to pay a small fee to view a selected program, Citizens United planned to pay for the service and to make Hillary available to viewers free of charge. To promote the film, Citizens United produced two 10-second advertisements and one 30-second ad for airing on broadcast and cable television. Each ad included a pejorative statement about Senator Clinton, followed by the name of the movie and the address of a website for the movie. Before the Bipartisan Campaign Reform Act of 2002 (BCRA), federal law prohibited corporations and unions from using general treasury funds for direct contributions to candidates or as independent expenditures expressly advocating, through any form of media, the election or defeat of a candidate in certain qualified federal elections. 2 U.S.C. § 441b. The BCRA amended § 441b to include any “electioneering communication” as well. The statute defined “electioneering communication” 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 election or 60 days of a general election. When combined, the federal law that preexisted the BCRA and the amendments added by the BCRA barred corporations and unions from using their general treasury funds for express advocacy or electioneering communications. However, they were permitted to establish a “separate segregated fund” (known as a political action committee, or PAC) for these purposes. The funds to be received by the PAC were limited to donations from the corporation’s stockholders and employees or from the union’s members. 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 promoting it would be covered by § 441b’s ban on corporate-funded independent expenditures and could thus subject the corporation to civil and criminal penalties. Citizens United therefore sought declaratory and injunctive relief against the FEC, arguing that § 441b was unconstitutional on its face and as applied to Hillary and that the BCRA’s disclaimer and disclosure requirements were unconstitutional as applied to Hillary and to the three ads for the movie. A federal district court granted the FEC’s motion for summary judgment. The court held that § 441b was constitutional under previous Supreme Court precedents, as were the statute’s disclaimer and disclosure requirements. Citizens United sought review by the Supreme Court (rather than a circuit court of appeals) under a review provision in the challenged law.

Kennedy, Justice Federal law prohibits corporations and unions from using their general treasury funds to make independent expenditures for speech defined as an “electioneering communication” or for speech expressly

advocating the election or defeat of a candidate. 2 U.S.C. § 441b. Limits on electioneering communications were upheld in ­McConnell v. Federal Election Comm’n, 540 U.S. 93 (2003). The holding of McConnell rested to a large extent on an earlier case, Austin v. ­Michigan Chamber of Commerce, 494 U.S. 652 (1990). In this case we are asked to reconsider Austin and, in effect, McConnell.

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Part One Foundations of American Law

The law before us is an outright ban [on speech], 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. These prohibitions are classic examples of censorship. Section 441b is a ban on corporate speech notwithstanding the fact that a PAC created by a corporation can still speak. A PAC is a separate association from the corporation. So the PAC exemption from § 441b’s expenditure ban does not allow corporations to speak. Even if a PAC could somehow allow a corporation to speak—and it does not—the option to form PACs does not alleviate the First Amendment problems with § 441b. PACs are burdensome alternatives; they are expensive to administer and subject to extensive regulations. [Also,] PACs must file detailed monthly reports with the FEC. 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.  [P]olitical 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. Premised on mistrust of governmental power, the First Amendment stands against attempts to disfavor certain subjects or viewpoints. Prohibited, too, are restrictions distinguishing among different speakers, allowing speech by some but not others. The Court has recognized [in various cases] that First Amendment protection extends to corporations. [E.g.,] First National Bank of Boston v. Bellotti, 435 U.S. 765 (1978). This protection has been extended by explicit holdings to the context of political speech.  At least since the latter part of the 19th century, the laws of some states and of the United States imposed a ban on corporate direct contributions to candidates. Yet not until 1947 did Congress first prohibit independent expenditures by corporations and labor unions. For almost three decades thereafter, the Court did not reach the question whether restrictions on corporate and union expenditures are constitutional. In Buckley v. Valeo, 424 U.S. 1 (1976), the Court addressed various challenges to the Federal Election Campaign Act of 1971 (FECA), as amended in 1974. [FECA limited direct contributions to candidates, established] an independent expenditure ban . . . that applied to individuals as well as corporations and labor unions, [and included a separate ban on corporate and union independent expenditures.] [Buckley considered only the direct contributions provision and the broader independent expenditure ban that applied to individuals as well as corporations and unions.] Before addressing the constitutionality of [the broader] independent expenditure ban, Buckley first upheld . . . FECA’s limits on direct

contributions to candidates. The Buckley Court recognized a “sufficiently important” governmental interest in “the prevention of corruption and the appearance of corruption.” This followed from the Court’s concern that large contributions could be given “to secure a political quid pro quo.” The Buckley Court explained that the potential for quid pro quo corruption distinguished direct contributions to candidates from independent expenditures. The Court emphasized that “the independent expenditure ceiling . . . fails to serve any substantial governmental interest in stemming the reality or appearance of corruption in the electoral process,” because “[t]he absence of prearrangement and coordination . . . alleviates the danger that expenditures will be given as a quid pro quo for improper commitments from the candidate.” Buckley invalidated [FECA’s broader] restriction on independent expenditures. Buckley did not consider [FECA’s] separate ban [that specifically applied to] corporate and union independent expenditures. Had [that specific ban] been challenged in the wake of Buckley, however, it could not have been squared with the reasoning and analysis of that precedent. [Nevertheless], Congress recodified [the] corporate and union expenditure ban at 2 U.S.C. § 441b four months after Buckley was decided. Section 441b is the independent expenditure restriction challenged here. Less than two years after Buckley, Bellotti reaffirmed the First Amendment principle that the government cannot restrict political speech based on the speaker’s corporate identity. Bellotti could not have been clearer when it struck down a state-law prohibition on corporate independent expenditures related to referenda issues. Bellotti did not address the constitutionality of the state’s ban on corporate independent expenditures to support candidates. In our view, however, that restriction would have been unconstitutional under Bellotti’s central principle: that the First Amendment does not allow political speech restrictions based on a speaker’s corporate identity. Thus the law stood until Austin, [which] “uph[eld] a direct restriction on the independent expenditure of funds for political speech for the first time in [this Court’s] history.” (Kennedy, J., dissenting in Austin.) [In Austin], the Michigan Chamber of Commerce sought to use general treasury funds to run a newspaper ad supporting a specific candidate. Michigan law, however, prohibited corporate independent expenditures that supported or opposed any candidate for state office. The Austin Court sustained the speech prohibition. To bypass Buckley and Bellotti, the Court identified a new governmental interest in limiting political speech: an anti-distortion interest. Austin found a compelling governmental interest in preventing “the corrosive and distorting effects of immense aggregations of wealth that are accumulated with the help of the corporate form and that have little or no correlation to the public’s support for the corporation’s political ideas.” The Court is thus confronted with conflicting lines of precedent: a pre-Austin line that forbids restrictions on political speech



Chapter Three Business and the Constitution

based on the speaker’s corporate identity and a post-Austin line that permits them. No case before Austin had held that Congress could prohibit independent expenditures for political speech based on the speaker’s corporate identity. In its defense of the corporate-speech restrictions in § 441b, the government notes the anti-distortion rationale on which Austin and its progeny rest in part, yet . . . the government does little to defend it. And with good reason, for the rationale cannot support § 441b. If the First Amendment has any force, it prohibits Congress from fining or jailing citizens, or associations of citizens, for simply engaging in political speech. If the anti-distortion rationale were to be accepted, however, it would permit government to ban political speech simply because the speaker is an association that has taken on the corporate form.   If Austin were correct, the government could prohibit a corporation from expressing political views in media beyond those presented here, such as by printing books. The government responds “that the FEC has never applied this statute to a book,” and if it did, “there would be quite [a] good as-applied [constitutional] challenge.” This troubling assertion of brooding governmental power cannot be reconciled with the confidence and stability in civic discourse that the First Amendment must secure. [As noted in Bellotti,] [p]olitical speech is “indispensable to decisionmaking in a democracy, and this is no less true because the speech comes from a corporation rather than an individual.” This protection for speech is inconsistent with Austin’s anti-distortion rationale. Austin sought to defend the anti-distortion rationale as a means to prevent corporations from obtaining “an unfair advantage in the political marketplace” by using “resources amassed in the economic marketplace.” But Buckley rejected the premise that the government has an interest “in equalizing the relative ability of individuals and groups to influence the outcome of elections.” Buckley was specific in stating that “the skyrocketing cost of political campaigns” could not sustain the governmental prohibition. The censorship we now confront is vast in its reach. The government has “muffle[d] the voices that best represent the most significant segments of the economy” (opinion of Scalia, J., in McConnell).  The purpose and effect of this law is to prevent corporations, including small and nonprofit corporations, from presenting both facts and opinions to the public. This makes Austin’s anti-distortion rationale all the more an aberration. 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 [another argument] 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

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corruption or its appearance. The Buckley Court . . . sustained limits on direct contributions in order to ensure against the reality or appearance of corruption. That case did not extend this rationale to independent expenditures, and the Court does not do so here. [The Court stated in Buckley that] “[t]he absence of prearrangement and coordination of an expenditure with the candidate or his agent not only undermines the value of the expenditure to the candidate, but also alleviates the danger that expenditures will be given as a quid pro quo for improper commitments from the candidate.” Limits on independent expenditures, such as § 441b, have a chilling effect extending well beyond the government’s interest in preventing quid pro quo corruption. The anti-corruption interest is not sufficient to displace the speech here in question. For the reasons above, it must be concluded that Austin was not well reasoned. Austin is [also] undermined by experience since its announcement. Political speech is so ingrained in our culture that speakers find ways to circumvent campaign finance laws. Our nation’s speech dynamic is changing, and informative voices should not have to circumvent onerous restrictions to exercise their First Amendment rights.  Rapid changes in technology—and the creative dynamic inherent in the concept of free expression—counsel against upholding a law that restricts political speech in certain media or by certain speakers. Today, 30-second television ads may be the most effective way to convey a political message. Soon, however, it may be that Internet sources, such as blogs and social networking websites, 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. Austin is overruled, so it provides no basis for allowing the government to limit corporate independent expenditures. As the government appears to concede [in its brief], overruling Austin “effectively invalidate[s] not only [the BCRA’s amendments to § 441(b)] but also § 441b’s prohibition on the use of corporate treasury funds for express advocacy.” Section 441b’s restrictions on corporate independent expenditures are therefore invalid and cannot be applied to Hillary. Given our conclusion, we are further required to overrule the part of McConnell that upheld [the BCRA’s] extension of § 441b’s restrictions on corporate independent expenditures. 

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Part One Foundations of American Law

District court’s judgment reversed as to constitutionality of restrictions on corporate independent expenditures. Stevens, Justice (joined by Ginsburg, Breyer, and Sotomayor, Justices), concurring in part and dissenting in part Although I concur in the Court’s decision to sustain the BCRA’s disclaimer and disclosure provisions, I emphatically dissent from its principal holding. Citizens United is a wealthy nonprofit corporation that runs a PAC with millions of dollars in assets. Under the BCRA, it could have used those assets to televise and promote Hillary wherever and whenever it wanted to. It also could have spent unrestricted sums to broadcast Hillary at any time other than the 30 days before the last primary election. Neither Citizens United’s nor any other corporation’s speech has been “banned.” All that the parties dispute is whether Citizens United had a right to use the funds in its general treasury to pay for broadcasts during the 30-day period. The notion that the First Amendment dictates an affirmative answer to that question is, in my judgment, profoundly misguided. The Court today rejects a century of history when it treats the distinction between corporate and individual campaign spending as an invidious novelty born of Austin. Relying largely on individual dissenting opinions, the majority blazes through our precedents, overruling or disavowing a [large] body of case law. The only thing preventing the majority from affirming the district court, or adopting a narrower ground that would retain Austin, is its disdain for

Austin. The laws upheld in Austin and McConnell leave open many additional avenues for corporations’ political speech. Roaming far afield from the case at hand, the majority worries that the government will use [the statute at issue] to ban books, pamphlets, and blogs. Yet by its plain terms, [the statute] does not apply to printed material. And . . . we highly doubt that [§ 441b] could be interpreted to apply to a website or book that happens to be transmitted at some stage over airwaves or cable lines, or that the FEC would ever try to do so. So let us be clear: Neither Austin nor McConnell held or implied that corporations may be silenced; the FEC is not a “censor”; and in the years since these cases were decided, corporations have continued to play a major role in the national dialogue. Laws such as [§ 441b] target a class of communications that is especially likely to corrupt the political process. Such laws burden political speech, and that is always a serious matter, demanding careful scrutiny. But the majority’s incessant talk of a “ban” aims at a straw man. In [our] democratic society, the longstanding consensus on the need to limit corporate campaign spending [reflects] the common sense of the American people, who have . . . fought against the distinctive corrupting potential of corporate electioneering since the days of Theodore Roosevelt. It is a strange time to repudiate that common sense. While American democracy is imperfect, few outside the majority of this Court would have thought its flaws included a dearth of corporate money in politics.

Figure 3.2 A Note on Post–Citizens United Developments After Citizens United, not-for-profit and for-profit corporations were free to spend unlimited sums from their general treasury funds for express advocacy purposes or for other electioneering communications regarding candidates for federal election, as long as the spending took place independently from the campaigns of favored candidates. Corporations could fund such advertisements directly, without being bound by the invalidated requirement of using a PAC to which only employees and shareholders could contribute. Further, they could engage in such independent expenditures by providing unlimited funds to so-called Super PACs—organizations that were not formally affiliated with candidates for office but accepted money from any individual or organization for the purpose of producing advertisements favoring or disfavoring candidates. In the run-up to the 2012 elections, some corporations donated significant amounts to Super PACs and other not-for-profit organizations in order to help fund such advertisements. So did many individual persons. This tendency became especially pronounced after a federal court of appeals reasoned that given the conclusions drawn in Citizens United and the Supreme Court’s long-standing position that the First Amendment rights of individuals and corporations are coextensive, individuals should be free to engage in unlimited spending for express advocacy purposes. In the 2012 elections, certain very wealthy individuals proved to be even bigger spenders in this regard than corporate entities were. The total dollars spent in connection with the 2012 elections easily surpassed the spending levels in previous elections. Similar patterns could be observed in the 2014 and 2016 elections.



Chapter Three Business and the Constitution

Commercial Speech The exact boundaries of the commercial speech category are not certain, though the Supreme Court has usually defined commercial speech as speech that proposes a commercial transaction. As a result, most cases on the subject involve advertisements for the sale of products or services or for the promotion of a business. In 1942, the Supreme Court held that commercial speech fell outside the First Amendment’s protective umbrella. The Court reversed its position, however, during the 1970s. It reasoned that informed consumer choice would be furthered by the removal of barriers to the flow of commercial information in which consumers would find an interest. Since the mid-1970s, commercial speech has received an intermediate level of First Amendment protection if it deals with a lawful activity and is nonmisleading. Commercial speech receives no protection, however, if it misleads or seeks to promote an illegal activity. As a result, there is no First Amendment obstacle to federal or state regulation of deceptive commercial advertising. (Political or other noncommercial speech, on the other hand, generally receives—with very few exceptions—full First Amendment protection even if it misleads or deals with unlawful matters.) Because nonmisleading commercial speech about a lawful activity receives intermediate protection, the government has greater ability to regulate such speech without violating the First Amendment than when the government seeks to regulate fully protected political or other noncommercial speech. Nearly four decades ago, the Supreme Court developed a still-controlling test that amounts to intermediate scrutiny. Under this test, a government restriction on protected commercial speech does not violate the First Amendment if the government proves each of these elements: that a substantial government interest underlies the restriction, that the restriction directly advances the underlying interest, and that the restriction is no more extensive than necessary to further the interest (i.e., that the restriction is narrowly tailored). It usually is not difficult for the government to prove that a substantial interest supports the commercial speech restriction. Almost any asserted interest connected with the promotion of public health, safety, or welfare will suffice. The government is likely to encounter more difficulty, however, in proving that the restriction at issue directly advances the underlying interest without being more extensive than necessary—the elements that address the “fit” between the restriction and the underlying interest. If the government fails to prove any element of the test, the restriction violates the First Amendment. Although the same test has been used in evaluating commercial speech restrictions for nearly four decades, the Supreme Court has varied the intensity with which

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it has applied the test. From the mid-1980s until 1995, the Court sometimes applied the test loosely and in a manner favorable to the government. The Court has applied the test—especially the “fit” elements—more strictly since 1995, however. For instance, in Coors v. Rubin, 514 U.S. 476 (1995), the Court struck down federal restrictions that kept beer producers from listing the alcohol content of their beer on product labels. (The Coors case was the subject of the introductory problem that began this chapter.) In 44 Liquormart v. Rhode Island, 517 U.S. 484 (1996), the Court held that Rhode Island’s prohibition on price disclosures in alcoholic beverage advertisements violated the First Amendment. A 1999 decision, Greater New Orleans Broadcasting Association v. United States, 527 U.S. 173 (1999), established that a federal law barring broadcast advertisements for a variety of gambling activities could not constitutionally be applied to radio and television stations located in the same state as the gambling casino whose lawful activities were being advertised. Sorrell v. IMS Health, Inc., 564 U.S. 552 (2011), involved a challenge to a Vermont law that barred pharmacies from releasing data about physicians’ prescribing practices and tendencies if the release would be to parties wishing to use the information for marketing purposes. The law, however, allowed pharmacies to disclose such information if it would be used for various other purposes. Continuing to display its inclination to afford significant protection to commercial speech, the Court held that in singling out marketing-related uses for adverse treatment while otherwise allowing the disclosure of the information, the statute violated the First Amendment. In its commercial speech decisions during the past twoplus decades, the Court has tended to emphasize that the government restrictions at issue suffered from a “fit” problem. Sometimes the defective fit consisted of too tenuous a relationship between the restriction and the government interest underlying it. More frequently the restriction prohibited more speech than was necessary because the government failed to adopt alternative measures that would have furthered the underlying public health, safety, or welfare interest just as well, if not better. Two key conclusions may be drawn from the Court’s commercial speech decisions since 1995: (1) the government has found it more difficult to justify restrictions on commercial speech and (2) the gap between the intermediate protection for commercial speech and the full protection for political and other noncommercial speech has effectively become smaller than it was roughly 25 years ago. Although the Court has hinted that it might consider formal changes in the commercial speech doctrine (so as

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Part One Foundations of American Law

CONCEPT REVIEW The First Amendment

Type of Speech

Level of First Amendment Consequences When Government Regulates  Protection Content of Speech

Noncommercial

Full

Government action is constitutional only if action is necessary to fulfillment of compelling government purpose. Otherwise, government action violates First Amendment.

Commercial (nonmisleading and about lawful activity)

Intermediate

Government action is constitutional if government has substantial underlying interest, action directly advances that interest, and action is no more extensive than necessary to fulfillment of that interest (i.e., action is narrowly tailored).

Commercial (misleading or about unlawful activity)

None

Government action is constitutional.

to enhance First Amendment protection for commercial speech), it had not made formal doctrinal changes as of the time this book went to press. Matal v. Tam, which appears later in the chapter, addresses the four-part test utilized in determining the constitutionality of commercial speech restrictions, and illustrates the rigor with which the Supreme Court has applied the third and fourth parts of the test in recent years. The Government Speech Doctrine Previous discussion has revealed that when the government restricts the content of private parties’ speech, a First Amendment violation is likely to have occurred. But when the government itself speaks, it is free to convey its preferred viewpoints and to reject contrary views that private parties wish to express. Such is the premise of the recently developed, and still not precisely defined, government speech doctrine. Whether government speech is present depends largely upon the extent to which the government crafted the conveyed messages or supervised, through heavy involvement, the communication of the messages. In Johanns v. Livestock Marketing Association, 544 U.S. 550 (2005), for instance, the Supreme Court upheld a federal statute that set up a program of paid advertisements designed to promote the image and sale of beef products. The Court emphasized that the U.S. Department of Agriculture designed the program, established its contours, and exercised close supervisory authority over the messages that were communicated in the advertisements. Therefore, the

Court, reasoned, the government speech doctrine applied and shielded the program against a First Amendment– based challenge by an association that did not want to participate in the government-created program. More recently, in Walker v. Texas Division, Sons of Confederate Veterans, Inc., 576 U.S. 200 (2015), the Supreme Court held that the First Amendment was not violated—and that the government speech doctrine applied—when the State of Texas rejected a group’s request for a specialty license plate consisting of an image of the Confederate battle flag. In deciding that the government speech doctrine applied, the Court stressed the government’s historic use of license plates to convey messages and the supervisory control maintained by the government in running the specialty license plate program. Figure 3.3, which appears later in the chapter, explores recent requirements to include graphic warnings on tobacco products. In Matal v. Tam, which follows, the Supreme Court struck down, on First Amendment grounds, a provision in federal law that allowed the government to refuse to register a trademark that is disparaging to individuals or groups. (Trademark registration is addressed in Chapter 8. Discussion of Tam also appears there.) In so ruling, the Court rejected the government’s attempt to invoke the government speech doctrine and reminded readers that the First Amendment protects a great deal of speech that is offensive in nature. Tam also explores an issue noted earlier in the chapter: the problematic nature, for First Amendment purposes, of laws that discriminate among speakers on the basis of the viewpoints they express.



Chapter Three Business and the Constitution

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Matal v. Tam   137 S. Ct. 1744 (2017) Simon Tam is the lead singer of a musical group known as “The Slants.” Members of the band are Asian Americans. Although “Slants” has been used as a derogatory term for persons of Asian descent, Tam and the other band members believe that by taking the term as the name of their group, they will help to “reclaim” the term and drain its denigrating force. Tam sought to have THE SLANTS registered as a trademark on the federal principal register. An examining attorney at the U.S. Patent and Trademark Office (PTO) denied Tam’s application, invoking a Lanham Act provision (referred to here as the disparagement clause). That provision bars the registration of trademarks that may “disparage . . . or bring . . . into contemp[t] or disrepute” any “persons, living or dead.” In the examining attorney’s judgment, THE SLANTS was disparaging with regard to persons of Asian descent. Tam unsuccessfully appealed the examining attorney’s denial of registration to the PTO’s Trademark Trial and Appeal Board. He then appealed to the U.S. Court of Appeals for the Federal Circuit, which held the disparagement clause unconstitutional under the First Amendment. The PTO filed a petition for certiorari, which the U.S. Supreme Court granted in order to decide whether the disparagement clause violates the First Amendment. Alito, Justice “The principle underlying trademark protection is that distinctive marks—words, names, symbols, and the like—can help distinguish a particular artisan’s goods from those of others.” B&B Hardware, Inc. v. Hargis Industries, Inc., 135 S. Ct. 1293 (2015). A trademark . . . helps consumers identify goods and services that they wish to purchase, as well as those they want to avoid. Trademarks . . . were protected at common law and in equity at the time of the founding of our country. Eventually, Congress stepped in to provide a degree of national uniformity [through] the Lanham Act, enacted in 1946. By that time, trademark had expanded far beyond phrases that do no more than identify a good or service. Then, as now, trademarks often consisted of catchy phrases that convey a message. Under the Lanham Act, trademarks that are used in commerce may be placed on the [federal] principal register. This system of federal registration helps to ensure that trademarks are fully protected and supports the free flow of commerce. Without federal registration, a valid trademark may still be used in commerce [and] can be enforced against would-be infringers. Federal registration, however, confers important legal rights and benefits on trademark owners who register their marks. [Authors’ note: Those rights and benefits are summarized in Chapter 8 of the text and will not be discussed here.] The Lanham Act contains provisions that bar certain trademarks from the principal register. At issue in this case is one such provision, which we will call “the disparagement clause.” This provision prohibits the registration of a trademark “which may disparage . . . persons, living or dead, institutions, beliefs, or national symbols, or bring them into contempt, or disrepute.”  When deciding whether a trademark is disparaging, an examiner at the PTO generally applies a two-part test [set forth in the Trademark Manual of Examining Procedure]. The examiner first considers “the likely meaning of the matter in question, taking into account not only dictionary definitions, but

also . . . the manner in which the mark is used in the marketplace in connection with the goods or services.” If that meaning refers to “identifiable persons, institutions, beliefs or national symbols,” the examiner moves to the second step, asking “whether that meaning may be disparaging to a substantial [component] of the referenced group.”  If the examiner finds that a “substantial [component], although not necessarily a majority, of the referenced group would find the proposed mark . . . to be disparaging in the context of contemporary attitudes,” a prima facie case of disparagement is made out, and the burden shifts to the applicant to prove that the trademark is not disparaging. What is more, the PTO has specified that “[t]he fact that an applicant may be a member of that group or has good intentions underlying its use of a term does not obviate the fact that a substantial composite of the referenced group would find the term objectionable.” [The examiner in this case applied the two-part test in concluding that THE SLANTS was a disparaging term.] [W]e must decide whether the disparagement clause violates the Free Speech Clause of the  First Amendment. And at the outset, we must consider [an argument] that would eliminate any  First Amendment  protection. Specifically,  the Government contends that trademarks are government speech, not private speech. The First Amendment prohibits Congress and other government entities and actors from “abridging the freedom of speech”; the First Amendment does not say that Congress and other government entities must abridge their own ability to speak freely. And our cases recognize that “[t]he Free Speech Clause . . . does not regulate government speech.” Pleasant Grove City v. Summum, 555 U.S. 460, 467 (2009). See Johanns v. Livestock Marketing Association, 544 U.S. 550, 553 (2005) (“[T]he Government’s own speech . . . is exempt from First Amendment scrutiny”). As we have said, “it is not easy to imagine how government could function” if it were subject to the restrictions that the First

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Part One Foundations of American Law

Amendment  imposes on private speech.  Summum,  555 U.S. at 468. See Walker  v.  Texas Division, Sons of Confederate Veterans, Inc., 135 S. Ct. 2239 (2015). [Although] “the  First Amendment  forbids the government to regulate speech in ways that favor some viewpoints or ideas at the expense of others,” [citation omitted,] . . . imposing a requirement of viewpoint-neutrality on government speech would be paralyzing. When a government entity embarks on a course of action, it necessarily takes a particular viewpoint and rejects others. The Free Speech Clause does not require government  to maintain viewpoint neutrality when its officers and employees speak about that venture. Here is a simple example. During the Second World War, the Federal Government produced and distributed millions of posters to promote the war effort. There were posters urging enlistment, the purchase of war bonds, and the conservation of scarce resources.  These posters expressed a viewpoint, but the  First Amendment did not demand that the Government balance the message of these posters by producing and distributing posters encouraging Americans to refrain from engaging in these activities. But while the government-speech doctrine is important— indeed, essential—it is a doctrine that is susceptible to dangerous misuse. If private speech could be passed off as government speech by simply affixing a government seal of approval, government could silence or muffle the expression of disfavored viewpoints. For this reason, we must exercise great caution before extending our government-speech precedents. At issue here is the content of trademarks that are registered by the PTO, an arm of the Federal Government. The Federal Government does not dream up these marks, and it does not edit marks submitted for registration. Except as required by the statute involved here, an examiner may not reject a mark based on the viewpoint that it appears to express. Thus, unless that section is thought to apply, an examiner does not inquire whether any viewpoint conveyed by a mark is consistent with Government policy or whether any such viewpoint is consistent with that expressed by other marks already on the principal register. Instead, if the mark meets the Lanham Act’s viewpoint-neutral requirements, registration is mandatory.  In light of all this, it is far-fetched to suggest that the  content of a registered mark is government speech. If the federal registration of a trademark makes the mark government speech, the Federal Government is babbling prodigiously and incoherently. It is saying many unseemly things. It is expressing contradictory views. (Compare, [for instance, these two registered marks:] “Abolish Abortion” [and] “I Stand With Planned Parenthood.”) It is unashamedly endorsing a vast array of commercial products and services. And it is providing Delphic advice to the consuming public. For example, if trademarks represent government speech, what does the Government have in mind when it advises Americans

to “make.believe” (Sony), “Think different” (Apple), “Just do it” (Nike), or “Have it your way” (Burger King)? Was the Government warning about a coming disaster when it registered the mark “EndTime Ministries”? None of our government speech cases even remotely supports the idea that registered trademarks are government speech. In Johanns, we considered advertisements promoting the sale of beef products. A federal statute called for the creation of a program of paid advertising “to advance the image and desirability of beef and beef products.”  544 U.S. at 561. Congress and the Secretary of Agriculture provided guidelines for the content of the ads, Department of Agriculture officials attended the meetings at which the content of specific ads was discussed, and the Secretary could edit or reject any proposed ad. Noting that “[t]he message set out in the beef promotions [was] from beginning to end the message established by the Federal Government,” we held that the ads were government speech. Id. at 560. The Government’s involvement in the creation of these beef ads bears no resemblance to anything that occurs when a trademark is registered. [Moreover, trademarks] have not traditionally been used to convey a Government message. With the exception of the enforcement of [the statute at issue here], the viewpoint expressed by a mark has not played a role in the decision whether to place it on the principal register. And there is no evidence that the public associates the contents of trademarks  with the Federal Government. This brings us to the case on which the Government relies most heavily,  Walker, which likely marks the outer bounds of the government-speech doctrine. Holding that the messages on Texas specialty license plates are government speech [and that the State of Texas therefore did not violate the First Amendment when it rejected a request for a specialty license consisting of a representation of the Confederate battle flag], the Walker Court cited three factors. First, license plates have long been used by the States to convey state messages. Second, license plates “are often closely identified in the public mind” with the State, since they are manufactured and owned by the State, generally designed by the State, and serve as a form of “government ID.” Third, Texas “maintain[ed] direct control over the messages conveyed on its specialty plates.” As explained above, none of these factors is present in this case. In sum, the federal registration of trademarks is vastly different from the beef ads in Johanns [and] the specialty license plates in Walker. Holding that the registration of a trademark converts the mark into government speech would constitute a huge and dangerous extension of the government-speech doctrine. For if the registration of trademarks constituted government speech, other systems of government registration could easily be characterized in the same way.



Chapter Three Business and the Constitution

Perhaps the most worrisome implication of the Government’s argument concerns the system of copyright registration. If federal registration makes a trademark government speech and thus eliminates all  First Amendment  protection, would the registration of the copyright for a book produce a similar transformation? The Government attempts to distinguish copyright on the ground that it is “the engine of free expression,” Brief for Petitioner (quoting  Eldred  v.  Ashcroft, 537 U.S. 186, 219 (2003)), but as this case illustrates, trademarks often have an expressive content. Companies spend huge amounts to create and ­publicize trademarks that convey a message. It is true that the necessary brevity of trademarks limits what they can say. But powerful messages can sometimes be conveyed in just a few words. Trademarks are private, not government, speech. Having concluded that the disparagement clause cannot be sustained under our government-speech [cases, we note the existence of] a dispute between the parties on the question whether trademarks are commercial speech and are thus subject to the relaxed scrutiny outlined in  Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980). The Government and  amici  supporting its position argue that all trademarks are commercial speech. They note that the central purposes of trademarks are commercial and that federal law regulates trademarks to promote fair and orderly interstate commerce. Tam and his amici, on the other hand, contend that many, if not all, trademarks have an expressive component. In other words, these trademarks do not simply identify the source of a product or service but go on to say something more, either about the product or service or some broader issue. The trademark in this case illustrates this point. The name “The Slants” not only identifies the band but expresses a view about social issues. We need not resolve this debate between the parties because the disparagement clause cannot withstand even  Central Hudson  review. Under  Central Hudson, a restriction of speech must serve “a substantial interest,” and it must be “narrowly drawn.”  Id. at 564–565. This means, among other things, that “[t]he regulatory technique may extend only as far as the interest it serves.” Id. at 565. The disparagement clause fails this requirement. It is claimed that the disparagement clause serves two interests. The first is phrased in a variety of ways in the briefs. The Government asserts [in its brief] an interest in preventing “underrepresented groups” from being “bombarded with demeaning messages in commercial advertising.” An amicus supporting the Government refers [in its brief] to “encouraging racial tolerance  and protecting the privacy and welfare of individuals.” But no matter how the point is phrased, its unmistakable thrust is this: The Government has an interest in preventing speech

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expressing ideas that offend. And that idea strikes at the heart of the  First Amendment. Speech that demeans on the basis of race, ethnicity, gender, religion, age, disability, or any other similar ground is hateful; but the proudest boast of our free speech jurisprudence is that we protect the freedom to express “the thought that we hate.” United States v. Schwimmer, 279 U.S. 644, 655 (1929) (Holmes, J., dissenting). The second interest asserted is protecting the orderly flow of commerce. Commerce, we are told, is disrupted by trademarks that “involv[e] disparagement of race, gender, ethnicity, national origin, religion, sexual orientation, and similar demographic classification”  [quoting the Federal Circuit’s decision in this case]. Such trademarks are analogized to discriminatory conduct, which has been recognized to have an adverse effect on commerce. A simple answer to this argument is that the disparagement clause is not narrowly drawn to drive out trademarks that support invidious discrimination. The clause reaches any trademark that disparages  any person, group, or institution. It applies to trademarks [such as] the following: “Down with racists,” “Down with sexists,” “Down with homophobes.” It is not an anti-discrimination clause; it is a happy-talk clause. In this way, it goes much further than is necessary to serve the interest asserted. There is also a deeper problem with the argument that commercial speech may be cleansed of any expression likely to cause offense. The commercial market is well stocked with merchandise that disparages prominent figures and groups, and the line between commercial and non-commercial speech is not always clear, as this case illustrates. If affixing the commercial label permits the suppression of any speech that may lead to political or social “volatility,” free speech would be endangered. For these reasons, we hold that [regardless of whether trademarks are or are not commercial speech,] the disparagement clause violates the Free Speech Clause of the First Amendment. [The disparagement clause] offends a bedrock  First Amendment principle: Speech may not be banned on the ground that it expresses ideas that offend. Justice Kennedy, with whom Justices Ginsburg, Sotomayor, and Kagan join, concurring in part and concurring in the judgment As the Court is correct to hold, [the disparagement clause] constitutes viewpoint discrimination—a form of speech suppression so potent that it must be subject to rigorous constitutional scrutiny. The Government’s action and the statute on which it is based cannot survive this scrutiny. The Court is correct in its judgment, and I join [most] of its opinion.  This separate writing explains in greater detail why the First Amendment’s protections against viewpoint discrimination apply to the trademark here. It submits further that the viewpoint discrimination rationale renders

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Part One Foundations of American Law

unnecessary any extended treatment of other questions raised by the parties. Those few categories of speech that the government can regulate or punish—for instance, fraud, defamation, or incitement—are well established within our constitutional tradition. Aside from these and a few other narrow exceptions, it is a fundamental principle of the First Amendment that the government may not punish or suppress speech based on disapproval of the ideas or perspectives the speech conveys. A law found to discriminate based on viewpoint is an “egregious form of content discrimination,” which is “presumptively unconstitutional.” [Citation omitted.] At its most basic, the test for viewpoint discrimination is whether . . . the government has singled out a subset of messages for disfavor based on the views expressed. In the instant case, the disparagement clause the Government now seeks to implement and enforce identifies the relevant subject as “persons, living or dead, institutions, beliefs, or national symbols.” Within that category, an applicant may register a positive or benign mark but not a derogatory one. The law thus reflects the Government’s disapproval of a subset of messages it finds offensive. This is the essence of viewpoint discrimination.

The parties dispute whether trademarks are commercial speech. [This] issue may turn on whether certain commercial concerns for the protection of trademarks might, as a general matter, be the basis for regulation. However that issue is resolved, the viewpoint based discrimination at issue here [causes the disparagement clause to violate the First Amendment]. Justice Thomas, concurring in part and concurring in the judgment I join [much of] the opinion of Justice Alito. I also write separately because “I continue to believe that when the government seeks to restrict truthful speech in order to suppress the ideas it conveys, strict scrutiny is appropriate, whether or not the speech in question may be characterized as ‘commercial.’”  Lorillard Tobacco Co. v. Reilly, 533 U.S. 525, 572 (2001) (Thomas, J., concurring in part and concurring in judgment). I nonetheless join . . . Justice Alito’s opinion [insofar as it] concludes that the disparagement clause is unconstitutional even under the less stringent test announced in Central Hudson Gas & Electric Corp. v. Public Service Commission. Judgment of Federal Circuit affirmed.

Figure 3.3 A Note on Tobacco Regulations What about rules that require tobacco companies to print warnings about their products; do those infringe on the companies’ First Amendment rights? Congress has passed and amended several laws regulating the labeling and advertising of tobacco products. In 2009, it passed a law known as the Family Smoking Prevention and Tobacco Control Act (TCA). The TCA requires a federal agency, the Food and Drug Administration (FDA), to issue regulations that require color graphics depicting the health risks of smoking. Here are some examples of the required graphic images the FDA has proposed (see www.fda.gov/tobacco-products/ labeling-and-warning-statements-tobacco-products/cigarette-health-warnings#sample):



Chapter Three Business and the Constitution

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Companies that produce these products have challenged both the FDA’s rules and the TCA. The U.S. Court of Appeals for the D.C. Circuit struck down one set of regulations in 2012, holding that the required images proposed by the FDA violated the First Amendment and that the FDA did not provide substantial evidence that graphic warnings on cigarette advertising would directly advance its interest in reducing smoking rates to a material degree. R.J. Reynolds Tobacco Co. v. Food & Drug Admin., 696 F.3d 1205 (D.C. Cir. 2012). In a separate ruling also in 2012, the U.S. Court of Appeals for the Sixth Circuit upheld the TCA’s graphic warning requirement, finding the provision did not violate the First Amendment and the graphic warning requirement was reasonably related to the government’s interest in preventing consumer deception. Discount Tobacco City & Lottery, Inc. v. United States, 674 F.3d 509 (6th Cir. 2012). Several public health and medical organizations sued in 2016 to force the FDA to issue final regulations on graphic labels, as required by the TCA. The U.S. District Court for the District of Massachusetts ruled in favor of the plaintiffs and ordered the FDA to issue a final rule requiring graphic health warnings by March 15, 2020. American Academy of Pediatrics v. FDA, 2019 WL 1047149 (D. Mass. March 5, 2019). The FDA then issued a new final rule, which at the time of this writing is the subject of litigation. Several tobacco companies filed a lawsuit in the Federal District Court for the Eastern District of Texas against the FDA, seeking to invalidate the graphic health warnings and the requirement under the Tobacco Control Act. The companies argued that the new rule requiring graphic warnings violates the First Amendment, the TCA’s requirement that FDA issue a rule requiring the health warning violates the First Amendment, and the FDA acted arbitrarily and capriciously in drafting and issuing the rule. Philip Morris USA Inc. filed a similar challenge in the U.S. District Court for the District of Columbia. The company alleges that the rule violates the First Amendment rights of tobacco companies by requiring them to “disparage their own products with shocking and inflammatory graphic images.” The complaint seeks declaratory and injunctive relief to prevent implementation of the rule.

Due Process The

Fifth and Fourteenth Amendments require that the federal government and the states observe due process when they deprive a person of life, liberty, or property. Due process has both procedural and substantive meanings. LO3-7

Explain the difference between procedural due process and substantive due process.

Procedural Due Process The traditional conception of due process, called procedural due process, establishes the procedures that government must follow when it takes life, liberty, or property. Although the requirements of procedural due process vary from situation to situation, their core idea is that one is entitled to adequate notice of the government action to be taken against him and to some sort of fair trial or hearing before that action can occur. For purposes of procedural due process claims, liberty includes a very broad and poorly defined range of freedoms. It even includes certain interests in personal reputation. For example, the firing of a government employee may require some kind of due process hearing if it is publicized, the fired

employee’s reputation is sufficiently damaged, and her future employment opportunities are restricted. The Supreme Court has said that procedural due process property is not created by the Constitution but by existing rules and understandings that stem from an independent source such as state law. These rules and understandings must give a person a legitimate claim of entitlement to a benefit, not merely some need, desire, or expectation for it. This definition includes almost all of the usual forms of property, as well as utility service, disability benefits, welfare benefits, and a driver’s license. It also includes the job rights of tenured public employees who can be discharged only for cause, but not the rights of untenured or probationary employees. Substantive Due Process Procedural due process does not challenge rules of substantive law—the rules that set standards of behavior for organized social life. For example, imagine that State X makes adultery a crime and allows people to be convicted of adultery without a trial. Arguments that adultery should not be a crime go to the substance of the statute, whereas objections to the lack of a trial are procedural in nature.

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Part One Foundations of American Law

Sometimes, the due process clauses have been used to attack the substance of government action. For our purposes, the most important example of this substantive due process occurred early in the 20th century, when courts struck down various kinds of social legislation as denying due process. They did so mainly by reading freedom of contract and other economic rights into the liberty and property protected by the Fifth and Fourteenth Amendments, and then interpreting “due process of law” to require that laws denying such rights be subjected to means-ends scrutiny. The best-known example is the Supreme Court’s 1905 decision in Lochner v. New York, 198 U.S. 45 (1905), which struck down a state law setting maximum hours of work for bakery employees because the statute limited freedom of contract and did not directly advance the legitimate state goal of promoting worker health. Since 1937, however, this “economic” form of substantive due process has been largely abandoned by the Supreme Court and has not amounted to a significant check on government regulation of economic matters. Substantive due process attacks on such regulations now trigger only a lenient type of rational basis review and thus have had little chance of success. During the 1970s and 1980s, however, substantive due process became increasingly important as a device for protecting noneconomic rights. The most important examples are the liberty and privacy interests, which consist of several rights that the Supreme Court regards as fundamental and as entitled to significant constitutional protection. The Court has declared that these include the rights to marry, have children and direct their education and upbringing, enjoy marital privacy, use contraception, and,

within certain limits, elect to have an abortion. Laws restricting these rights must be narrowly tailored to meet a compelling government purpose in order to avoid being declared unconstitutional. Obergefell v. Hodges, which appears later in the chapter, illustrates the influence of substantive due process interests.

Equal Protection Identify the instances when an Equal Protection Clause–

LO3-8 based challenge to government action triggers more

rigorous scrutiny than the rational basis test.

The Fourteenth Amendment’s Equal Protection Clause says that “[n]o State shall . . . deny to any person . . . the equal protection of the laws.” Because the equal protection guarantee has been incorporated within Fifth Amendment due process, it also restricts the federal government. The equal protection guarantee potentially applies to all situations in which government classifies or distinguishes people. The law inevitably makes distinctions among people, benefiting or burdening some groups but not others. Equal protection doctrine, as developed by the Supreme Court, sets the standards such distinctions must meet in order to be constitutional. Economic Regulations The basic equal protection standard is the rational basis test described earlier. This is the standard usually applied to social and economic regulations that are challenged as denying equal protection. As the following case illustrates, this lenient test usually does not impede state and federal regulation of social and economic matters.

Fitzgerald v. Racing Association of Central Iowa    539 U.S. 103 (2003) Before 1989, Iowa permitted only one form of gambling: parimutuel betting at racetracks. A 1989 Iowa statute authorized other forms of gambling, including slot machines on riverboats. The 1989 law established that adjusted revenues from riverboat slot machine gambling would be taxed at graduated rates, with a top rate of 20 percent. In 1994, Iowa enacted a law that authorized racetracks to operate slot machines. That law also imposed a graduated tax upon racetrack slot machine adjusted revenues, with a top rate that started at 20 percent and would automatically rise over time to 36 percent. The 1994 enactment left in place the 20 percent tax rate on riverboat slot machine adjusted revenues. Contending that the 1994 legislation’s 20 percent versus 36 percent tax rate difference violated the federal Constitution’s Equal Protection Clause, a group of racetracks and an association of dog owners brought suit against the State of Iowa (through its state treasurer, Michael Fitzgerald). A state district court upheld the statute, but the Iowa Supreme Court reversed. The U.S. Supreme Court granted Iowa’s petition for a writ of certiorari.



Chapter Three Business and the Constitution

Breyer, Justice We here consider whether a difference in state tax rates violates the Fourteenth Amendment’s mandate that “no State shall . . . deny to any person . . . the equal protection of the laws.” The law in question does not distinguish on the basis of, for example, race or gender. It does not distinguish between in-state and out-of-state businesses. Neither does it favor a State’s longtime residents at the expense of residents who have more recently arrived from other States. Rather, the law distinguishes for tax purposes among revenues obtained within the State of Iowa by two enterprises, each of which does business in the State. Where that is so, the law is subject to rational-basis review: The Equal Protection Clause is satisfied so long as there is a plausible policy reason for the classification, the legislative facts on which the classification is apparently based rationally may have been considered to be true by the governmental decisionmaker, and the relationship of the classification to its goal is not so attenuated as to render the distinction arbitrary or irrational. [Case citation omitted.] [We have also held that] rational-basis review “is especially deferential in the context of classifications made by complex tax laws.” [Case citation omitted.] The Iowa Supreme Court found that the 20 percent/36 ­percent tax rate differential failed to meet this standard because, in its view, that difference frustrated what it saw as the law’s basic objective, namely, rescuing the racetracks from economic distress. And no rational person, it believed, could claim the contrary. The Iowa Supreme Court could not deny, however, that the Iowa law, like most laws, might predominately serve one general objective, say, helping the racetracks, while containing subsidiary provisions that seek to achieve other desirable (perhaps even contrary) ends as well, thereby producing a law that balances objectives but still serves the general objective when seen as a whole. After all, if every subsidiary provision in a law designed to help racetracks had to help those racetracks and nothing more, then (since any tax rate hurts the racetracks when compared with a lower rate) there could be no taxation of the racetracks at all. Neither could the Iowa Supreme Court deny that the 1994 legislation, seen as a whole, can rationally be understood to do what that court says it seeks to do, namely, advance the racetracks’ economic interests. Its grant to the racetracks of authority to

Fundamental Rights The rational basis test is the basic equal protection standard. Some classifications, however, receive tougher means-ends scrutiny. According to Supreme Court precedent, laws that discriminate regarding

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operate slot machines should help the racetracks economically to some degree—even if its simultaneous imposition of a tax on slot machine adjusted revenue means that the law provides less help than respondents might like. At least a rational legislator might so believe. And the Constitution grants legislators, not courts, broad authority (within the bounds of rationality) to decide whom they wish to help with their tax laws and how much help those laws ought to provide. “The ‘task of classifying persons for . . . benefits . . . inevitably requires that some persons who have an almost equally strong claim to favored treatment be placed on different sides of the line,’ and the fact the line might have been drawn differently at some points is a matter for legislative, rather than judicial, consideration.” [Case citation omitted.] Once one realizes that not every provision in a law must share a single objective, one has no difficulty finding the necessary rational support for the 20 percent/36 percent differential here at issue. That difference, harmful to the racetracks, is helpful to the riverboats, which, as [those challenging the 1994 statute] concede, were also facing financial peril. These two characterizations are but opposite sides of the same coin. Each reflects a rational way for a legislator to view the matter. And aside from simply aiding the financial position of the riverboats, the legislators may have wanted to encourage the economic development of river communities or to promote riverboat history, say, by providing incentives for riverboats to remain in the State, rather than relocate to other States. Alternatively, they may have wanted to protect the reliance interests of riverboat operators, whose adjusted slot machine revenue had previously been taxed at the 20 percent rate. All these objectives are rational ones, which lower riverboat tax rates could further and which suffice to uphold the different tax rates. We conclude that there is “a plausible policy reason for the classification,” that the legislature “rationally may have . . . considered . . . true” the related justifying “legislative facts,” and that the “relationship of the classification to its goal is not so attenuated as to render the distinction arbitrary or irrational.” [Case citation omitted.] Consequently the State’s differential tax rate does not violate the Federal Equal Protection Clause. Iowa Supreme Court decision reversed, and case remanded for further proceedings.

fundamental rights or suspect classes must undergo more rigorous review. Although the list of rights regarded as fundamental for equal protection purposes is not completely clear,

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Part One Foundations of American Law

it clearly includes the right to marry. As made plain in Obergefell v. Hodges, which follows shortly, this right exists regardless of whether the couple to be married is of opposite genders or of the same gender. The list also includes certain criminal procedure protections as well as the rights to vote and engage in interstate travel. Laws creating unequal enjoyment of these rights receive full strict scrutiny. In 1969, for instance, the Supreme Court struck down the District of Columbia’s one-year residency requirement for receiving welfare benefits because that requirement unequally and impermissibly restricted the right of interstate travel. An equal protection claim involving the fundamental right to vote was addressed in high-profile fashion by the Supreme Court in Bush v. Gore, 531 U.S. 98 (2000). A fivejustice majority in the historic and controversial decision terminated an ongoing vote recount in Florida because, in the majority’s view, Florida law’s “intent of the voter” test was not a sufficiently clear standard for determining whether a ballot not counted in the initial machine count should be counted as valid during the manual recount. The majority was concerned that in the absence of a more specific standard, vote counters taking part in the recount might apply inconsistent standards in determining what the voter supposedly intended, and might thereby value some votes over others. The termination of the Florida recount meant that then-governor Bush won the state of Florida, giving him enough Electoral College votes to win the presidency despite the fact that candidate Gore tallied more popular votes nationally. The four dissenters in Bush v. Gore faulted the majority for focusing on the supposed equal protection violation it identified, when, in the dissenters’

view, the Court ignored a potentially bigger equal protection problem created by termination of the recount: the prospect that large numbers of ballots not counted during the machine count would never be counted, even though they may have been valid votes under Florida’s “intent of the voter” test. In Crawford v. Marion County Election Board, 553 U.S. 181 (2008), the Supreme Court again addressed the fundamental right to vote. This time, the Court was faced with determining whether an Indiana law violated the Equal Protection Clause by requiring that voters produce a government-issued photo ID as a precondition to being allowed to vote. Those who raised the equal protection challenge to the requirement asserted that its burdens would fall disproportionately on low-income and elderly voters, who would be less likely than other persons to have a driver’s license or other photo ID. The Court upheld the Indiana law, ruling that it did not violate the Equal Protection Clause. Six justices agreed that even though voter fraud at the polls had not been a demonstrated problem in Indiana, the photo ID requirement was a generally applicable and not excessively burdensome way of furthering the state’s purposes of preventing voter fraud and preserving voter confidence in the integrity of elections. Since Crawford, lower courts have decided various cases that presented constitutional challenges to voter ID laws enacted in other states. Some such laws have been upheld. In other cases, however, voter ID laws have been struck down if they imposed more onerous ID requirements than the law at issue in Crawford and if the showing of a disproportionate adverse effect on certain groups of voters was especially strong.

Obergefell v. Hodges   576 U.S. 644 (2015) Cases from Michigan, Kentucky, Ohio, and Tennessee—states whose statutes defined marriage as a union between one man and one woman—were consolidated for purposes of the U.S. Supreme Court decision that appears below in edited form. The petitioners before the Supreme Court were 14 same-sex couples and two men whose same-sex partners were deceased. The respondents were state officials responsible for enforcing the laws in question. The petitioners claimed that the respondents violated the Fourteenth Amendment to the U.S. Constitution by denying them the right to marry or by refusing to give full recognition to marriages that were lawfully performed in another state. The petitioners filed their cases in U.S. district courts in their home states. Each district court ruled in their favor. The respondents appealed these decisions to the U.S. Court of Appeals for the Sixth Circuit, which consolidated the cases and reversed the judgments of the district courts. The Sixth Circuit held that a state has no constitutional obligation to license same-sex marriages or to recognize same-sex marriages performed out of state. This ruling conflicted with rulings by other federal courts of appeals on the same set of issues. The petitioners sought certiorari from the U.S. Supreme Court, which granted review regarding two questions. The first was whether the Fourteenth Amendment requires a state to issue a marriage license to two persons of the same sex. The second was whether the Fourteenth Amendment requires a state to recognize a same-sex marriage licensed and performed in a state that does grant that right. (Further facts appear in the following edited version of the Supreme Court’s decision.)



Chapter Three Business and the Constitution

Kennedy, Justice The Constitution promises liberty to all within its reach, a liberty that includes certain specific rights that allow persons . . . to define and express their identity. The petitioners seek to find that liberty by marrying someone of the same sex and having their marriages deemed lawful on the same terms and conditions as marriages between persons of the opposite sex. [T]he annals of human history reveal the transcendent importance of marriage. Marriage is sacred to those who live by their religions and offers unique fulfillment to those who find meaning in the secular realm. There are untold references to the beauty of marriage in religious and philosophical texts spanning time, cultures, and faiths, as well as in art and literature in all their forms. It is fair and necessary to say these references were based on the understanding that marriage is a union between two persons of the opposite sex. That history is the beginning of these cases. The respondents say it should be the end as well. To them, it would demean a timeless institution if the concept and lawful status of marriage were extended to two persons of the same sex. This view long has been held—and continues to be held—in good faith by reasonable and sincere people here and throughout the world. The petitioners acknowledge this history but contend that these cases cannot end there. [They do not seek] to demean the revered idea and reality of marriage. To the contrary, it is the enduring importance of marriage that underlies the petitioners’ contentions. [T]he petitioners seek [the right to marry] because of their respect—and need—for its privileges and responsibilities. And their immutable nature dictates that same-sex marriage is their only real path to this profound commitment. Recounting the circumstances of three of these cases illustrates the urgency of the petitioners’ cause from their perspective. Petitioner James Obergefell, a plaintiff in the Ohio case, met John Arthur over two decades ago. They fell in love and started a life together. In 2011, however, Arthur was diagnosed with amyotrophic lateral sclerosis, or ALS. This debilitating disease is progressive, with no known cure. Two years ago, Obergefell and Arthur decided to commit to one another, resolving to marry before Arthur died. To fulfill their mutual promise, they traveled from Ohio to Maryland, where same-sex marriage was legal, [and were wed there]. Three months later, Arthur died. Ohio law does not permit Obergefell to be listed as the surviving spouse on Arthur’s death certificate. By statute, they must remain strangers even in death, a state-imposed separation Obergefell deems “hurtful for the rest of time.” He brought suit to be shown as the surviving spouse on Arthur’s death certificate. April DeBoer and Jayne Rowse are co-plaintiffs in the case from Michigan. They celebrated a commitment ceremony to honor their permanent relation in 2007. In 2009, DeBoer and Rowse fostered and then adopted a baby boy. Later that same

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year, they welcomed another son into their family. The new baby, born prematurely and abandoned by his biological mother, required around-the-clock care. The next year, a baby girl with special needs joined their family. Michigan, however, permits only opposite-sex married couples or single individuals to adopt, so each child can have only one woman as his or her legal parent. If an emergency were to arise, schools and hospitals may treat the three children as if they had only one parent. And, were tragedy to befall either DeBoer or Rowse, the other would have no legal rights over the children she had not been permitted to adopt. This couple seeks relief from the continuing uncertainty their unmarried status creates in their lives. Army Sergeant Ijpe DeKoe and his partner Thomas Kostura, co-plaintiffs in the Tennessee case, fell in love. In 2011, DeKoe received orders to deploy to Afghanistan. Before leaving, he and Kostura married in New York. When DeKoe returned [from his deployment], the two settled in Tennessee, where DeKoe works for the Army Reserve. Their lawful marriage is stripped from them whenever they reside in Tennessee, returning and disappearing as they travel across state lines. DeKoe . . . endure[s] a substantial burden [as a result]. The ancient origins of marriage confirm its centrality, but [its history] is one of both continuity and change. For example, marriage was once viewed as an arrangement by the couple’s parents based on political, religious, and financial concerns; but by the time of the Nation’s founding, it was understood to be a voluntary contract between a man and a woman. [Another example involves] the centuries-old doctrine of coverture, [under which] a married man and woman were treated by the State as a single, male-dominated legal entity. As women gained legal, political, and property rights, and as society began to understand that women have their own equal dignity, the law of coverture was abandoned. These and other developments in the institution of marriage . . . worked deep transformations in its structure [and] have strengthened, not weakened, the institution of marriage. Indeed, changed understandings of marriage are characteristic of a Nation where new dimensions of freedom become apparent to new generations, often through perspectives that begin in pleas or protests and then are considered in the political sphere and the judicial process. This dynamic can be seen in the Nation’s experiences with the rights of gays and lesbians. Until the mid-20th century, same-sex intimacy long had been condemned as immoral by the State itself in most Western nations, a belief often embodied in the criminal law. For this reason, among others, many  persons did not deem homosexuals to have dignity in their own distinct identity. A truthful declaration by same-sex couples of what was in their hearts had to remain unspoken. Even when a greater awareness of the humanity and integrity of homosexual persons came in the

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Part One Foundations of American Law

period after World War II, the argument that gays and lesbians had a just claim to dignity was in conflict with both law and widespread social conventions. Same-sex intimacy remained a crime in many States. Gays and lesbians were prohibited from most government employment, barred from military service, excluded under immigration laws, targeted by police, and burdened in their rights to associate. For much of the 20th century, moreover, homosexuality was treated as . . . a mental disorder. Only in more recent years have psychiatrists and others recognized that sexual orientation is both a normal expression of human sexuality and immutable. In the late 20th century, following substantial cultural and political developments, same-sex couples began to lead more open and public lives and to establish families. This development was followed by a quite extensive discussion of the issue in both governmental and private sectors and by a shift in public attitudes toward greater tolerance. As a result, questions about the rights of gays and lesbians reached the courts. This Court first gave detailed consideration to the legal status of homosexuals in Bowers v. Hardwick, 478 U.S. 186 (1986). There it upheld the constitutionality of a Georgia law deemed to criminalize certain homosexual acts. Ten years later, in Romer v. Evans, 517 U.S. 620 (1996), the Court invalidated an amendment to Colorado’s Constitution that sought to foreclose any branch or political subdivision of the State from protecting persons against discrimination based on sexual orientation. Then, in 2003, the Court overruled  Bowers, holding that laws making same-sex intimacy a crime “demea[n] the lives of homosexual persons.” Lawrence v. Texas, 539 U.S. 558, 575 (2003). Against this background, the legal question of same-sex marriage arose. In 1993, the Hawaii Supreme Court held Hawaii’s law restricting marriage to opposite-sex couples constituted a classification on the basis of sex and was therefore subject to strict scrutiny under the Hawaii Constitution. Although this decision did not mandate that same-sex marriage be allowed, some States [chose to reaffirm] in their laws that marriage is defined as a union between opposite-sex partners. So too in 1996, Congress passed the Defense of Marriage Act (DOMA), defining marriage for all federal-law purposes as “only a legal union between one man and one woman as husband and wife.”  The new and widespread discussion of the subject led other States to a different conclusion. In 2003, the Supreme Judicial Court of Massachusetts held that the State’s constitution guaranteed same-sex couples the right to marry. After that ruling, some additional States granted marriage rights to same-sex couples, either through judicial or legislative processes. Two terms ago, in  United States  v.  Windsor, 133 S. Ct. 2675 (2013), this Court invalidated DOMA to the extent it barred the federal government from treating same-sex marriages as valid even when they were lawful in the State where they were licensed. DOMA, the Court

held, impermissibly disparaged those same-sex couples “who wanted to affirm their commitment to one another before their children, their family, their friends, and their community.”  Numerous cases about same-sex marriage have reached the United States Courts of Appeals in recent years. With the exception of the opinion here under review and one other, the Courts of Appeals have held that excluding same-sex couples from marriage violates the Constitution. There also have been many thoughtful district court decisions addressing same-sex marriage—and most of them, too, have concluded same-sex couples must be allowed to marry. Under the Due Process Clause of the Fourteenth Amendment, no State shall “deprive any person of life, liberty, or property, without due process of law.” The fundamental liberties protected by this Clause include most of the rights enumerated in the  Bill of Rights. In addition, these liberties extend to certain personal choices central to individual dignity and autonomy, including intimate choices that define personal identity and beliefs. See,  e.g.,  Eisenstadt  v.  Baird, 405 U.S. 438, 453 (1972);  Griswold v. Connecticut, 381 U.S. 479, 484–486 (1965). The identification and protection of fundamental rights is an enduring part of the judicial duty to interpret the Constitution. [I]t requires courts to exercise reasoned judgment in identifying interests of the person so fundamental that the State must accord them its respect. History and tradition guide and discipline this inquiry but do not set its outer boundaries. That method respects our history and learns from it without allowing the past alone to rule the present. The nature of injustice is that we may not always see it in our own times. The generations that wrote and ratified the Bill of Rights and the Fourteenth Amendment did not presume to know the extent of freedom in all of its dimensions, and so they entrusted to future generations a charter protecting the right of all persons to enjoy liberty as we learn its meaning. When new insight reveals discord between the Constitution’s central protections and a received legal stricture, a claim to liberty must be addressed. Applying these established tenets, the Court has long held  that the right to marry is protected by the Constitution. In  Loving  v.  Virginia, 388 U.S. 1, 12 (1967), which invalidated bans on interracial unions, a unanimous Court held that marriage is “one of the vital personal rights essential to the orderly pursuit of happiness by free men.” The Court reaffirmed  that holding in Zablocki v. Redhail, 434 U.S. 374, 384 (1978), which held the right to marry was burdened by a law prohibiting fathers who were behind on child support from marrying. Over time and in other contexts, the Court has reiterated that the right to marry is fundamental under the Due Process Clause. [Citations omitted.] It cannot be denied that this Court’s cases describing the right to marry presumed a relationship involving opposite-sex partners. The Court, like many institutions, has made assumptions defined



Chapter Three Business and the Constitution

by the world and time of which it is a part. This was evident in  Baker  v.  Nelson, 409 U.S. 810, a one-line summary decision issued in 1972, holding the exclusion of same-sex couples from marriage did not present a substantial federal question. Still, there are other, more instructive precedents. In defining the right to marry, [this Court’s] cases have identified essential attributes of that right based in history, tradition, and other constitutional liberties inherent in this intimate bond. See,  e.g.,  Zablocki; Loving; Griswold. And in assessing whether the force and rationale of its cases apply to same-sex couples, the Court must respect the basic reasons why the right to marry has been long protected. This analysis compels the conclusion that same-sex couples may exercise the right to marry. The four principles and traditions to be discussed demonstrate that the reasons marriage is fundamental under the Constitution apply with equal force to same-sex couples. A first premise of the Court’s relevant precedents is that the right to personal choice regarding marriage is inherent in the concept of individual autonomy. This abiding connection between marriage and liberty is why  Loving  invalidated interracial marriage bans under the  Due Process Clause. See  388 U.S. at 12. Like choices concerning contraception, family relationships, procreation, and childrearing, all of which are protected by the Constitution, decisions concerning marriage are among the most intimate that an individual can make. The nature of marriage is that, through its enduring bond, two persons together can find other freedoms, such as expression, intimacy, and spirituality. This is true for all persons, whatever their sexual orientation. See Windsor, 133 S. Ct. 2675. There is dignity in the bond between two men or two women who seek to marry and in their autonomy to make such profound choices. A second principle in this Court’s jurisprudence is that the right to marry is fundamental because it supports a two-person union unlike any other in its importance to the committed individuals. This point was central to Griswold v. Connecticut, which held the Constitution protects the right of married couples to use contraception. 381 U.S. at 485. As this Court held in  Lawrence, same-sex couples have the same right as opposite-sex couples to enjoy intimate association.  But while  Lawrence  confirmed a dimension of freedom that allows individuals to engage in intimate association without criminal liability, it does not follow that freedom stops there. Outlaw to outcast may be a step forward, but it does not achieve the full promise of liberty. A third basis for protecting the right to marry is that it safeguards children and families and thus draws meaning from related rights of childrearing, procreation, and education. The Court has recognized these connections by describing the varied rights as a unified whole: “[T]he right to marry, establish a home and bring

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up children is a central part of the liberty protected by the Due Process Clause.”  Zablocki, 434 U.S. at 384. Under the laws of the several States, some of marriage’s protections for children and families are material. But marriage also confers more profound benefits. By giving recognition and legal structure to their parents’ relationship, marriage allows children “to understand the integrity and closeness of their own family and its concord with other families in their community and in their daily lives.” Windsor, 133 S. Ct. 2675. Marriage also affords the permanency and stability important to children’s best interests. As all parties agree, many same-sex couples provide loving and nurturing homes to their children, whether biological or adopted. And hundreds of thousands of children are presently being raised by such couples. Most States have allowed gays and lesbians to adopt, either as individuals or as couples, and many adopted and foster children have same-sex parents. This provides powerful confirmation from the law itself that gays and lesbians can create loving, supportive families. Excluding same-sex couples from marriage thus conflicts with a central premise of the right to marry. Without the recognition, stability, and predictability marriage offers, their children suffer the stigma of knowing their families are somehow lesser. They also suffer the significant material costs of being raised by unmarried parents, relegated through no fault of their own to a more difficult and uncertain family life. The marriage laws at issue here thus harm and humiliate the children of same-sex couples. That is not to say the right to marry is less meaningful for those who do not or cannot have children. An ability, desire, or promise to procreate is not and has not been a prerequisite for a valid marriage in any State. Fourth and finally, this Court’s cases and the Nation’s traditions make clear that marriage is a keystone of our social order. [J]ust as a couple vows to support each other, so does society pledge to support the couple, offering symbolic recognition and material benefits to protect and nourish the union. [States] have throughout our history made marriage the basis for an expanding list of governmental rights, benefits, and responsibilities. These aspects of marital status include: taxation; inheritance and property rights; rules of intestate succession; spousal privilege in the law of evidence; hospital access; medical decisionmaking authority; adoption rights; the rights and benefits of survivors; birth and death certificates; professional ethics rules; campaign finance restrictions; workers’ compensation benefits; health insurance; and child custody, support, and visitation rules. Valid marriage under state law is also a significant status for over a thousand provisions of federal law. The States have contributed to the fundamental character of the marriage right by placing that institution at the center of so many facets of the legal and social order. There is no difference between same- and opposite-sex couples with respect to this principle. Yet by virtue of their exclusion

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Part One Foundations of American Law

from that institution, same-sex couples are denied the constellation of benefits that the States have linked to marriage. This harm results in more than just material burdens. Same-sex couples are consigned to an instability many opposite-sex couples would deem intolerable in their own lives. As the State itself makes marriage all the more precious by the significance it attaches to it, exclusion from that status has the effect of teaching that gays and lesbians are unequal in important respects. It demeans gays and lesbians for the State to lock them out of a central institution of the Nation’s society. The limitation of marriage to opposite-sex couples may long have seemed natural and just, but its inconsistency with the central meaning of the fundamental right to marry is now manifest. With that knowledge must come the recognition that laws excluding same-sex couples from the marriage right impose stigma and injury of the kind prohibited by our basic charter. Under the Constitution, same-sex couples seek in marriage the same legal treatment as opposite-sex couples, and it would disparage their choices and diminish their personhood to deny them this right. The right of same-sex couples to marry that is part of the liberty promised by the  Fourteenth Amendment  is derived, too, from that Amendment’s guarantee of the equal protection of the laws. The  Due Process Clause  and the  Equal Protection Clause are connected in a profound way, though they set forth independent principles. Rights implicit in liberty and rights secured by equal protection may rest on different precepts and are not always coextensive, yet in some instances each may be instructive as to the meaning and reach of the other. In any particular case one Clause may be thought to capture the essence of the right in a more accurate and comprehensive way, even as the two Clauses may converge in the identification and definition of the right. This interrelation of the two principles furthers our understanding of what freedom is and must become. The Court’s cases touching upon the right to marry reflect this dynamic. In Loving, the Court invalidated a prohibition on interracial marriage under both the Equal Protection Clause and the  Due Process Clause. The Court . . . stated: “There can be no doubt that restricting the freedom to marry solely because of racial classifications violates the central meaning of the  Equal Protection Clause.” 388 U.S. at 12. With this link to equal protection, the Court proceeded to hold that the prohibition offended central precepts of liberty: “To deny this fundamental freedom on so unsupportable a basis as the racial classifications embodied in these statutes, classifications so directly subversive of the principle of equality at the heart of the Fourteenth Amendment, is surely to deprive all the State’s citizens of liberty without due process of law.” Id.  The synergy between the two protections is illustrated further in Zablocki. There the Court invoked the Equal Protection Clause  as its basis for invalidating the challenged law, which

barred fathers who were behind on child-support payments from marrying without judicial approval. The equal protection analysis depended in central part on the Court’s holding that the law burdened a right “of fundamental importance.” 434 U.S. at 383. It was the essential nature of the marriage right that made apparent the law’s incompatibility with requirements of equality. Each concept—liberty and equal protection—leads to a stronger understanding of the other. Other cases confirm this relation between liberty and equality. In M. L. B. v. S. L. J., 519 U.S. 102, 119–24 (1996), the Court invalidated under due process and equal protection principles a statute requiring indigent mothers to pay a fee in order to appeal the termination of their parental rights. In Eisenstadt v. Baird, the Court invoked both principles to invalidate a prohibition on the distribution of contraceptives to unmarried persons but not married persons. See 405 U.S. at 446–54. In Lawrence, the Court acknowledged the interlocking nature of these constitutional safeguards in the context of the legal treatment of gays and lesbians. Although Lawrence elaborated its holding under the Due Process Clause, it acknowledged, and sought to remedy, the continuing inequality that resulted from laws making intimacy in the lives of gays and lesbians a crime against the State. See 539 U.S. at 575. Lawrence therefore drew upon principles of liberty and equality to define and protect the rights of gays and lesbians, holding the State “cannot demean their existence or control their destiny by making their private sexual conduct a crime.” Id. at 578. This dynamic also applies to same-sex marriage. It is now clear that the challenged laws burden the liberty of same-sex couples, and it must be further acknowledged that they abridge central precepts of equality. Here the marriage laws enforced by the respondents are in essence unequal: same-sex couples are denied all the benefits afforded to opposite-sex couples and are barred from exercising a fundamental right. Especially against a long history of disapproval of their relationships, this denial to same-sex couples of the right to marry works a grave and continuing harm. These considerations lead to the conclusion that the right to marry is a fundamental right inherent in the liberty of the person, and under the Due Process and  Equal Protection Clauses of the Fourteenth Amendment couples of the same-sex may not be deprived of that right and that liberty. The Court now holds that same-sex couples may exercise the fundamental right to marry. No longer may this liberty be denied to them. Baker v. Nelson must be and now is overruled, and the State laws challenged by Petitioners in these cases are now held invalid to the extent they exclude same-sex couples from civil marriage on the same terms and conditions as opposite-sex couples. There may be an initial inclination in these cases to proceed with caution—to await further legislation, litigation, and debate. The respondents warn there has been insufficient democratic



Chapter Three Business and the Constitution

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discourse before deciding an issue so basic as the definition of marriage. Yet there has been far more deliberation than this argument acknowledges. There have been referenda, legislative debates, and grassroots  campaigns, as well as countless studies, papers, books, and other popular and scholarly writings. There has been extensive litigation in state and federal courts. Judicial opinions addressing the issue have been informed by the contentions of parties and counsel, which, in turn, reflect the more general, societal discussion of same-sex marriage and its meaning that has occurred over the past decades. As more than 100 amici make clear in their filings, many of the central institutions in American life—state and local governments, the military, large and small businesses, labor unions, religious organizations, law enforcement, civic groups, professional organizations, and universities—have devoted substantial attention to the question. This has led to an enhanced understanding of the issue—an understanding reflected in the arguments now presented for resolution as a matter of constitutional law. Of course, the Constitution contemplates that democracy is the appropriate process for change, so long as that process does not abridge fundamental rights. But . . . when the rights of persons are violated, the Constitution requires redress by the courts, notwithstanding the more general value of democratic decisionmaking. An individual can invoke a right to constitutional protection when he or she is harmed, even if the broader public disagrees and even if the legislature refuses to act. The idea of the Constitution “was to withdraw certain subjects from the vicissitudes of political controversy, to place them beyond the reach of majorities and officials and to establish them as legal principles to be applied by the courts.” West Virginia Bd. of Ed. v. Barnette, 319 U.S. 624, 638 (1943). This is why “fundamental rights may not be submitted to a vote; they depend on the outcome of no elections.” Id.  This is not the first time the Court has been asked to adopt a cautious approach to recognizing and protecting fundamental rights. In  Bowers, a bare majority upheld a law criminalizing same-sex intimacy. See 478 U.S. at 186. That approach might have been viewed as a cautious endorsement of the democratic process, which had only just begun to consider the rights of gays and lesbians. Yet, in effect, Bowers upheld state action that denied gays and lesbians a fundamental right and caused them

pain and humiliation. Although Bowers was eventually repudiated in Lawrence, men and women were harmed in the interim, and the substantial effects of these injuries no doubt lingered long after Bowers was overruled. Dignitary wounds cannot always be healed with the stroke of a pen. A ruling against same-sex couples would have the same effect— and, like  Bowers, would be unjustified under the  Fourteenth Amendment. The petitioners’ stories[, as detailed earlier in this opinion,] make clear the urgency of the issue they present to the Court. These cases also present the question whether the Constitution requires States to recognize same-sex marriages validly performed out of State. As made clear by the case of Obergefell and Arthur, and by that of DeKoe and Kostura, the recognition bans inflict substantial and continuing harm on same-sex couples. Being married in one State but having that valid marriage denied in another is one of “the most perplexing and distressing complication[s]” in the law of domestic relations. [Citation omitted.] Leaving the current state of affairs in place would maintain and promote instability and uncertainty. For some couples, even an ordinary drive into a neighboring State to visit family  or friends risks causing severe hardship in the event of a spouse’s hospitalization while across state lines. In light of the fact that many States already allow same-sex marriage—and hundreds of thousands of these marriages already have occurred—the disruption caused by the recognition bans is significant and ever-growing. The Court, in this decision, holds that same-sex couples may exercise the fundamental right to marry in all States. It follows that the Court also must hold—and it now does hold—that there is no lawful basis for a State to refuse to recognize a lawful same-sex marriage performed in another State on the ground of its samesex character. No union is more profound than marriage, for it embodies the highest ideals of love, fidelity, devotion, sacrifice, and family. [The petitioners’] hope is not to be . . . excluded from one of civilization’s oldest institutions. They ask for equal dignity in the eyes of the law. The Constitution grants them that right.

Suspect Classes Certain “suspect” bases of classification also trigger more rigorous equal protection review. Although what is considered a “suspect class” is subject to review and change, race, alienage, and national origin generally are considered suspect classes.

1. Race and national origin.  Classifications disadvantaging racial or national minorities receive the most rigorous kind of strict scrutiny and are almost never constitutional. For instance, in a recent decision that dealt not only with the suspect class of race but also the fundamental right to

Sixth Circuit’s judgment reversed.

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Part One Foundations of American Law

vote, the Supreme Court struck down North Carolina’s formulation of certain legislative voting districts because the formulation depended upon impermissible drawing of race-based lines. (The case was Cooper v. Harris, 137 S. Ct. 1455 (2017).) The Supreme Court has sometimes upheld governmentrequired affirmative action plans and what critics have called reverse racial discrimination—government action that benefits racial minorities and allegedly disadvantages whites. In 1989, however, a majority of the Court concluded that state action of this kind should receive the same full strict scrutiny as discrimination against racial or national minorities. A 1995 Supreme Court decision held that this is true of federal government action as well as state action. These developments have curtailed certain government-created affirmative action programs but have not eliminated them. In the companion cases of Gratz v. Bollinger, 539 U.S. 244 (2003), and Grutter v. Bollinger, 539 U.S. 306 (2003), the Supreme Court considered whether the University of Michigan violated the Equal Protection Clause by taking minority students’ race into account in its undergraduate and law school admissions policies. The Court recognized in the two cases that seeking student diversity in a higher education context is a compelling government interest. However, in Gratz, a five-justice majority of the Court held that the university’s undergraduate admissions policy violated the Equal Protection Clause because the policy’s consideration of minority applicants’ race became effectively the automatic determining factor in admission decisions regarding minority applicants. In Grutter, on the other hand, a different five-justice majority held that the university’s law school admissions policy did not violate the Equal Protection Clause. The Grutter majority reasoned that the law school’s policy, in considering minority applicants’ race, did so as part of individualized consideration of applicants and of various types of diversity, not simply race. Thus, the law school’s policy did not make race the determining factor in the impermissible way that the undergraduate policy did. In the years following the decisions in Gratz and Grutter, the composition of the Supreme Court changed. When the Court agreed to decide a challenge to a race-conscious student admissions policy at the University of Texas (a policy patterned in large part after what the Court had approved in Grutter), speculation mounted that the Court might use the case as a vehicle for overruling Grutter or substantially cutting back on its effect. The Court did not do so, however. In Fisher v. University of Texas, 136 S. Ct. 2198 (2016), the Court reiterated a key Grutter principle: that seeking diversity in the student body at colleges and universities counts as a compelling government purpose in

the strict scrutiny analysis. The Court also left unaltered Grutter’s approach of permitting race to be considered in admissions decisions, as long as it was among a number of other factors taken into account in an individualized consideration of applicants and of various types of diversity. According to the Court, the challenged University of Texas plan passed the constitutional test by being narrowly tailored to achievement of the compelling government interest in achieving student body diversity. In 2014, the Supreme Court decided an affirmative action–related case that presented a different wrinkle in the form of this question: If consideration of race in state university admission decisions is sometimes permissible (as Grutter and Fisher indicate), can the voters of a state constitutionally bar the use of race as a consideration in such decisions? In a Michigan referendum that took place three years after the decision in Grutter, voters approved an amendment to the state constitution that prohibited the use of race-conscious affirmative action in public education, government contracting, and public employment. Ruling on a challenge to this action, the Court emphasized in Schuette v. Coalition to Defend Affirmative Action, 572 U.S. 291 (2014), that the case was “not about how the debate about racial preferences should be resolved.” Rather, it was “about who may resolve it.” The Court went on to hold that there was “no authority in the [U.S.] Constitution . . . or in this Court’s precedents for the judiciary to set aside Michigan laws that commit this policy determination to the voters.” A lawsuit against Harvard College claims that Harvard’s admissions process violates Asian American applicants. The claim is not based on the Constitution; rather, it alleges violation of a federal law that prohibits discrimination among organizations or programs that receive federal funds (42 U.S.C. §2000d et seq.). But it is relevant for this discussion because the equal protection analysis applies to cases brought under that law. The federal district court in the Harvard case therefore analyzed the issue under the principles set forth in Fisher and found in favor of Harvard. At the time of this drafting, the case remained on appeal. See Students for Fair Admissions, Inc. v. President and Fellows of Harvard College, 397 F. Supp. 3d 126 (D. Mass. 2019). A similar case (though a direct constitutional challenge) against the University of North Carolina was pending as this book went to press (see Students for Fair Admission, Inc. v. University of North Carolina, 2019 WL 4773908 (M.D.N.C. Sept. 30, 2019)). 2. Sex. Although the Supreme Court has been hesitant to make a formal declaration that sex is a suspect class, for roughly four decades laws discriminating on the basis



Chapter Three Business and the Constitution

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Ethics and Compliance in Action As discussion in this chapter reveals, Supreme Court precedent establishes that when government action discriminates on the basis of race or sex, the action will receive heightened scrutiny from the court if an equal protection challenge is brought. Despite cases such as Obergefell v. Hodges (in which the Supreme Court held that same-sex couples cannot be denied the fundamental right to marry), the Court has not recognized sexual orientation or transgender status as a suspect class for equal protection purposes. Unless and until the Court does so, the government may

of gender have been subjected to a fairly rigorous form of intermediate scrutiny. As the Court has said, such laws require an “exceedingly persuasive” justification. The usual test is that government action discriminating on the basis of sex must be substantially related to the furtherance of an important government purpose. Under this test, measures discriminating against women have almost always been struck down. The Supreme Court has said that laws disadvantaging men receive the same scrutiny as those disadvantaging women, but this has not prevented the Court from upholding men-only draft registration and a law making statutory rape a crime for men alone. With gender as a longstanding suspect class and with legal developments such as the Obergefell decision’s extension of the right to marry to same-sex couples, will the Supreme Court formally recognize sexual orientation and transgender status as suspect classes for equal protection purposes? Signs of such a development are at least discernible, but how immediately such a development may occur is an open question.

Independent Checks Applying Only to the States The Contract Clause Article I, § 10 of the Con-

stitution states: “No State shall . . . pass any . . . Law impairing the Obligation of Contracts.” Known as the Contract Clause, this provision deals with state laws that change the parties’ performance obligations under an existing contract after that contract has been made.2 The original purpose of the Contract Clause was to strike down the many debtor relief statutes passed by the states after the Revolution. Under the Fifth Amendment’s Due Process Cause, standards similar to those described in this section apply to the federal government. 2

have more legal latitude to regulate in ways that draw lines on the basis of persons’ sexual orientation or transgender status than in ways that classify on the basis of persons’ race or sex. Now view this set of issues from an ethical perspective. Should the government be any freer to take actions that discriminate against gays, lesbians, or transgender persons than it is to take actions that discriminate on the basis of race or sex? As you consider this question, you may wish to examine Chapter 4’s discussion of ethical theories and ethical decision making.

These statutes impaired the obligations of existing private contracts by relieving debtors of what they owed to creditors. In two early 19th-century cases, however, the Contract Clause was also held to protect the obligations of governmental contracts, charters, and grants. The Contract Clause probably was the most important constitutional check on state regulation of the economy for much of the 19th century. Beginning in the latter part of that century, the clause gradually became subordinate to legislation based on the states’ police powers. By the mid20th century, most observers treated the clause as being of historical interest only. In 1977, however, the Supreme Court gave the Contract Clause new life by announcing a fairly strict constitutional test governing situations in which a state impairs its own contracts, charters, and grants. Such impairments, the Court said, must be “reasonable and necessary to serve an important public purpose.” During recent decades, the Court has continued its deference toward state regulations that impair the obligations of private contracts. Consider, for instance, Exxon Corp. v. Eagerton, 462 U.S. 176 (1983). For years, Exxon had paid a severance tax under Alabama law on oil and gas it drilled within the state. As the tax increased, appropriate provisions in Exxon’s contracts with the purchasers of its oil and gas allowed Exxon to pass on the amounts of the increases to the purchasers. Alabama, however, enacted a law that not only increased the severance tax but also forbade producers of oil and gas from passing on the increase to purchasers. Exxon filed suit, seeking a declaration that the law’s pass-on prohibition violated the Contract Clause. Affirming Alabama’s highest court, the U.S. Supreme Court observed that the Contract Clause allows the states to adopt broad regulatory measures without having to be concerned that private contracts will be affected. The pass-on prohibition was designed to advance a broad public interest in protecting consumers against excessive prices and

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CONCEPT REVIEW Equal Protection and Levels of Scrutiny Type of Government Action

Controlling Test

Operation and Effect of Test

Government action that discriminates but neither affects exercise of fundamental right nor discriminates against suspect class (e.g., most social and economic regulation)

Rational basis

Lenient test—government action is constitutional if rationally related to legitimate government purpose.

Government action that discriminates concerning ability to exercise fundamental right

Full strict scrutiny

Very rigorous test—government action is unconstitutional unless necessary to fulfillment of compelling government purpose.

Government action that discriminates on basis of race or national origin

Full strict scrutiny

Very rigorous test—government action is unconstitutional unless necessary to fulfillment of compelling government purpose.

Government action that discriminates on basis of sex (gender)

Intermediate scrutiny

Moderately rigorous test—government action is unconstitutional unless substantially related to fulfillment of important government purpose.

was applicable to all oil and gas producers regardless of whether they were then parties to contracts containing pass-on provisions. Therefore, the Court reasoned, the Alabama statute did not violate the Contract Clause.

Federal Preemption LO3-9

Identify the major circumstances in which federal law will preempt state law.

The constitutional principle of federal supremacy dictates that when state law conflicts with valid federal law, the federal law is supreme. In such a situation, the state law is said to be preempted by the federal regulation. The central question in most federal preemption cases is the intent of Congress. Thus, such cases often present complex questions of statutory interpretation. Federal preemption of state law generally occurs for one or more of these reasons: 1. There is a literal conflict between the state and federal measures, so that it is impossible to follow both simultaneously. 2. The federal law specifically states that it will preempt state regulation in certain areas. Similar statements may also appear in the federal statute’s legislative history. Courts sometimes find such statements persuasive even when they appear only in the legislative history and not in the statute itself.

3. The federal regulation is pervasive. If Congress has “occupied the field” by regulating a subject in great breadth and/or in considerable detail, such action by Congress may suggest an intent to displace state regulation of the subject. This may be especially likely where Congress has given an administrative agency broad regulatory power in a particular area. 4. The state regulation is an obstacle to fulfilling the purposes of the federal law. Here, the party challenging the state law’s constitutionality typically claims that the state law interferes with the purposes she attributes to the federal measure (purposes usually found in its legislative history).  Arizona v. United States, 567 U.S. 387 (2012), illustrates the principles set forth in the above discussion of grounds for preemption. In that case, the Supreme Court was faced with deciding whether certain provisions in an Arizona law were preempted by federal immigration law, which has been enacted pursuant to the power granted to Congress over immigration matters in Article I, § 8 of the Constitution. The Court held that the so-called show me your papers provision in the Arizona law was not preempted. That provision called for state law enforcement officers to determine the immigration status of anyone they stopped or arrested if there was reason to suspect that the person might be in the country illegally. However, the Court held that federal immigration law preempted three other provisions in the Arizona law: a



Chapter Three Business and the Constitution

provision making it a crime under Arizona law for an immigrant to fail to register under a federal law, a provision making it a crime under Arizona law for illegal immigrants to work or seek work, and a provision allowing Arizona law enforcement officers to make warrantless arrests if the officers have probable cause to believe the arrested persons committed acts that would make them subject to deportation under federal law. The preempted provisions either conflicted with federal law or posed too great an impediment to fulfillment of the federal law’s objectives.

The Takings Clause LO3-10

Explain the power granted to the government by the Takings Clause, as well as the limits on that power.

The Fifth Amendment states that “private property [shall not] be taken for public use, without just compensation.” Because this Takings Clause has been incorporated within Fourteenth Amendment due process, it applies to the states. Traditionally, it has come into play when the government formally condemns land through its power of eminent domain,3 but it has many other applications as well. The Takings Clause both recognizes government’s power to take private property and limits the exercise of that power. It does so by requiring that when property is subjected to a governmental taking, the taking must be for a public use and the property owner must receive just compensation. We now consider these four aspects of the Takings Clause in turn. 1. Property. The Takings Clause protects other property interests besides land and interests in land. Although its full scope is unclear, the clause has been held to cover takings of personal property, liens, trade secrets, and contract rights. Eminent domain and the Takings Clause’s application to land use problems are discussed in Chapter 24. 3

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2. Taking. Because of the range of property interests it may cover, the Takings Clause potentially has a broad scope. Another reason for the clause’s wide possible application is the range of government activities that may be considered takings. Of course, the government’s use of formal condemnation procedures to acquire private property is a taking. There may also be a taking when the government physically invades private property or allows someone else to do so. It has long been recognized, moreover, that overly extensive land use regulation may so diminish the value of property or the owner’s enjoyment of it as to constitute a taking. Among the factors courts consider in such “regulatory taking” cases are the degree to which government deprives the owner of free possession, use, and disposition of his property; the overall economic impact of the regulation on the owner; and how much the regulation interferes with the owner’s reasonable investment-backed expectations regarding the future use of the property. In Lucas v. South Carolina Coastal Council, 505 U.S. 1003 (1992), the Supreme Court held that there is an automatic taking when the government denies the owner all economically beneficial uses of the land. When this is not the case, courts tend to apply some form of means-ends scrutiny in determining whether land use regulation has gone too far and thus amounts to a regulatory taking. 3. Public use. Once a taking of property has occurred, it is unconstitutional unless it is for a public use. The public use element took center stage in a widely publicized 2005 Supreme Court decision, Kelo v. City of New London. For discussion of Kelo, see Figure 3.4. 4. Just compensation. Even if a taking of property is for a public use, it still is unconstitutional if the property owner does not receive just compensation. Although the standards for determining just compensation vary with the circumstances, the basic test is the fair market value of the property (or of the lost property right) at the time of the taking.

Figure 3.4 Economic Development as Public Use? Does the government’s taking of private property for the purpose of economic development satisfy the public use requirement set forth in the Fifth Amendment’s Takings Clause? In Kelo v. City of New London, 545 U.S. 469 (2005), the U.S. Supreme Court answered “yes.” New London, Connecticut, experienced economic decline for a considerable number of years. The city therefore made economic revitalization efforts, which included a plan to acquire 115 parcels of real estate in a 90-acre area and create, in collaboration with private developers, a multifaceted

zone that would combine commercial, residential, and recreational elements. The planned development was designed to increase tax revenue, create jobs, and otherwise capitalize on the economic opportunities that city officials expected would flow from a major pharmaceutical company’s alreadyannounced plan to construct a large facility near the area the city wished to develop. The city was able to negotiate the purchase of most parcels of property in the 90-acre area, but some property owners refused to sell. The latter group included Susette

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Kelo and Wilhelmina Dery. Kelo had lived in her home for several years, had made substantial improvements to it, and especially enjoyed the water view it afforded. Dery had lived her entire life in the home the city sought to acquire. Both homes were well maintained. After the city decided to use its eminent domain power to acquire the properties of those owners who refused to sell, Kelo, Dery, and the other nonselling owners filed suit. They contended that the city’s plan to take their property for the purpose of economic development did not involve a public use and thus would violate the Fifth Amendment’s Takings Clause. The dispute made its way through the Connecticut courts and then to the U.S. Supreme Court, where a five-justice majority ruled in favor of the city. Writing for the majority in Kelo v. City of New London, Justice Stevens noted that earlier decisions had identified three types of eminent domain settings in which the government’s acquisition of private property satisfied the constitutional public use element: first, when the government planned to develop a government-owned facility (e.g., a military base); second, when the government planned to construct, or allow others to construct, improvements to which the public would have broad access (e.g., highways or railroads); and third, when the government sought to further some meaningful public purpose. Justice Stevens observed that precedents had recognized the public purpose type of public use even if the government would not ultimately retain legal title to the acquired property (unlike the military base example) and the acquired property would not be fully opened up for public access (unlike the highway and railroad examples). The Court acknowledged that the public use requirement clearly would not be satisfied if the government took private party A’s property simply to give it to private party B. However, the Court stressed, the prospect that private parties might ultimately own or control property the government had acquired through eminent domain would not make the taking unconstitutional if an overriding public purpose prompted the government’s use of eminent domain. Similarly, even if certain private parties (e.g., the pharmaceutical company and private developers in the Kelo facts) would stand to benefit from the government’s exercise of eminent domain, such a fact would not make the taking unconstitutional if a public purpose supported the taking. The Kelo majority stressed the particular relevance of two earlier Supreme Court decisions, Berman v. Parker,  348 U.S. 26 (1954), and Hawaii Housing Authority v. Midkiff, 467 U.S. 299 (1984). In Berman, the Court sustained Washington, D.C.’s use of eminent domain to take property that included businesses and “blighted” dwellings

in order to construct a low-income housing project and new streets, schools, and public facilities. In Midkiff, the Court upheld Hawaii’s use of eminent domain to effectuate a legislative determination that Hawaii’s longstanding land oligopoly, under which property ownership was highly concentrated among a small number of property owners, had to be broken up for social and economic reasons. The Kelo majority concluded that significant public purposes were present in both Berman and Midkiff and that those decisions led logically to the conclusion that economic development was a public purpose weighty enough to constitute public use for purposes of the Takings Clause. Therefore, the Court upheld the city’s exercise of eminent domain in Kelo. In his majority opinion, Justice Stevens was careful to point out that because the constitutional question was whether a public use existed, it was not the Court’s job to determine the wisdom of the government’s attempt to exercise eminent domain. Neither should the Court allow its decision to be guided by the undoubted hardship that eminent domain places on unwilling property owners who must yield their homes to the state (albeit in return for “just compensation”). Justice Stevens emphasized that if state legislatures believed an economic development purpose such as the one the City of New London had in mind should not be used to support an exercise of eminent domain, the legislatures were free to specify, in their state statutes, that eminent domain could not be employed for an economic development purpose. The Court’s determination of what is a public use for purposes of the Takings Clause sets a protective floor for property owners, with states being free to give greater protection against takings by the government. The four dissenting justices in Kelo issued sharply worded opinions expressing their disagreement with the majority’s characterization of Berman and Midkiff as having led logically to the conclusion that economic development was a public use. In emotional terms, the dissenters accused the majority of having effectively erased the public use requirement from the Takings Clause. The Kelo decision drew considerable media attention, perhaps more because of what appeared to be considerable hardship to property owners such as Kelo and Dery than because of new legal ground—if any—broken in the decision. For many observers, the case’s compelling facts led to a perception that the city had engaged in overreaching. The Court’s decision in Kelo meant that in a legal sense, there was no overreaching on the part of the city. Was there, however, overreaching in an ethical sense? How would utilitarians answer that question? What about rights theorists? (As you consider the questions, you may wish to consult Chapter 4.)



Chapter Three Business and the Constitution

Problems and Problem Cases 1. In 1967, Gary Jones purchased a house on North Bryan Street in Little Rock, Arkansas. He and his wife lived in the house until they separated in 1993. Jones then moved into an apartment in Little Rock, and his wife continued to live in the house. Jones paid his mortgage each month for 30 years. The mortgage company paid the property taxes on the house. After Jones paid off his mortgage in 1997, the property taxes went unpaid. In April 2000, the Arkansas Commissioner of State Lands (Commissioner) attempted to notify Jones of his tax delinquency and his right to redeem the property by paying the past-due taxes. The Commissioner sought to provide this notice by mailing a certified letter to Jones at the North Bryan Street address. Arkansas law approved the use of such a method of providing notice. The packet of information sent by the Commissioner stated that unless Jones redeemed the property, it would be subject to public sale two years later. No one was at home to sign for the letter. No one appeared at the post office to retrieve the letter within the next 15 days. The post office then returned the unopened packet to the Commissioner with an “unclaimed” designation on it. In the spring of 2002, a few weeks before the public sale scheduled for Jones’s house, the Commissioner published a notice of public sale in a local newspaper. No bids were submitted, meaning that under Arkansas law, the state could negotiate a private sale of the property.  Several months later, Linda Flowers submitted a purchase offer. The Commissioner then mailed another certified letter to Jones at the North Bryan Street address, attempting to notify him that his house would be sold to Flowers if he did not pay his delinquent taxes. As with the first letter, the second letter was returned to the Commissioner with an “unclaimed” designation. Flowers purchased the house. Immediately after the expiration of the 30-day period in which Arkansas law would have allowed Jones to make a post-sale redemption of the property by paying the past-due taxes, Flowers had an eviction notice delivered to the North Bryan Street property. The notice was served on Jones’s daughter, who contacted Jones and notified him of the tax sale. Jones then filed a lawsuit in Arkansas state court against the Commissioner and Flowers. In his lawsuit, Jones contended that the Commissioner’s failure to provide notice of the tax sale and of Jones’s right to redeem resulted in the taking of his property without due process. The

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trial court ruled in favor of the Commissioner and Flowers, and the Arkansas Supreme Court affirmed. The U.S. Supreme Court agreed to decide the case and its central question of whether Jones was afforded due process. How did the U.S. Supreme Court rule? 2. Two Rhode Island statutes prohibited advertising the retail price of alcoholic beverages. The first applied to vendors licensed in Rhode Island as well as to out-of-state manufacturers, wholesalers, and shippers. It prohibited them from “advertising in any manner whatsoever” the price of any alcoholic beverage offered for sale in the state. The only exception to the restriction was for price tags or signs displayed with the merchandise within licensed premises, if the tags or signs were not visible from the street. The second statute barred the Rhode Island news media from publishing or broadcasting advertisements that made reference to the price of any alcoholic beverages. 44 Liquormart Inc., a licensed retailer of alcoholic beverages, operated a store in Rhode Island. Because it wished to advertise prices it would charge for alcoholic beverages, 44 Liquormart filed a declaratory judgment action against the state. 44 Liquormart asked the court to rule that the statutes referred to above violated the First Amendment. The district court concluded that the statutes failed the applicable test for restrictions on commercial speech and therefore struck them down. The U.S. Court of Appeals for the First Circuit reversed, determining that the statutes were constitutionally permissible restrictions on commercial speech. The U.S. Supreme Court granted 44 Liquormart’s petition for a writ of certiorari. How did the Supreme Court rule? 3. A federal statute, 8 U.S.C. § 1409, sets requirements for acquisition of U.S. citizenship by a child born outside the United States to unwed parents, only one of whom is a U.S. citizen. If the mother is the U.S. citizen, the child acquires citizenship at birth. Section 1409(a) states that when the father is the citizen parent, the child acquires citizenship only if, before the child reaches the age of 18, the child is legitimized under the law of the child’s residence or domicile, the father acknowledges paternity in writing under oath, or paternity is established by a competent court. Tuan Anh Nguyen was born in Vietnam to a Vietnamese mother and a U.S. citizen father, Joseph Boulais. At six years of age, Nguyen came to the United States, where he became a lawful permanent resident and was raised by his father. When Nguyen was 22, he pleaded guilty in a Texas court to two counts of sexual assault.

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The U.S. Immigration and Naturalization Service initiated deportation proceedings against Nguyen, and an immigration judge found him deportable. While Nguyen’s appeal to the U.S. Board of Immigration Appeals was pending, Boulais obtained from a state court an order of parentage that was based on DNA testing. The board dismissed Nguyen’s appeal, denying his citizenship claim on the ground that he had not established compliance with § 1409(a). Nguyen and Boulais appealed to the U.S. Court of Appeals for the Fifth Circuit, which rejected their contention that § 1409 discriminated on the basis of gender and thus violated the Constitution’s equal protection guarantee. Was the Fifth Circuit’s decision correct? 4. As most other states do, the Commonwealth of Kentucky taxes its residents’ income. Kentucky law establishes that interest on bonds issued by Kentucky and its political subdivisions is exempt from Kentucky’s income tax, whereas interest on bonds issued by other states and their political subdivisions is taxable. The tax exemption for Kentucky bonds helps make those bonds attractive to in-state purchasers even if they carry somewhat lower rates of interest than other states’ bonds or those issued by private companies. Most other states have differential tax schemes that resemble Kentucky’s. Kentucky residents George and Catherine Davis paid state income tax on interest from out-of-state municipal bonds, and then sued the Department of Revenue of Kentucky in an effort to obtain a refund. The Davises contended that Kentucky’s differential taxation of municipal bond interest impermissibly discriminates against interstate commerce in violation of the U.S. Constitution’s Commerce Clause. Were the Davises correct? 5. Nike Inc. mounted a public relations campaign in order to refute news media allegations that its labor practices overseas were unfair and unlawful. The campaign involved the use of press releases, letters to newspapers, a letter to university presidents and athletic directors, and full-page advertisements in leading newspapers. Relying on California statutes designed to curb false and misleading advertising and other forms of unfair competition, California resident Mark Kasky filed suit in a California court on behalf of the general public of the state. Kasky contended that Nike had made false statements in its campaign and that the court should therefore grant the legal relief contemplated by the California statutes. In terms of Nike’s potential liability, why would it make a difference whether the speech in which Nike engaged was commercial or, instead,

noncommercial? What are the arguments in favor of a conclusion that Nike was engaged in commercial speech? What are the arguments in favor of a conclusion that Nike was engaged in noncommercial speech? How did the court rule on the speech classification issue—that is, whether Nike’s speech was commercial or, instead, that it is noncommercial? 6. Public school districts in Seattle, Washington, and Louisville, Kentucky, faced litigation in which it was alleged that they violated the Equal Protection Clause by considering race when assigning students to schools. The Seattle district, which had neither created segregated schools nor been subject to court-ordered desegregation, generally allowed students to choose which high school they wished to attend. However, the district classified students as white or nonwhite. It then used the racial classifications as a “tiebreaker” to allocate available slots in particular high schools and thereby seek to achieve racially diverse schools despite the existence of certain housing patterns that would have produced little racial diversity at certain schools. The Louisville district had been subject to a federal court’s desegregation decree during a two-decadeslong period, but a court had lifted the desegregation order after concluding that the district had eliminated the vestiges of prior segregation to the greatest extent feasible. The Louisville district then adopted a plan under which students were classified as Black or “other.” Using these classifications in making elementary school assignments and in ruling on transfer requests, the district sought to achieve racial diversity in schools that would have reflected less racial diversity in light of traditional housing patterns. The cases challenging the two districts’ policies of considering race made their way through the federal courts and were later consolidated for decision by the U.S. Supreme Court.  What test would the Seattle and Louisville school districts need to pass in order to avoid a Supreme Court determination that their policies violate the Equal Protection Clause? Could the school districts pass that test? Why or why not? 7. Marijuana is classified under federal law as an illegal drug. On what enumerated power would Congress have relied when it enacted the federal statute that outlaws marijuana and other specified drugs?  A number of states have legalized marijuana possession and use up to certain levels designated in their laws. Several other states have legalized marijuana possession and use for medicinal purposes, but for



Chapter Three Business and the Constitution

those purposes only. As a constitutional matter, could the federal government—if it were so inclined—adopt an aggressive enforcement posture in which it would override the state laws to the contrary? If so, on what constitutional basis? If not, why not? 8. The Minnesota legislature passed a statute banning the sale of milk in plastic nonrefillable, nonreusable containers. However, it allowed sales of milk in other nonrefillable, nonreusable containers such as paperboard cartons. One of the justifications for this ban on plastic jugs was that it would ease the state’s solid waste disposal problems because plastic jugs occupy more space in landfills than other nonreturnable milk containers. A group of dairy businesses challenged the statute, arguing that its distinction between plastic containers and other containers was unconstitutional under the Equal Protection Clause. What means-ends test or level of scrutiny applies in this case? Under that test, is easing the state’s solid waste disposal problems a sufficiently important end? Under that test, is there a sufficiently close “fit” between the classification and that end to make the statutory means constitutional? In answering the last question, assume for the sake of argument that there probably were more effective ways of alleviating the solid waste disposal problem than banning plastic jugs while allowing paperboard cartons. 9. The plaintiffs in the case described below were two married same-sex couples who conceived children through anonymous sperm donation. Leigh and Jana Jacobs were married in Iowa in 2010, and Terrah and Marisa Pavan were married in New Hampshire in 2011. Leigh and Terrah each gave birth to a child in Arkansas in 2015. When it came time to secure birth certificates for the newborns, each couple filled out paperwork listing both spouses as parents—Leigh and Jana in one case, Terrah and Marisa in the other. Both times, however, the Arkansas Department of Health issued certificates bearing only the birth mother’s name. The department’s decision rested on a provision of ­Arkansas law that specified which individuals will appear as parents on a child’s state-issued birth certificate. The statute stated that “[f]or the purposes of birth registration, the mother is deemed to be the woman who gives birth to the child.” The statute also instructed that “[i]f the mother was married at the time of either conception or birth, the name of [her] husband shall be entered on the certificate as the father of the child.” The requirement that a married woman’s husband appear on her child’s birth certificate applied, according to the state’s

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interpretation of the statute, if the couple conceived by means of artificial insemination with the help of an anonymous sperm donor.  The Jacobses and Pavans brought this suit in Arkansas state court against the director of the Arkansas Department of Health in an effort to obtain a declaration that the state’s birth-certificate law violated the U.S. Constitution. The trial court so ruled, but the Arkansas Supreme Court reversed the trial court’s decision. The U.S. Supreme Court agreed to decide the case. What constitutional provision or provisions do you see as relevant here? How did the Supreme Court rule? 10. While it was preparing a comprehensive land use plan in the area, the Tahoe Regional Planning Agency (TRPA) imposed two moratoria on development of property in the Lake Tahoe Basin. The moratoria together lasted 32 months. A group of property developers affected by the moratoria filed suit in federal court alleging that the moratoria constituted an unconstitutional taking without just compensation. Were the developers correct? 11. A federal statute criminalized the creation, sale, or possession of certain depictions of animal cruelty. For purposes of the statute, a depiction of “animal cruelty” was defined as one “in which a living animal is intentionally maimed, mutilated, tortured, wounded, or killed,” if the depicted conduct violated federal or state law at the place where the creation, sale, or possession took place. The legislative history of the statute indicated that it was prompted by a congressional objective of eliminating dissemination of so-called crush videos (videos showing live animals being crushed to death by persons stomping on them).  Robert Stevens operated a website on which he sold videos of pitbulls engaging in dogfighting and otherwise attacking animals. After he was convicted of violating the above-described statute by selling the videos, he appealed on the ground that the statute violated the First Amendment. The case made its way to the U.S. Supreme Court. How did the Court rule? Was Stevens entitled to the protection of the First Amendment? 12. Florida’s Code of Judicial Conduct bars judges and candidates running for election to a judgeship from personally soliciting campaign contributions of a financial nature. Attorney Lanell Williams-Yulee, a candidate running for election to a Florida judgeship, drafted and mailed a letter to voters. In the letter, she asked for donations to her campaign. The State Bar

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Part One Foundations of American Law

of Florida brought a disciplinary proceeding against Williams-Yulee because of the letter. The proceedings concluded with a finding that a public reprimand was in order because she had violated the Code of Judicial Conduct. The Bar rejected Williams-Yulee’s argument that the ban on personal solicitation violated her First Amendment rights. The Supreme Court of Florida also rejected that argument. The U.S. Supreme Court agreed to decide the case. What kind of speech was Williams-Yulee engaging in through her letter soliciting contributions to her campaign? Did the Code of Judicial Conduct’s restriction on personal solicitation violate her First Amendment rights? 13. A federal law, the Immigration Reform and Control Act (IRCA), makes it “unlawful for a person or other entity . . . to hire, or to recruit or refer for a fee, for employment in the United States an alien knowing the alien is an unauthorized alien.” Employers that violate this prohibition may be subjected to civil and criminal sanctions. IRCA also restricts the ability of states to combat employment of unauthorized workers. It does so by expressly preempting “any state or local law imposing civil or criminal sanctions (other than through licensing and similar laws) upon those who employ, or recruit or refer for a fee for employment,

unauthorized aliens.” In addition, IRCA requires employers to take steps to verify an employee’s eligibility for employment. Seeking to improve that verification process, Congress created E-Verify, an Internet-based system employers can use to check the work authorization status of employees. Federal law does not require the use of E-Verify, however.  Arizona was among several states that enacted statutes designed to impose sanctions for the employment of unauthorized aliens. According to an Arizona law (the Legal Arizona Workers Act), the licenses of state employers that knowingly or intentionally employ unauthorized aliens may be, and in certain circumstances must be, suspended or revoked. The Arizona law also requires that all Arizona employers use E-Verify. The Chamber of Commerce of the United States and various business and civil rights organizations filed suit against those charged with administering the Arizona law. The plaintiffs argued that the state law’s license suspension and revocation provisions were both expressly and impliedly preempted by federal immigration law, and that the mandatory use of E-Verify was impliedly preempted. Were the plaintiffs right? Did federal immigration law preempt the challenged provisions of the Arizona statute?

CHAPTER 4

Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

W

hat defines ethical behavior? Think of a time when you thought that someone or some business did something ethical. Was it someone going out of her way to help another person? Was it, for example, a young man—a customer at a store—helping an elderly woman carry heavy packages to her car? Was it someone entering a building during a pouring rain and giving her umbrella to a father and his small children who were waiting to leave until the rain stopped? Was it a corporate executive speaking for an hour to a friend’s daughter—a young college student—helping her understand how to seek an internship and prepare for a career in the executive’s industry? Was it a business giving a second chance to a young man who fell in with the wrong crowd, made a mistake, and served time in prison? Was it a company recalling and repairing an allegedly defective product, even when not required by the government, at great cost to its profits and shareholders? Was it a business that bought a failing company in the solar industry? Was it a corporation buying a competitor, achieving synergies, improving options and pricing for consumers, and increasing the company’s profits? Was it a business that chose to upgrade its factories in a midwestern town instead of moving manufacturing operations overseas? Was it a business that opened a new plant in Indonesia, creating jobs for 1,000 workers? Was it a corporation with excess cash opting to increase its dividend by 25 percent and buy back 10 percent of its stock, thereby increasing returns to shareholders and the price of the shareholders’ stock in the company? In these and other situations in which you observed what you believed was ethical conduct, what made you think the behavior was ethical? Was it that the ethical actor obeyed some fundamental notion of rightness? Was it that the person treated someone the way you would want to be treated? Was it that the actor gave an opportunity to someone who was in greater need than most people? Was it that the company helped someone who deserved aid? Was it that most people thought that it was the right thing to do or that the majority wanted it done, whether right or not? Was it that the business took full advantage of the resources entrusted to it by society? Was it that the business helped society use its scarce resources in a productive or fair way? What ethical responsibilities do businesses and business leaders have and to whom? What defines ethical behavior?

4-2

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Part One Foundations of American Law

LEARNING OBJECTIVES After studying this chapter, you should be able to: 4-1 Appreciate the strengths and weaknesses of the various ethical theories. 4-2 Apply the Guidelines for Ethical Decision Making to business and personal decisions.

Why Study Business Ethics? General Motors hiding that it sold cars with faulty ignitions. Target failing to protect customers’ credit card information. Enron maintaining its stock price by moving liabilities off balance sheet. WorldCom using fraudulent accounting to increase its stock price. ImClone executives and their family members trading on inside information. These business names and acts from the past two decades conjure images of unethical and socially irresponsible behavior by business executives. The U.S. Congress, employees, investors, and other critics of the power held and abused by some corporations and their management have demanded that corporate wrongdoers be punished and that future wrongdoers be deterred. Consequently, shareholders, creditors, and state and federal attorneys general have brought several civil and criminal actions against wrongdoing corporations and their executives. Congress has also entered the fray, passing the Sarbanes–Oxley Act of 2002, which increased penalties for corporate wrongdoers and established rules designed to deter and prevent future wrongdoing. The purpose of the statute is to encourage and enable corporate executives to be ethical and socially responsible. But statutes and civil and criminal actions can go only so far in directing business managers down an ethical path. And while avoiding liability by complying with the law is one reason to be ethical and socially responsible, there are noble and economic reasons that encourage current and future business executives to study business ethics. Although it is tempting to paint all businesses and all managers with the same brush that colors unethical and irresponsible corporations and executives, in reality corporate executives are little different from you, your friends, and your acquaintances. All of us from time to time fail to do the right thing, and we know that people have varying levels of commitment to acting ethically. The difference between most of us and corporate executives is that they are in positions of power that allow them to do greater damage to others when they act unethically or socially irresponsibly. They also act under the microscope of public scrutiny.

4-3 Recognize critical thinking errors in your own and others’ arguments. 4-4 Utilize a process to make ethical decisions in the face of pressure from others. 4-5 Be an ethical leader. It is also tempting to say that current business managers are less ethical than managers historically. But as former Federal Reserve chair Alan Greenspan said, “It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed have grown enormously.” This brings us to the first and most important reason we need to study business ethics: to make better decisions for ourselves, the businesses we work for, and the society we live in. As you read this chapter, you will not only study the different theories that attempt to define ethical conduct but, more importantly, learn to use a strategic framework for making decisions. This framework provides a process for systematic ethical analysis, which will increase the likelihood you have considered all the facts affecting your decision. By learning a methodology for ethical decision making and studying common thinking errors, you will improve your ability to make decisions that build trust and solidify relationships with your business’s stakeholders. Another reason we study ethics is to understand ourselves and others better. While studying the various ethical theories, you will see concepts that reflect your own thinking and the thinking of others. This chapter, by exploring ethical theories systematically and pointing out the strengths and weaknesses of each ethical theory, should help you understand better why you think the way you do and why others think the way they do. By studying ethical theories, learning a process for ethical decision making, and understanding common reasoning fallacies, you should also be better equipped to decide how you should think and whether you should be persuaded by the arguments of others. Along the way, by better understanding where others are coming from and avoiding fallacious reasoning, you should become a more rigorous, critical thinker, as well as persuasive speaker and writer. There are also pragmatic reasons for executives to study business ethics. By learning how to act ethically and by, in fact, doing so, businesses forestall public criticism, reduce lawsuits against them, prevent Congress from passing onerous legislation, and make higher profits. For many corporate actors, however, these are not reasons to act ethically, but instead the natural consequences of so acting.



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

While we are studying business ethics, we will also examine the role of the law and regulations in defining ethical conduct. Some argue that it is sufficient for corporations and executives to comply with the requirements of the law; commonly, critics of the corporation point out that because laws cannot and do not encompass all expressions of ethical behavior, compliance with the law is necessary but not sufficient to ensure ethical conduct. This introduces us to one of the major issues in the corporate social responsibility debate.

The Corporate Social Responsibility Debate Although interest in business ethics education has increased greatly in the last few decades, that interest is only the latest stage in a long struggle to control corporate misbehavior. Ever since large corporations emerged in the late 19th century, such firms have been heroes to some and villains to others. Large corporations perform essential national and global economic functions, including raw material extraction, energy production, transportation, and communication, as well as providing consumer goods, professional services, and entertainment to millions of people. Critics, however, claim that in their pursuit of profits, corporations ruin the environment, mistreat employees, sell shoddy and dangerous products, produce immoral television shows and motion pictures, and corrupt the political process. Critics claim that even when corporations provide vital and important services, business is not nearly as accountable to the public as are organs of government. For example, the public has little to say about the election of corporate directors or the appointment of corporate officers. This lack of accountability is aggravated by the large amount of power that big corporations wield in America and throughout much of the world. These criticisms and perceptions have led to calls for changes in how corporations and their executives make decisions. The main device for checking corporate misdeeds has been the law. The perceived need to check abuses of business power was a force behind the New Deal laws of the 1930s and extensive federal regulations enacted in the 1960s and 1970s. Some critics, however, believe that legal regulation, while an important element of any corporate control scheme, is insufficient by itself. They argue that businesses should adhere to a standard of ethical or socially responsible behavior that is higher than the law. One such standard is the stakeholder theory of corporate social responsibility. It holds that rather than merely striving to maximize profits for its shareholders, a corporation should balance the interests of investors against the

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interests of other corporate stakeholders, such as employees, suppliers, customers, and the community. In August 2019, the Business Roundtable endorsed the stakeholder theory approach, noting the importance of delivering value to customers, investing in employees, dealing fairly and ethically with suppliers, supporting local communities, and generating long-term value for shareholders. To promote such behavior, some corporate critics have proposed changes that increase the influence of the various stakeholders in the internal governance of a corporation. We will study many of these proposals later in the chapter in the subsection on shareholder theory and its emphasis on profit maximization. You will also learn later that an ethical decision-making process requires a business executive to anticipate the effects of a corporate decision on the various corporate stakeholders. Despite concerns about abuses of power, big business has contributed greatly to the unprecedented abundance in America and elsewhere. Partly for this reason and partly because many businesses attempt to be ethical actors, critics have not totally dominated the debate about control of the modern corporation. Some defenders of business argue that in a society founded on capitalism, profit maximization should be the main goal of businesses: The only ethical norms firms must follow are those embodied in the law or those impacting profits. In short, they argue that businesses that maximize profits within the limits of the law are acting ethically. Otherwise, the marketplace would discipline them for acting unethically by reducing their profits. Former Fed chair Alan Greenspan wrote in 1963 that moral values are the power behind capitalism. He wrote, “Capitalism is based on self-interest and self-esteem; it holds integrity and trustworthiness as cardinal virtues and makes them pay off in the marketplace, thus demanding that [business persons] survive by means of virtue, not of vices.” Note that companies that are successful decade after decade, like Procter & Gamble and Johnson & Johnson, adhere to society’s core values. We will explore other arguments supporting and criticizing shareholder theory and its emphasis on profit maximization later in the chapter, where we will consider proposals to improve corporate governance and accountability. For now, however, having set the stage for the debate about business ethics and corporate social responsibility, we want to study the definitions of ethical behavior.

Ethical Theories For centuries, religious and secular scholars have explored the meaning of human existence and attempted to define a “good life.” In this section, we will define and examine some of the most important theories of ethical conduct.

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Ethics and Compliance in Action American physicist, mathematician, and futurist Freeman Dyson provided insights into why we humans may have difficulty determining which ethical viewpoint to embrace. His research also helps explain why different people have different ethical leanings. The destiny of our species is shaped by the imperatives of survival on six distinct time scales. To survive means to compete successfully on all six time scales. But the unit of survival is different for each of the six time scales. On a time scale of years, the unit is the individual. On a time scale of decades, the unit is the family. On a time scale of centuries, the unit is the tribe or nation. On a time scale of millennia, the unit is the culture. On a time scale of tens of millennia, the unit is the species. On a time scale of eons, the unit is the whole web of life on our planet. That is why conflicting loyalties are deep in our nature. In order to survive, we need to be loyal to ourselves, to our families, to our tribes, to our culture, to our species, to our planet. If our psychological impulses are complicated, it is because they were shaped by complicated and conflicting demands.1

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Appreciate the strengths and weaknesses of the various ethical theories.

As we cover these theories, much of what you read will be familiar to you. The names may be new, but almost certainly you have previously heard speeches and read writings of politicians, religious leaders, and commentators that incorporate the values in these theories. You will discover that your own thinking is consistent with one or more of the theories. You can also recognize the thinking of friends and antagonists in these theories. None of these theories is necessarily invalid, and many people believe strongly in any one of them. Whether you believe your theory to be right and the others to be wrong, it is unlikely that others will accept what you see as the error of their ways and agree with all your values. Instead, it is important for you to recognize that people’s ethical values can be as diverse as human culture. Therefore, no amount of argumentation appealing to theories you accept is likely to influence someone who subscribes to a different ethical viewpoint. The key, therefore, is to understand the complexity of ethical perspectives so that you can better understand both your viewpoint and the viewpoints of others. Only then is it possible to pursue common ground and provide a rational explanation for the decision that must ultimately be made.

Dyson goes on to write, “Nature gave us greed, a robust desire to maximize our personal winnings. Without greed we would not have survived at the individual level.” Yet he points out that Nature also gave us the connections and tools to survive at the family level (Dyson calls this tool love of family), the tribal level (love of friends), the cultural level (love of conversation), the species level (love of people in general), and the planetary level (love of nature). If Dyson is correct, why are humans sometimes vastly different from each other in some of their ethical values? Why do some of us argue, for example, that universal health care is a right for each citizen, while others believe health care is a privilege? The answer lies in the degree to which each of us embraces, innately or rationally, Dyson’s six units of survival and the extent to which each of us possesses the connections and tools to survive on each of those levels. Freeman Dyson, From Eros to Gaia (London: Penguin Books, 1993), pp. 341–42. 1

This means that if you want to be understood by and to influence someone who has a different ethical underpinning than you do, you must first determine her ethical viewpoint and then speak in an ethical language that will be understood and accepted by her. Otherwise, you and your opponent are like the talking heads on nighttime cable TV news shows, whose debates often are reduced to shouting matches void of any attempt to understand the other side.

LOG ON Go to www.iep.utm.edu The Internet Encyclopedia of Philosophy gives you background on all the world’s great philosophers from Abelard to Zizek. You can also study the development of philosophy from ancient times to the present. Many of the world’s great philosophers addressed the question of ethical or moral conduct.

The five ethical theories we will highlight are rights theory, justice theory, utilitarianism, shareholder theory, and virtue theory. Some of these theories focus on results of our decisions or actions: Do our decisions or actions produce the right results? Theories that focus on the consequences of a decision are teleological ethical theories. For example, a teleological theory may justify a manufacturing



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

company laying off 5,000 employees because the effect is to keep the price of manufactured goods low for consumers and to increase profits for the company’s shareholders. Other theories focus on the inherent rightness or wrongness of a decision or action itself, irrespective of what results it produces. This rightness or wrongness can be determined by a rule or principle or flow from a duty or responsibility. Theories that focus on decisions or actions alone are deontological ethical theories. For example, a deontological theory may find unacceptable that any competent employee loses his job, even if the layoff’s effect is to reduce prices to consumers and increase profits. Or a deontological theory emphasizing the principle that it is wrong to be dishonest might require that one never tell a lie, regardless of the consequences. Deontological theories place great emphasis on the duties and responsibilities that flow from rules, laws, policies, or social norms governing our actions. First, we will cover rights theory, which is a deontological theory. Next will be justice theory, which has concepts common to rights theory but with a focus primarily on outcomes. Our study of ethical theories will then turn to two additional teleological theories, utilitarianism and shareholder theory. Finally, we’ll consider virtue theory, which places the issue of one’s character and core virtues at the fore, instead of focusing first on rules and responsibilities or the consequences that inevitably flow from all of our actions.

Rights Theory Rights theory encompasses a variety

of ethical philosophies holding that certain human rights are fundamental and must be respected by other humans. The focus is on each individual member of society and her rights. As an ethically responsible individual, each of us faces a moral compulsion not to harm the fundamental rights of others, especially stakeholders impacted by our business activity. Kantianism Few rights theorists are strict deontologists, and one of the few is 18th-century philosopher Immanuel Kant. Kant viewed humans as moral actors who are free to make choices. He believed humans are able to judge the morality of any action by applying his famous categorical imperative. One formulation of the categorical imperative is, “Act only on that maxim whereby at the same time you can will that it shall become a universal law.” This means that we judge an action by applying it universally. Suppose you want to borrow money even though you know that you will never repay it. To justify this action using the categorical imperative, you state the following maxim or rule: “When I want money, I will borrow money and promise to repay it, even though I know I won’t repay.” According to Kant, you would not want this

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maxim to become a universal law because no one would believe in promises to repay debts and you would not be able to borrow money when you want. The ability to trust others in society would be completely impossible, and relationships would deteriorate. Thus, your maxim or rule fails to satisfy the categorical imperative. You are compelled, therefore, not to promise falsely that you will repay a loan. Kant had a second formulation of the categorical imperative: “Always act to treat humanity, whether in yourself or in others, as an end in itself, never merely as a means.” Thus arises a rule or principle creating a duty not to use or manipulate others in order to achieve our own happiness. In Kant’s eyes, if you falsely promise a lender to repay a loan, you are manipulating that person’s trust in you for your own ends because she would not agree to the loan if she knew all the facts. Modern Rights Theories Strict deontological ethical theories like Kant’s face an obvious problem: The duties are often viewed as absolute and universally applicable. A deontologist might argue that one must never lie or kill, even though most of us find lying and killing acceptable in some contexts, such as in self-defense. Responding to these difficulties, some modern philosophers have proposed mixed deontological theories. There are many theories here, but one popular theory requires us to abide by a moral rule unless a more important rule conflicts with it. In other words, our moral compulsion is not to compromise a person’s right unless a greater right takes priority over it. For example, members of society have the right not to be lied to. Therefore, in most contexts you are morally compelled not to tell a falsehood. That is an important right because it is critical in a community or marketplace that one be able to rely on another’s word. If, however, you could save someone’s life by telling a falsehood, such as telling a lie to a criminal about where a witness who will testify against him can be found, you probably will be required to save that person’s life by lying about his whereabouts. In this context, the witness’s right to live is a more important right than the criminal’s right to hear the truth. In effect, one right “trumps” the other right. What are these fundamental rights? How do we rank them in importance? Seventeenth-century philosopher John Locke argued for fundamental rights that we see embodied in the constitutions of modern democratic states: the protection of life, liberty, and property. Libertarians and others include the important rights of freedom of contract and freedom of expression. Modern liberals, like Bertolt Brecht, argued that all humans have basic rights to employment, food, housing, and education. In much of the ongoing debate

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around health care policy in the United States, a key question is whether or not every citizen has a right to health care. Strengths of Rights Theory The major strength of rights theory is that it recognizes the moral worth of each individual and the importance of protecting fundamental rights. This means that members of modern democratic societies have extensive liberties and rights around which a consensus has formed and citizens need not fear the removal of these rights by their government or other members of society. In the U.S. context, one need look no further than the Declaration of Independence and its emphasis on “life, liberty, and the pursuit of happiness” as those “unalienable rights” that lie beyond the reach of government interference. In the global context, the Universal Declaration of Human Rights was adopted by the United Nations in 1948 as an expression of fundamental rights to which many people believe all are entitled. Criticisms of Rights Theory Most of the criticisms of rights theory deal with the near absolute yet relative value of the rights protected, sometimes making it difficult to articulate and administer a comprehensive rights theory.

First, it is difficult to achieve agreement about which rights are protected. Rights fundamental to modern countries like the United States (such as many women’s or GLBT rights) are more limited in other countries around the world. Even within one country, citizens disagree on the existence and ranking of rights. For example, as noted earlier, some Americans argue that the right to health care is an important need that should be met by government or a person’s employer. Other Americans believe funding universal health care would interfere with the libertarian right to limited government intervention in our lives. Balancing rights in conflict can be difficult. In addition, rights theory does not concern itself with the costs or benefits of requiring respect for another’s right. For example, rights theory probably justifies the protection of a neo-Nazi’s right to spout hateful speech, even though the costs of such speech, including damage to relations between ethnic groups, may far outweigh any benefits the speaker, listeners, and society receive from the speech. Moreover, in the context of discussions around public policy and political economy, some argue that rights theory can be perverted to create a sense of entitlement reducing innovation, entrepreneurship, and production.

The Global Business Environment The Golden Rule in the World’s Religions and Cultures

ISLAM: No one of you is a believer until he desires for his brother that which he desires for himself.

Immanuel Kant’s categorical imperative, which is one formulation of rights theory, has its foundations in the Golden Rule. Note that the Golden Rule exists in all cultures and in all countries of the world. Here is a sampling.

JAINISM: In happiness and suffering, in joy and grief, we should regard all creatures as we regard our own self.

BUDDHISM: Hurt not others in ways that you would find hurtful. CHRISTIANITY: Do to others as you would have others do to you. CONFUCIANISM: Do not to others what you would not like yourself. GRECIAN: Do not that to a neighbor which you shall take ill from him.

JUDAISM: Whatever is hateful to you, do not to another. NATIVE AMERICAN SPIRITUALITY: Respect for all life is the foundation. PERSIAN: Do as you would be done by. ROMAN: Treat your inferiors as you would be treated by your superiors. SHINTOISM: The heart of the person before you is a mirror. See there your own form. SIKHISM: As you deem yourself, so deem others.

HINDUISM: This is the sum of duty: do nothing to others which if done to you would cause you pain.

TAOISM: Regard your neighbor’s gain as your own gain, and your neighbor’s loss as your own loss.

HUMANISM: Individual and social problems can only be resolved by means of human reason, intelligent effort, and critical thinking joined with compassion and a spirit of empathy for all living beings.

YORUBAN: One going to take a pointed stick to pinch a baby bird should first try it on himself to feel how it hurts. ZOROASTRIANISM: That nature alone is good which refrains from doing to another whatsoever is not good for itself.



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

For example, if one is able to claim an entitlement to a job, a place to live, food, and health care—regardless of how hard he is expected to work—motivations to pull one’s own weight and contribute to society and the greater good may be compromised, resulting in a financially unsustainable culture of dependency. The overlap between theories of ethics and their political policy implications is explored further as we turn our attention to justice theory.

Justice Theory In 1971, John Rawls published his

book A Theory of Justice, the philosophical underpinning for the bureaucratic welfare state. Based upon the principle of justice, Rawls reasoned that it was right for governments to redistribute wealth in order to help the poor and disadvantaged. He argued for a just distribution of society’s resources by which a society’s benefits and burdens are allocated fairly among its members. Rawls expressed this philosophy in his Greatest Equal Liberty Principle: Each person has an equal right to basic rights and liberties. He qualified or limited this principle with the Difference Principle: Social inequalities are acceptable only if they cannot be eliminated without making the worst-off class even worse off. The basic structure is perfectly just, he wrote, when the prospects of the least fortunate are as great as they can be. Rawls’s justice theory has application in the business context. Justice theory requires decision makers to be guided by fairness and impartiality and to take seriously what outcomes these principles produce. In the business context, justice theory prompts leadership to ask: Are our employees getting what they deserve? It would mean, for example, that a business deciding in which of two communities to build a new manufacturing plant should consider which community has the greater need for economic development. Chief among Rawls’s critics was his Harvard colleague Robert Nozick. Nozick argued that the rights of the individual are primary and that nothing more was justified than a minimal government that protected against violence and theft and ensured the enforcement of contracts. Nozick espoused a libertarian view that unequal distribution of wealth is moral if there is equal opportunity. Applied to the business context, Nozick’s formulation of justice would permit a business to choose between two manufacturing plant sites after giving each community the opportunity to make its best bid for the plant. Instead of picking the community most in need, the business may pick the one offering the best deal. Strengths of Justice Theory The strength of Rawls’s justice theory lies in its basic premise that society owes a duty to protect those who are least advantaged—that

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is, positioned unfairly vis-à-vis the distribution of social goods. Its motives are consistent with the religious and secular philosophies that urge humans to help those in need. Many religions and cultures hold basic to their faith the assistance of those who are less fortunate. Criticisms of Justice Theory Rawls’s justice theory shares some of the criticisms of rights theory. It treats equality as an absolute, without examining the potential costs of producing equality, including reduced incentives for innovation, entrepreneurship, and production. Moreover, any attempt to rearrange social benefits requires an accurate measurement of current wealth. For example, if a business is unable to measure accurately which employees are in greater need of benefits due to their wealth level, application of justice theory may make the business a Robin Hood in reverse: taking from the poor to give to the rich.

Utilitarianism Utilitarianism

requires a decision maker to maximize utility for society as a whole. Maximizing utility means achieving the highest level of satisfactions over dissatisfactions. This means that a person must consider the benefits and costs of his actions to everyone in society. A utilitarian will act only if the benefits of the action to society outweigh the societal costs of the action. Note that the focus is on society as a whole. This means a decision maker may be required to do something that harms her if society as a whole is benefited by her action. A teleological theory, utilitarianism judges our actions as good or bad depending on their consequences. This is sometimes expressed as “the ends justify the means.” Utilitarianism is most identified with 19th-century philosophers Jeremy Bentham and John Stuart Mill. Bentham argued that maximizing utility meant achieving the greatest overall balance of pleasure over pain. A critic of utilitarianism, Thomas Carlyle, called utilitarianism “pig philosophy” because it appeared to base the goal of ethics on the swinish pleasures of the multitude. Mill thought Bentham’s approach too narrow and broadened the definition of utility to include satisfactions such as health, knowledge, friendship, and aesthetic delights. Responding to Carlyle’s criticisms, Mill also wrote that some satisfactions count more than others. For example, the pleasure of seeing wild animals free in the world may be a greater satisfaction morally than shooting them and seeing them stuffed in one’s den. How does utilitarianism work in practice? It requires that you consider not just the impact of decisions on yourself, your family, and your friends, but also the impact on everyone in society. Before deciding whether to ride a bicycle

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to school or work rather than to drive a car, a utilitarian would consider the wear and tear on her clothes, the time saved or lost by riding a bike, the displeasure of riding in bad weather, her improved physical condition, her feeling of satisfaction for not using fossil fuels, the cost of buying more food to fuel her body for the bike trips, the dangers of riding near automobile traffic, and a host of other factors that affect her satisfaction and dissatisfaction. But her utilitarian analysis doesn’t stop there. She has to consider her decision’s effect on the rest of society. Will she interfere with automobile traffic flow and decrease the driving pleasure of automobile drivers? Will commuters be encouraged to ride as she does and benefit from doing so? Will her lower use of gasoline for her car reduce demand and consumption of fossil fuels, saving money for car drivers and reducing pollution? Will her and other bike riders’ increased food consumption drive up food prices and make it less affordable for poor families? This only scratches the surface of her utilitarian analysis. The process we used earlier, act utilitarianism, judges each act separately, assessing a single act’s benefits and costs to society’s members. Obviously, a person cannot make an act utilitarian analysis for every decision. It would take too much time and many variables are difficult to calculate. Utilitarianism recognizes that human limitation. Rule utilitarianism judges actions by a rule that over the long run maximizes benefits over costs. For example, you may find that taking a shower every morning before school or work maximizes society’s satisfactions, as a rule. Most days, people around you will be benefited by not having to smell noisome odors, and your personal and professional prospects will improve by practicing good hygiene. Therefore, you are likely to be a rule utilitarian and shower each morning, even though some days you may not contact other people. Many of the habits we have are the result of rule utilitarian analysis. Likewise, many business practices, such as a retailer’s regular starting and closing times, also are based in rule utilitarianism. Strengths of Utilitarianism What are the strengths of utilitarianism as a guide for ethical conduct? It is easy to articulate the standard of conduct: You merely need to do what is best for society as a whole. Moreover, many find it intuitive to employ an ethical reasoning that seeks to maximize human flourishing and eliminate harm or suffering. Criticisms of Utilitarianism Those strengths also expose some of the criticisms of utilitarianism as an ethical construct. It is difficult to measure one’s own pleasures

and pains and satisfactions and dissatisfactions, let alone those of all of society’s members. In short, how does one adequately and accurately measure human flourishing? In addition, those benefits and costs are inevitably distributed unequally across society’s members. It can foster a tyranny of the majority that may result in morally monstrous behavior, such as a decision by a 100,000-person community to use a lake as a dump for human waste because only one person otherwise uses or draws drinking water from the lake. That example exhibits how utilitarianism differs from rights theory. While rights theory may protect a person’s right to clean drinking water regardless of its cost, utilitarianism considers the benefits and costs of that right as only one factor in the total mix of society’s benefits and costs. In some cases, the cost of interfering with someone’s right may outweigh the benefits to society, resulting in the same decision that rights theory produces. But where rights theory is essentially a one-factor analysis, utilitarianism requires a consideration of that factor and a host of others as well, in an attempt to balance pleasure over pain. A final criticism of utilitarianism is that it is not constrained by law. Certainly, the law is a factor in utilitarian analysis. Utilitarian analysis must consider, for example, the dissatisfactions fostered by not complying with the law and by creating an environment of lawlessness in a society. Yet the law is only one factor in utilitarian analysis. The pains caused by violating the law may be offset by benefits the violation produces. Rational actors may ultimately determine that the cost–benefit analysis justifies deviation from a law or rule. Most people, however, are rule utilitarian when it comes to law, deciding that obeying the law in the long run maximizes social utility.

Shareholder Theory Premised

on the concept that corporate leaders are agents who owe contractual obligations to investors, shareholder theory argues that ethical dilemmas should be resolved with a focus on maximizing the firm’s long-term profits within the limits of the law. It is based in the laissez faire theory of capitalism first expressed by Adam Smith in the 18th century and more recently promoted by the Nobel Prize–winning economist Milton Friedman. Laissez faire economists argue total social welfare is optimized if humans are permitted to work toward their own selfish goals. The role of government, law, and regulation is solely to ensure the workings of a free market by not interfering with economic liberty, by eliminating collusion among competitors, and by promoting accurate information in the marketplace. By focusing on results—maximizing total social welfare through a corporate focus on profit maximization— a shareholder theory approach to ethical decisions is a



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

teleological- or consequences-oriented ethical theory. It is closely related to utilitarianism, but it differs fundamentally in how ethical decisions are made. While utilitarianism considers all stakeholders as it seeks to maximize social utility by focusing the actor on a broad-based creation of social value and reduction in social harm, a shareholder approach to profit maximization optimizes total social utility by narrowing the actor’s focus, requiring the decision maker to make a wealth-maximizing decision that is focused on enhancing profits for those investors or shareholders who can claim a direct financial interest in the organization’s bottom line. Strengths of Focusing on Profit Maximization By working in our own interests, we compete for society’s scarce resources (iron ore, labor, and land, to name a few), which are allocated to those people and businesses that can use them most productively. By allocating society’s resources to their most efficient uses, as determined by a free market, shareholder theory claims to maximize total social utility or benefits. Thus, in theory, society as a whole is bettered if all of us compete freely for its resources by trying to increase our personal or organizational profits. If we fail to maximize profits, some of society’s resources will be allocated to less productive uses that reduce society’s total welfare. In addition, shareholder theory emphasizes that a commitment first and foremost to profit maximization must always be constrained by what is permitted under the law. A profit maximizer theoretically acts ethically by complying with society’s mores as expressed in its laws. Moreover, the emphasis on profit maximization requires the decision maker and business to be disciplined according to the dictates of the marketplace. Consequently, an analysis of the ethical issue pursuant to shareholder theory probably requires a decision maker to consider the rights protected by rights theory, especially the shareholder’s or investor’s contractual rights to a return on investment, as well as fairness dictates embedded in justice theory. Ignoring important rights of employees, customers, suppliers, communities, and other stakeholders may negatively impact a corporation’s long-term profits. A business that engages in behavior that is judged unethical by consumers and other members of society is subject to boycotts, adverse publicity, demands for more restrictive laws, and other reactions that damage its image, decrease its revenue, and increase its costs. Consider, for example, the reduced sales of Martha Stewart–branded goods at Kmart after Ms. Stewart was accused of trading ImClone stock while possessing inside information. Consider also the fewer number of college

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graduates willing to work for Waste Management Inc. in the wake of adverse publicity and indictments against its executives for misstating its financial results. Note also the higher cost of capital for firms like Dell as investors bid down the stock price of companies accused of accounting irregularities and other wrongdoing. All these reactions to perceived unethical conduct impact the business’s profitability in the short and long run, motivating that business to make decisions that comply with ethical views that transcend legal requirements. Criticisms of Focusing on Profit Maximization The strengths of shareholder theory’s emphasis on profit maximization as a model for ethical behavior also suggest criticisms and weaknesses of the theory. Striking at the heart of the theory is the criticism that corporate managers are subject to human failings that make it impossible for them to maximize corporate profits. The failure to discover and process all relevant information and varying levels of aversion to risk can result in one manager making a different decision than another manager. Group decision making in the business context introduces other dynamics that interfere with rational decision making. Social psychologists have found that groups often accept a higher level of risk than they would as individuals. There is also the tendency of a group to internalize the group’s values and suppress critical thought. Furthermore, even if an emphasis on profit maximization results in an efficient allocation of society’s resources and maximization of total social welfare, it does not concern itself with how wealth is allocated within society. In the United States, the top wealthiest 1 percent own more than 40 percent of the nation’s wealth, and globally, it is estimated that 26 individuals control more wealth than the combined wealth of 50 percent of the global population. To some people, those levels of wealth disparity are unacceptable. To laissez faire economists, wealth disparity is an inevitable component of a free market that rewards hard work, acquired skills, innovation, and risk taking. Yet critics of shareholder theory’s emphasis on profit maximization respond that market imperfections, structural barriers, and a person’s position in life at birth interfere with his ability to compete. Critics charge that the ability of laws and market forces to control corporate behavior is limited because it requires lawmakers, consumers, employees, and other constituents to detect unethical corporate acts and take appropriate steps. Even if consumers notice irresponsible behavior and inform a corporation, a bureaucratic corporate structure may interfere with the information being received by the proper person inside the corporation. If, instead,

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consumers are silent and refuse to buy corporate products because of perceived unethical acts, corporate management may notice a decrease in sales, yet attribute it to something other than the corporation’s unethical behavior. Critics also argue that equating ethical behavior with legal compliance is a tautology in countries like the United States where businesses distort the lawmaking process by lobbying legislators and making political contributions. It cannot be ethical, they argue, for businesses to merely comply with laws reflecting the interests of businesses and over which corporations have enormous influence post–Citizens United. Proponents of the emphasis on profit maximization respond that many laws restraining businesses are passed despite businesses lobbying against those laws. The Sarbanes–Oxley Act, which increases penalties for wrongdoing executives, requires CEOs to certify financial statements, and imposes internal governance rules on public companies, is such an example. So are laws restricting drug companies from selling a drug unless it is approved by the Food and Drug Administration and requiring environmental impact studies before a business may construct a new manufacturing plant. Moreover, businesses are nothing other than a collection of individual stakeholders, which includes employees, shareholders, and their communities. When they act to influence political policies or lobby for legal or regulatory change, their advocacy is arguably in the best interests of all these stakeholders.

Critics respond that ethics transcends law, requiring, in some situations, that businesses adhere to a higher standard than required by law. We understand this in our personal lives. For example, despite the absence of law dictating, for the most part, how we treat friends, we know that ethical behavior requires us to be loyal to friends and to spend time with them when they need our help. In the business context, a firm may be permitted to release employees for nearly any reason, except the few legally banned bases of discrimination (such as race, age, and gender), yet some critics will argue businesses should not terminate an employee for other reasons currently not banned by most laws (such as sexual orientation or appearance). Moreover, these critics further argue that businesses—due to their influential role in a modern society—should be leaders in setting a standard for ethical conduct. Those who emphasize profit maximization respond that such an ethical standard is difficult to define and hampers efficient decision making. Moreover, they argue that experience shows the law has been a particularly relevant definition of ethical conduct. Consider that many corporate scandals would have been prevented had the executives merely complied with the law and had existing regulations been enforced. For example, Enron executives illegally kept some liabilities off the firm’s financial statements, while regulatory oversight also failed. Tyco and Adelphia executives illegally looted corporate assets. Had these executives

Ethics and Compliance in Action Minimum Wage Laws In recent years, debate has raged over whether governments in the United States should increase dramatically the federal or state minimum wage that most employers must pay employees, from about $7 per hour to as much as $15 per hour. In 2015, the City of Seattle increased its minimum wage of city workers to $15 per hour, and New York City followed suit in 2019. Between 2020 and 2025, Washington, D.C.; New Jersey; Massachusetts; Maryland; Illinois; and California are scheduled to see similar increases. The efforts to increase the minimum wage are directed mostly against McDonald’s, Walmart, and other employers who employ large numbers of low-skilled or inexperienced workers. For example, one 26-year-old woman who worked at a Chicago McDonald’s as a cashier for 10 years claimed she could not support her two children on the wage paid by McDonald’s. Should a government protect employees by increasing the minimum wage? If a minimum wage is imposed by government, what is the right wage? A $15-per-hour wage translates into

annual compensation of $30,000, hardly enough to support a family. Should the minimum wage be $25 per hour? Why not make it $50 per hour, which would be $100,000 annual income, enough to permit most families to survive quite well? Why should government impose a minimum wage on private employers? Are employees without power to demand higher wages? Will a minimum wage distort the employment market? Do employees deserve higher wages than the amount they and their employers agree on? Does a high minimum wage encourage workers to remain in low-skill jobs rather than improving their skills and qualifying for higher-wage jobs? Should a 42-year-old woman be required to improve her lot in life by increasing her education rather than continuing to do a job that any 16-year-old can do? What social barriers or structural inequities might exist to hinder some in society from gaining necessary skills and improving access to better employment options? Do the answers to those questions depend on the ethical theory to which one subscribes?



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

simply complied with the law and maximized their firms’ long-run profits, none of those ethical debacles would have occurred. Critics of profit maximization respond that the corporate crises at companies like Enron and WorldCom prove that flaws in corporate governance encourage executives to act unethically. These examples, critics say, show that many executives do not maximize profits for their firms. Instead, driven by short-term, quarterly financial expectations, they maximize their own profits at the expense of the firm and its shareholders. They claim that stock options and other incentives intended to align the interests of executives with those of shareholders promote decisions that raise short-term profits to the long-run detriment of the firms. They point out that many CEOs and other top executives negotiate compensation plans that do not require them to stay with the firm long term and that allow them to benefit enormously from short-term profit taking. Executive greed, encouraged by these perverse executive compensation plans, also encourage CEOs and other executives to violate the law. Defenders of business, profit maximization, and capitalist economics point out that it is nearly impossible to stop someone who is bent on fraud. A dishonest executive will lie to shareholders, creditors, board members, and the public and also treat the law as optional. Yet enlightened proponents of the modern corporation accept that there are problems with corporate management culture that require changes. They know that an unconstrained CEO; ethically uneducated executives; perverse compensation incentives; and inadequate supervision of executives by the firm’s CEOs, board of directors, and shareholders present golden opportunities to the unscrupulous person and make unwitting accomplices of the ignorant and the powerless. Such an awareness highlights the role of corporate culture—for example, an ethical climate—in fostering an environment in which individuals are supported in their desire to act and live according to their moral compass. Finally, divining the shareholders’ ethical viewpoint may be difficult. While nearly all shareholders are mostly profit driven, a small minority of shareholders have other agendas, such as protecting the environment or workers’ rights, regardless of the cost to the corporation. It is often not possible to please all shareholders. Nonetheless, increasing shareholder democracy by enhancing the shareholders’ role in the nomination and election of board members is essential to uniting the interests of shareholders and management. So is facilitating the ability of shareholders to bring proposals for ethical policy to a vote of shareholders. In the past several years, for public companies at least, the Securities and Exchange

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Commission has taken several steps to increase shareholder democracy. These steps, which are covered fully in Chapter 45, are having their intended effect. For example, during the 2014 shareholder meeting season, shareholder proposals included requiring annual election of directors and limiting corporate political lobbying and contributions. Moreover, the New York Stock Exchange and NASDAQ require companies listed on those exchanges to submit for shareholder approval certain actions, such as approval of stock option plans.

Virtue Theory Differing from both the deontologi-

cal emphasis on rights and justice flowing from duties and responsibilities, as well as the teleological focus on consequences and outcomes (measured according to either a utilitarian or profit maximization calculus), is a third approach to ethical analysis that highlights the importance of character—for both individuals and an organization. Virtue theory demands that an individual know his values and how they correlate to his identity, habits, and ways of engaging with others. Focusing on an intentional pursuit of virtues, the theory emphasizes questions such as: Who are you? What values are most important to you? Are my stated values and the actions I take aligned? For an organization, the theory inquires: What is your corporate purpose? What are your corporate values? Are our corporate actions and our values integrated?  Virtue theory, therefore, approaches ethical dilemmas from a commitment to integrity and an emphasis on character development. Deontological and teleological considerations are still important components of the ethical analysis, but the starting point is different. Instead of focusing on what action is right, virtue theory focuses on whether the individual (or the corporation) is acting consistently with those virtues or values that will result in a life well lived.   As developed in the West, a virtue-oriented approach owes much to Aristotle and other Greek philosophers, who explored practical notions of the good life and how best to achieve it. In the East, virtue theory was largely cultivated by Confucius, who focused on the centrality of benevolence and righteousness as hallmarks in the development of character. In short, a virtue theory approach emphasizes the person and the daily struggle to become a better person through identification and cultivation—or habituation—of virtues, such as wisdom or courage or benevolence.  As an example, consider a person in need of help. A deontologist might offer assistance out of a sense of duty or responsibility or allegiance to the Golden Rule. A utilitarian might offer aid because the consequences would result in a maximization of overall well-being. One acting according to virtue theory, however, would be helping out of desire to

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become a more charitable or benevolent person. The giving of aid would flow from a commitment to becoming a person who gives aid. In this instance, one might imagine that a virtue theorist would have predetermined that she values the virtues of charity and benevolence. Upon confronting an opportunity to help someone in need, she would simply have acted in a way that promoted these virtues and made them more habitual in the person’s daily activity.  Strengths of Virtue Theory As noted in the previous discussion, acting with regard to one’s self-interest is a hallmark of the human condition. Virtue theory offers an opportunity to convert impulses at the heart of selfishness and greed into opportunities to act with a self-interested focus to become more personally virtuous and integrated with regard to one’s values, actions, and the habits we wish to cultivate. In organizations, virtue theory can create an aspirational climate and an additional way of emphasizing the importance of manifesting those corporate values that may otherwise be seen as mere words on a website or posters in the break room. Moreover, virtue theory’s focus on the development of practical wisdom—that is, moral imagination and sound judgment honed by experience—creates space and structure to encourage personal growth and continuous teaching and training of employees.   Additional value brought by a virtue approach to ethics is its appreciation for the ambiguity of dilemmas where simple maxims or principles are not adequate to the maintenance of human relationships nor accommodating to the complexity of human emotions. Criticisms of Virtue Theory Some critics argue that virtue theory is ultimately too subjective, too limited in scope, and too difficult to codify to be useful, especially in the corporate context. Certainly, those deontologists or teleologists seeking a universally applicable code of ethics may be unsatisfied, but then any such code is probably unrealistic given the complexities of the 21st-century global business environment. Other concerns have been raised about the inability of virtue theory to apply in a diverse global business environment because virtues that might be recognized and celebrated in one part of the world might be different from those virtues recognized elsewhere. Indeed, cultural relativity is an important issue to be considered when conducting ethical analysis using any theory or framework, as notions of what constitutes “right” and “wrong” are frequently contested. 

Improving Corporate Governance and Corporate Social Responsibility Even if

we cannot stop all fraudulent executives, we can modify the corporate governance model to educate, motivate, and

supervise executives and thereby improve corporate social responsibility. Corporate critics have proposed a wide variety of cures, all of which have been implemented to some degree and with varying degrees of success. Ethics Codes Many large corporations and several industries have adopted codes of ethics or codes of conduct to guide executives and other employees. The Sarbanes– Oxley Act requires a public company to disclose whether it has adopted a code of ethics for senior financial officers and to disclose any change in the code or waiver of the code’s application. There are two popular views of such codes. One sees the codes as genuine efforts to foster ethical behavior within a firm or an industry. The other view regards them as thinly disguised attempts to make the firm function better, to mislead the public into believing the firm behaves ethically, to prevent the passage of legislation that would impose stricter constraints on business, or to limit competition under the veil of ethical standards. Even where the first view is correct, ethical codes fail to address concretely all possible forms of corporate misbehavior. Instead, they often emphasize either the behavior required for the firm’s effective internal function, such as not accepting gifts from customers, or the relations between competitors within a particular industry, such as prohibitions on some types of advertising. Better corporate ethics codes make clear that the corporation expects employees not to violate the law in a mistaken belief that loyalty to the corporation or corporate profitability requires it. Such codes work best, however, when a corporation also gives its employees an outlet for dealing with a superior’s request to do an unethical act. That outlet may be the corporate legal department, a corporate compliance/ethics officer, or even an anonymous reporting procedure. Ethical Instruction Some corporations require their employees to enroll in classes that teach ethical decision making. The idea is that a manager trained in ethical conduct will recognize unethical actions before they are taken and deter herself and the corporation from the unethical acts. While promising in theory, in practice, many managers are resistant to ethical training that requires them to examine their principles. They are reluctant to question a set of long-held principles with which they are comfortable. Therefore, there are some doubts whether managers are receptive to ethical instruction. Even if the training is accepted, will managers retain the ethical lessons of their training and use it, or will time and other job-related pressures force a manager to think only of completing the job at hand?



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

Moreover, what ethical values should be emphasized? Is it enough to teach only one, a few, or all the theories of ethical conduct? Corporations may favor the simplicity of a shareholder orientation that focuses on maximization of profits. But should a corporation also teach rights theory and expect its employees to follow it? How should concerns over justice and fair distribution of benefits and burdens be addressed?  Most major corporations today express their dedication to ethical decision making by having an ethics officer who is not only responsible for ethical instruction, but also in charge of ethical supervision. The ethics officer may attempt to instill ethical decision making as a component of daily corporate life by sensitizing employees to the perils of ignoring ethical issues. The ethics officer may also be a mentor or sounding board for all employees who face ethical issues. Whether an ethics officer is effective, however, is determined by the level of commitment top executives make to ethical behavior and the position and power granted to the ethics officer. For example, will top executives and the board of directors allow an ethics officer to nix an important deal on ethical grounds, or will they replace the ethics officer with another executive whose ethical views permit the deal? Therefore, probably more important than an ethics officer is a CEO with the character to do the right thing. Consider All Stakeholders’ Interests Utilitarianism analysis clearly requires an executive to consider a decision’s impact on all stakeholders. How else can one determine all the benefits and costs of the decision? Likewise, modern rights theory also dictates considering all stakeholders’ rights, including not compromising an important right unless trumped by another. Kant’s categorical imperative also mandates a concern for others by requiring one to act as one would require others to act. For those seeking to maximize profits, the wisdom of considering all stakeholders is apparent because ignoring the interests of any stakeholder may negatively affect profits. For example, a decision may affect a firm’s ability to attract high-quality employees, antagonize consumers, alienate suppliers, and motivate the public to lobby lawmakers to pass laws that increase a firm’s cost of doing business. This wisdom is reflected in the Guidelines for Ethical Decision Making, which you will learn in the next section. Nonetheless, there are challenges when a corporate manager considers the interests of all stakeholders. Beyond the enormity of identifying all stakeholders, stakeholders’ interests may conflict, requiring a compromise that harms some stakeholders and benefits others. In addition, the impact on each stakeholder group may be difficult to assess accurately.

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For example, if a manager is considering whether to terminate the 500 least productive employees during an economic downturn, the manager will note that shareholders will benefit from lower labor costs and consumers may find lower prices for goods, but the manager also knows that the terminated employees, their families, and their communities will likely suffer from the loss of income. Yet if the employees terminated are near retirement and have sizable retirement savings or if the termination motivates employees to return to college and seek better jobs, the impact on them, their families, and their communities may be minimal or even positive. On the other hand, if the manager makes the decision to retain the employees, shareholder wealth may decrease and economic inefficiency may result, which harms all society.

Independent Boards of Directors In some

of the instances in which corporate executives have acted unethically and violated the law, the board of directors was little more than a rubber stamp or a sounding board for the CEO and other top executives. The CEO handpicked a board that largely allowed the CEO to run the corporation with little board supervision. CEO domination of the board is a reality in most large corporations because the market for CEO talent has skewed the system in favor of CEOs. Few CEOs are willing to accept positions in which the board exercises real control. Often, therefore, a CEO determines which board members serve on the independent board nominating committee and selects who is nominated by the committee. Owing their positions to the CEO and earning handsome fees sometimes exceeding $100,000, many directors are reluctant to oppose the CEO’s plans. For more than four decades, corporate critics have demanded that corporate boards be made more independent of the CEO. The corporate ethical crises of recent years have increased those calls for independence. The New York Stock Exchange and NASDAQ require companies with securities listed on the exchanges to have a majority of directors independent of the company and top management. Their rules also require independent management compensation, board nomination, and audit committees. The Sarbanes–Oxley Act requires public companies to have board audit committees comprising only independent directors. One criticism of director independence rules is the belief that no director can remain independent after joining the board because every director receives compensation from the corporation. There is a concern that an independent director, whose compensation is high, will side with management to ensure his continuing nomination, election, and receipt of high fees.

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More extreme proposals of corporate critics include recommendations that all corporate stakeholders—such as labor, government, environmentalists, and communities— have representation on the board or that special directors or committees be given responsibility over special areas, such as consumer protection and workers’ rights. Other critics argue for contested elections for each board vacancy. Few corporations have adopted these recommendations. While honestly motivated, these laws and recommendations often fail to produce greater corporate social responsibility because they ignore the main reason for management’s domination of the board: the limited time, information, and resources that directors have. One solution is to give outside directors a full-time staff with power to acquire information within the corporation. This solution, while providing a check on management, also may produce inefficiency by creating another layer of management in the firm. In addition, some of the recommendations complicate management by making the board less cohesive. Conflicts between stakeholder representatives or between inside and outside directors may be difficult to resolve. For example, the board could be divided by disputes among shareholders who want more dividends, consumers who want lower prices, and employees who want higher wages. Changing the Internal Management Structure Some corporate critics argue that the historic shift of corporate powers away from a public corporation’s board and shareholders to its managers is irreversible. They recommend, therefore, that the best way to produce responsible corporate behavior is to change the corporation’s management structure. The main proponent of this view, Christopher Stone, recommended the creation of offices dedicated to areas such as environmental affairs and workers’ rights, higher educational requirements for officers in positions like occupational safety, and procedures to ensure that important information inside and outside the corporation is directed to the proper person within the corporation. He also recommended that corporations study certain important issues and create reports of the study before making decisions. These requirements aim to change the process by which corporations make decisions. The objective is to improve decision making by raising the competency of decision makers, increasing the amount of relevant information they hold, and enhancing the methodology by which decisions are made. More information held by more competent managers using better tools should produce better decisions. Two of the later sections in this chapter in part reflect these recommendations. The Guidelines for Ethical Decision Making

require a decision maker to study a decision carefully before making a decision. This includes acquiring all relevant facts, assessing a decision’s impact on each stakeholder, and considering the ethics of one’s decision from each ethical perspective. In addition, the Thinking Critically section will help you understand when fallacious thinking interferes with a manager’s ability to make good decisions. Eliminating Perverse Incentives and Supervising Management Even if a corporation modifies its internal management structure by improving the decision-making process, there are no guarantees more responsible decisions will result. To the extent unethical corporate behavior results from faulty perception and inadequate facts, a better decision-making process helps. But if a decision maker is motivated solely to increase short-term profits, irresponsible decisions may follow. When one examines closely recent corporate debacles, three things are clear: The corporate wrongdoers acted in their selfish interests; the corporate reward system encouraged them to act selfishly, illegally, and unethically; and the wrongdoers acted without effective supervision. These facts suggest other changes that should be made in the internal management structure. During the high-flying stock market of the 1990s, stock options were the compensation package preferred by highlevel corporate executives. Shareholders and boards of directors were more than willing to accommodate them. On one level, stock options seem to align the interests of executives with those of the corporation and its shareholders. Issued at an exercise price usually far above the current market price of the stock, stock options have no value until the corporation’s stock price exceeds the exercise price of the stock options. Thus, executives are motivated to increase the corporation’s profits, which should result in an increase in the stock’s market price. In the 1990s stock market, in which some stock prices were doubling yearly, the exercise price of executives’ stock options was quickly dwarfed by the market price. Executives exercised the stock options, buying and then selling stock and, in the process, generating profits for a single executive in the tens and hundreds of millions of dollars. Shareholders also benefited from the dramatic increase in the value of their stock. So what is the problem with stock options? As executives accepted more of their compensation in the form of stock options and became addicted to the lifestyle financed by them, some executives felt pressure to keep profits soaring to ever-higher levels. In companies like Enron and WorldCom, which had flawed business models and suspect accounting practices, some executives were encouraged to create business deals that had little, if any, economic justification and could be accounted for in ways that kept profits growing.



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

In what were essentially pyramid schemes, once the faulty economics of the deals were understood by prospective partners, no new deals were possible, and the schemes crashed like houses of cards. But until the schemes were discovered, many executives, including some who were part of the fraudulent schemes, pocketed tens and hundreds of millions of dollars in stock option profits. The Sarbanes–Oxley Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, addressed this issue by requiring executive officers to disgorge any bonus and incentive-based or equitybased compensation received during the three-year period prior to which the corporation was required to restate its financial statements. It is easy to see how fraudulent actions subvert the objective of stock options to motivate executives to act in the best interests of shareholders. Adolph Berle, however, has argued for more than 50 years that stock options are flawed compensation devices that allow executives to profit when stock market prices rise in general, even when executives have no positive effect on profitability. He proposed that the best way to compensate executives is to allow them to trade on inside information they possess about a corporation’s prospects, information they possess because they helped produce those prospects. His proposal, however, is not likely ever to be legal compensation because insider trading creates the appearance that the securities markets are rigged. Even with incentives in place to encourage executives to inflate profits artificially, it is unlikely that the recent fraudulent schemes at Enron, WorldCom, and other companies would have occurred had there been better scrutiny of upper management and its actions by the CEO and the board of directors. At Enron, executives were given great freedom to create partnerships that allowed Enron to keep liabilities off the balance sheet yet generate income that arguably could be recognized in the current period. It is not surprising that this freedom from scrutiny, when combined with financial incentives to create the partnerships, resulted in executives creating partnerships that had little economic value to Enron. Better supervision of management is mostly the responsibility of the CEO, but the board of directors bears this duty also. We addressed earlier proposals to create boards of directors that are more nearly independent of the CEO and, therefore, better able to supervise the CEO and other top managers. Primarily, however, better supervision is a matter of attitude, or a willingness to devote time and effort to discover the actions of those under your charge and to challenge them to justify their actions. It is not unlike the responsibility a parent owes to a teenage child to scrutinize her actions and her friends to make sure that she is acting consistent with the values of the family. So, too,

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boards must make the effort to scrutinize their CEOs and hire CEOs who are able and willing to scrutinize the work of the managers below them. Yet directors must also be educated and experienced. Poor supervision of management has also been shown to be partly due to some directors’ ignorance of business disciplines like finance and accounting. Unless board members are able to understand accounting numbers and other information that suggests management wrongdoing, board scrutiny of management is a process with no substance.

The Law The law has been the primary means of con-

trolling corporate misdeeds. Lawmakers usually assume that corporations and executives are rational actors that can be deterred from unethical and socially irresponsible behavior by the threats law presents. Those threats are fines and civil damages, such as those imposed and increased by the Sarbanes–Oxley Act. For deterrence to work, however, corporate decision makers must know when the law’s penalties will be imposed, fear those penalties, and act rationally to avoid them. To some extent, the law’s ability to control executive misbehavior is limited. As we discussed earlier in this chapter, corporate lobbying may result in laws reflecting the views of corporations, not society as a whole. Some corporate executives may not know the law exists. Others may view the penalties merely as a cost of doing business. Some may think the risk of detection is so low that the corporation can avoid detection. Other executives believe they are above the law, that it does not apply to them out of arrogance or a belief that they know better than lawmakers. Some rationalize their violation of the law on the grounds that “everybody does it.” Nonetheless, for all its flaws, the law is an important means by which society controls business misconduct. Of all the devices for corporate control we have considered, only market forces and the law impose direct penalties for corporate misbehavior. Although legal rules have no special claim to moral correctness, at least they are knowable. Laws also are the result of an open political process in which competing arguments are made and evaluated. This cannot be said about the intuitions of a corporate ethics officer, edicts from public interest groups, or the theories of economists or philosophers, except to the extent they are reflected in law. Moreover, in mature political systems like the United States, respect for and adherence to law is a well-entrenched value. Where markets fail to promote socially responsible conduct, the law can do the job. For example, the antitrust laws discussed in Chapter 49, while still controversial, have eliminated the worst anticompetitive business practices. The federal securities laws examined in Chapters 45 and 46 arguably restored investor confidence in the securities markets after

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the stock market crash of 1929. Although environmentalists often demand more regulation, the environmental laws treated in Chapter 52 have improved the quality of water and reduced our exposure to toxic substances. Employment regulations discussed in Chapter 51—especially those banning employment discrimination—have forced significant changes in the American workplace. Thus, the law has an accomplished record as a corporate control device. Indeed, sometimes the law does the job too well, often imposing a maze of regulations that deter socially valuable profit seeking without producing comparable benefits. Former Fed chair Greenspan once wrote, “Government regulation is not an alternative means of protecting the consumer. It does not build quality into goods, or accuracy into information. Its sole ‘contribution’ is to substitute force and fear for incentive as the ‘protector’ of the consumer.” The hope was that the Sarbanes–Oxley Act would restore investor confidence in audited financial statements and corporate governance. A 2007 survey by Financial Executives International found that 69 percent of financial executives agreed that compliance with SOX section 404 resulted in more investor confidence in their companies’ financial reports. Fifty percent agreed that financial reports were more accurate. As for the cost of SOX compliance, a 2014 Protiviti report found that more than one-third of large companies (at least $10 billion in annual revenue) spent less than $500,000, while 30 percent spent more than $2 million.

Guidelines for Ethical Decision Making Now that you understand the basics of ethical theories and the issues in the corporate governance debate, how do you use this information to make decisions for your business that are ethical and socially responsible? That is, what

process will ensure that you have considered all the ethical ramifications and arrived at a decision that is good for your business, good for your community, good for society as a whole, and good for you. LO4-2

Apply the Guidelines for Ethical Decision Making to business and personal decisions.

Figure 4.1 lists nine factors in the Guidelines for Ethical Decision Making. Let’s consider each Guideline and explain how each helps you make better decisions.

What Facts Impact My Decision? This

is such an obvious component of any good decision that it hardly seems necessary to mention. Yet it is common that people make only a feeble attempt to acquire all the facts necessary to a good decision. Many people enter a decision-making process biased in favor of a particular option. As a result, they look only for facts that support that option. You have seen this done many times by your friends and opponents, and because you are an honest person, you have seen yourself do this as well from time to time. In addition, demands on our time, fatigue, laziness, ignorance of where to look for facts, and aversion to inconveniencing someone who has information contribute to a reluctance or inability to dig deep for relevant facts. Because good decisions cannot be made in a partial vacuum of information, it is important to recognize when you need to acquire more facts. That is primarily the function of your other classes, which may teach you how to make stock market investment decisions, how to audit a company’s financial records, and how to do marketing research. For our purposes, let’s consider this example. Suppose we work for a television manufacturing company that has a factory in Sacramento, California. Our company has placed

Figure 4.1  Guidelines for Ethical Decision Making 1. What FACTS impact my decision? 2. What are the ALTERNATIVES? 3. Who are the STAKEHOLDERS? 4. How do the alternatives impact SOCIETY AS A WHOLE? 5. How do the alternatives impact MY BUSINESS FIRM? 6. How do the alternatives impact ME, THE DECISION MAKER? 7. What are the ETHICS of each alternative? 8. What are the PRACTICAL CONSTRAINTS of each alternative? 9. What COURSE OF ACTION should be taken and how do we IMPLEMENT it?



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

you in charge of investigating the firm’s decision whether to move the factory to Juarez, Mexico. What facts are needed to make this decision, and where do you find those facts? Among the facts you need are: What are the firm’s labor costs in Sacramento, and what will those costs be in Juarez? How much will labor costs increase in subsequent years? What is the likelihood of good labor relations in each location? What is and will be the productivity level of employees in each city? What are and will be the transportation costs of moving the firm’s inventory to market? What impact will the move have on employees, their families, the communities, the schools, and other stakeholders in each community? Will Sacramento employees find other jobs in Sacramento or elsewhere? How much will we have to pay in severance pay? How will our customers and suppliers be affected by our decision? If we move to Juarez, will our customers boycott our products even if our televisions are better and cheaper than before? If we move, will our suppliers’ costs increase or decrease? How will our profitability be affected? How will shareholders view the decision? Who are our shareholders? Do we have a lot of Mexican shareholders, or do Americans dominate our shareholder list? What tax concessions and other benefits will the City of Sacramento give our firm if we promise to stay in Sacramento? What will Ciudad Juarez and the government of Mexico give us if we move to Juarez? How will our decision impact U.S.– Mexican economic and political relations? This looks like a lot of facts, but we have only scratched the surface. You can probably come up with another 100 facts that should be researched. To give you another example of how thorough managers must be to make prudent decisions, consider that the organizers for the Olympics and Boston Marathon must attempt to predict and prevent terrorist attacks. For the 2000 Summer Olympics in Sydney, Australia, organizers created 800 different terrorist scenarios before developing an antiterrorism plan. You can see that, to some extent, we are discussing other factors in the Guidelines as we garner facts. The factors do overlap to some degree. Note also that some of the facts you want to find are not facts at all, but estimates, such as cost and sales projections. We’ll discuss in the Eighth Guideline the practical problems with the facts we find.

What Are the Alternatives? A decision maker

must be thorough in listing the alternative courses of actions. For many of us, the temptation is to conclude that there are only two options: to do something or not to do something. Let’s take our decision whether to move our factory to Juarez, Mexico. You might think that the only choices are to stay in Sacramento or to move to Juarez. Yet there are several combinations that fall in between those extremes.

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For example, we could consider maintaining the factory in Sacramento temporarily, opening a smaller factory in Juarez, and gradually moving production to Mexico as employees in Sacramento retire. Another alternative is to offer jobs in the Juarez factory to all Sacramento employees who want to move. If per-unit labor costs in Sacramento are our concern, we could ask employees in Sacramento to accept lower wages and fringe benefits or to increase their productivity. There are many other alternatives that you can imagine. It is important to consider all reasonable alternatives. If you do not, you increase the risk that the best course of action was not chosen only because it was not considered.

Who Are the Stakeholders? In modern soci-

eties, where diversity is valued as an independent virtue, considering the impacts of your decision on the full range of society’s stakeholders has taken on great significance in prudent and ethical decision making. While a public corporation with thousands of shareholders obviously owes a duty to its shareholders to maximize shareholder wealth, corporate managers must also consider the interests of other important stakeholders, including employees, suppliers, customers, and the communities in which they live. Stakeholders also include society as a whole, which can be defined as narrowly as your country or more expansively as an economic union of countries, such as the European Union of 27 countries, or even the world as a whole. Not to be omitted from stakeholders is you, the decision maker who is also impacted by your decisions for your firm. The legitimacy of considering your own selfish interests will be considered fully in the Sixth Guideline. Listing all the stakeholders is not a goal by itself but helps the decision maker apply more completely other factors in the ethical Guidelines. Knowing whom your decision affects will help you find the facts you need. It also helps you evaluate the alternatives using the next three Guidelines: how the alternatives we have proposed impact society as a whole, your firm, and the decision maker.

How Do the Alternatives Impact Society as a Whole? We covered some aspects of this

Guideline earlier when we made an effort to discover all the facts that impact our decision. We can do a better job discovering the facts if we try to determine how our decision impacts society as a whole. For example, if the alternative we evaluate is keeping the factory in Sacramento after getting property tax and road building concessions from the City of Sacramento, how is society as a whole impacted? What effect will tax concessions have on the quality of Sacramento schools (most schools are funded with property taxes)? Will lower taxes

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cause the Sacramento infrastructure (roads and governmental services) to decline to the detriment of the ordinary citizen? Will the economic benefits to workers in Sacramento offset the harm to the economy and workers in Juarez? Will our firm’s receiving preferential concessions from the Sacramento government undermine the ordinary citizen’s faith in our political and economic institutions? Will we contribute to the feelings of some citizens that government grants privileges only to the powerful? Will our staying in Sacramento foster further economic growth in Sacramento? Will staying in Sacramento allow our suppliers to stay in business and continue to hire employees who will buy goods from groceries and malls in Sacramento? What impact will our decision have on efforts to create a global economy in which labor and goods can freely travel between countries? Will our decision increase international tension between the United States and Mexico? Note that the impact of our decision on society as a whole fits neatly with one of the ethical theories we discussed earlier: utilitarianism. Yet profit maximization, rights theory, and justice theory also require a consideration of societal impacts.

How Do the Alternatives Impact My Business Firm? The most obvious impact any alternative has on your firm is its effect on the firm’s bottom-line profitability. Yet that answer requires explaining because what you really want to know is what smaller things leading to profitability are impacted by an alternative. For example, if our decision is to keep the factory in ­Sacramento open temporarily and gradually move the plant to Juarez as retirements occur, what will happen to employee moral and productivity in Sacramento? Will our suppliers in Sacramento abandon us to serve more permanent clients instead? Will consumers in Sacramento and the rest of California boycott our televisions? Will they be able to convince other American laborers to boycott our TVs? Will a boycott generate adverse publicity and media coverage that will damage our brand name? Will investors view our firm as a riskier business, raising our cost of capital? Again, you can see some redundancy here as we work through the Guidelines, but that redundancy is all right because it ensures that we are examining all factors important to our decision.

How Do the Alternatives Impact Me, the Decision Maker? At first look, considering how a decision you make for your firm impacts you hardly seems to be a component of ethical and responsible decision making. The term selfish probably comes to mind.

Many of the corporate ethical debacles of the last few years comprised unethical and imprudent decisions that probably were motivated by the decision makers’ selfish interests. Mortgage brokers’ desires to earn large fees encouraged them to falsify borrowers’ financial status and to make imprudent loans to high-risk clients. Several of Enron’s off-balance-sheet partnerships, while apparently helping Enron’s financial position, lined the pockets of conflicted Enron executives holding stock options and receiving management fees from the partnerships. Despite these examples, merely because a decision benefits you, the decision maker, does not always mean it is imprudent or unethical. Even decisions by some Enron executives in the late 1990s, while motivated in part by the desire to increase the value of the executives’ stock options, could have been prudent and ethical if the off-balance-sheet partnerships had real economic value to Enron (as they did when Enron first created off-balance-sheet partnerships in the 1980s) and accounting for them complied with the law. At least two reasons explain why you can and should consider your own interest yet act ethically for your firm. First, as the decision maker, you are impacted by the decision. Whether deservedly or not, the decision maker is often credited or blamed for the success or failure of the course of action chosen. You may also be a stakeholder in other ways. For example, if you are an executive in the factory in Sacramento, you and your family may be required to move to Juarez (or El Paso, Texas, which borders Juarez) if the factory relocates. It is valid to consider a decision’s impact on you and your family, although it should not be given undue weight. A second, and more important, reason to consider your own interest is that your decision may be better for your firm and other stakeholders if you also consider your selfish interest. For example, suppose when you were charged to lead the inquiry into the firm’s decision whether to move to Juarez, it was made clear that the CEO preferred to close the Sacramento factory and move operations to Juarez. Suppose also that you would be required to move to Juarez. Your spouse has a well-paying job in Sacramento, and your teenage children are in a good school system and have very supportive friends. You have a strong relationship with your parents and siblings, who also live within 50 miles of your family in Sacramento. You believe that you and your family could find new friends and good schools in El Paso or Juarez, and the move would enhance your position in the firm and increase your chances of a promotion. Nonetheless, overall you and your spouse have determined that staying in the Sacramento area is best for your family. So you are considering quitting your job with the firm and finding another job in the Sacramento area rather than make an attempt to oppose the CEO’s preference.



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

If you quit your job, even in protest, you will have no role in the decision and your resignation will likely have no impact on the firm’s Sacramento–Juarez decision. Had you stayed with the firm, you could have led a diligent inquiry into all the facts that may have concluded that the prudent and ethical decision for the firm was to stay in Sacramento. Without your input and guidance, the firm may make a less prudent and ethical decision. You can think of other examples where acting selfishly also results in better decisions. Suppose a top-level accounting executive, to whom you are directly responsible, has violated accounting standards and the law by pressuring the firm’s auditors to book as income in the current year a contract that will not be performed for two years. You could quit your job and blow the whistle, but you may be viewed as a disgruntled employee and your story given no credibility. You could confront the executive, but you may lose your job or at least jeopardize your chances for a promotion while tipping off the executive, who will cover her tracks. As an alternative, the more effective solution may be to consider how you can keep your job and prospects for promotion while achieving your objective to blow the whistle on the executive. One alternative may be to go through appropriate channels in the firm, such as discussing the matter with the firm’s audit committee or legal counsel. Finding a way to keep your job will allow you to make an ethical decision that benefits your firm, whereas your quitting may leave the decision to someone else who would not act as prudently. The bottom line is this: While, sometimes, ethical conduct requires acting unselfishly, in other contexts, consideration of your self-interest is not only consistent with ethical conduct, but also necessary to produce a moral result.

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employees and other citizens of Sacramento. Another benefit of the move may be the reduced cost of the U.S. government dealing with illegal immigration as Mexican workers decide to work at our plant in Juarez. Another cost may be the increased labor cost for a Texas business that would have hired Mexican workers had we not hired them. If we define society as all countries in the North American Free Trade Agreement (NAFTA was signed by the United States, Mexico, and Canada), the benefit to workers in Juarez may completely offset the harm to workers in Sacramento. For example, the benefit to Juarez workers may be greater than the harm to Sacramento employees if many Juarez employees would otherwise be underemployed and Sacramento employees can find other work or are protected by a severance package or retirement plan. As we discussed earlier in the discussion of ethical theories, finding and weighing all the benefits and costs of an alternative are difficult tasks. Even if we reject this theory as the final determinant, it is a good exercise for ensuring that we maximize the number of facts we consider when making a decision.

What Would Someone Focused on Maximizing Profits Do? One following traditional shareholder theory and its emphasis on profit maximization would choose the alternative that produces the most long-run profits for the company, within the limits of the law. This may mean, for example, that the firm should keep the factory in Sacramento if that will produce the most profits for the next 10 to 15 years. This does not mean that the firm may ignore the impact of the decision on Juarez’s community and workers. It may be that moving to Juarez will create a more affluent population in Juarez and consequently increase the firm’s What Are the Ethics of Each Alternative?  television sales in Juarez. But that impact is judged not by Because our goal is to make a decision that is not only whether society as a whole is bettered (as with utilitarian prudent for the firm, but also ethical and defensible in the analysis) or whether Juarez workers are more deserving of event we are required to give an accounting for our actions, jobs (as with justice theory analysis), but is solely judged by we must consider the ethics of each alternative, not from how it impacts the firm’s bottom line. one but a variety of ethical viewpoints. Our stakeholders’ Nonetheless, profit maximization may compel a devalues comprise many ethical theories; ignoring any one cision maker to consider stakeholders other than the theory will likely cause an incomplete consideration of the corporation and its shareholders. A decision to move to issues and may result in unforeseen, regrettable outcomes. Juarez may mobilize American consumers to boycott our TVs, for example, or cause a public relations backlash if What Would a Utilitarian Do? A utilitarian would choose our Juarez employees receive wages far below our Sacrathe alternative that promises the highest net welfare to socimento workers. These and other impacts on corporate ety as a whole. If we define our society as the United States, stakeholders may negatively impact the firm’s profits.  moving to Juarez may nonetheless produce the highest Although projecting profits is not a precise science, net benefit because the benefits to American citizens from tools you learned in finance classes should enhance your a lower cost of televisions and to American shareholders ability to select an alternative that maximizes your firm’s from higher profits may more than offset the harm to our profits within the limits of the law.

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What Would a Rights Theorist Do? A follower of modern rights theory will determine whether anyone’s rights are negatively affected by an alternative. If several rights are affected, the rights theorist will determine which right is more important or trumps the other rights, and choose the alternative that respects the most important right. For example, if the alternative is to move to Juarez, the Sacramento employees, among others, are negatively affected. Yet if we do not move, potential employees in Juarez are harmed. Are these equal rights a mere wash, or is it more important to retain a job one already has than to be deprived of a job one has never had? Are other rights at work here, and how are they ranked? Is it more important to maintain manufacturing production in the firm’s home country for national security and trade balance reasons than to provide cheaper televisions for the firm’s customers? Does the right of all citizens to live in a global economy that spreads wealth worldwide and promotes international harmony trump all other rights? While apparently difficult to identify and rank valid rights, this theory has value even to a utilitarian and a profit maximizer. By examining rights that are espoused by various stakeholders, we are more likely to consider all the costs and benefits of our decision and know which rights can adversely affect the firm’s profitability if we fail to take them into account. What Would a Justice Theorist Do? A justice theorist would choose the alternative that allocates society’s benefits and burden most fairly. This requires the decision maker to consider whether everyone is getting what he deserves. If we follow the preaching of John Rawls, the firm should move to Juarez if the workers there are less advantaged than those in Sacramento, who may be protected by savings, severance packages, and retirement plans. If we follow Nozick’s libertarian approach, it is sufficient that the firm gives Sacramento workers an opportunity to compete for the plant by matching the offer the firm has received from Juarez workers. Under this analysis, if Sacramento workers fail to match the Juarez workers’ offer of lower wages, for example, it would be fair to move the factory to Juarez, even if Sacramento workers are denied their right to jobs. Even if the firm has difficulty determining who most deserves jobs with our firm, justice theory, like rights theory, helps the firm identify constituents who suffer from our decision and who can create problems impacting the firm’s profitability if the firm ignores their claims. What Does Virtue Theory Require? Virtue theory requires the decision maker to review those personal or

corporate virtues and values that are essential to the individual’s or organization’s flourishing. This approach acknowledges the fact that all business is communal and requires individuals working together in an effort to realize the good life. Virtue theory, therefore, would prompt decision makers to ask what decision is consistent with the corporate identity or character they wish to cultivate.  Practically speaking, this would involve revisiting the corporate statement of values and considering seriously what impact closing the Sacramento facility would have on the corporate culture internally and externally—that is, in terms of reputation in the market—and whether this impact is consistent with the pursuit of excellence in terms of those predetermined corporate values. Again, as noted earlier, this analysis is potentially more ambiguous than a mere determination of what maximizes profits or what produces an overall most efficient allocation of utility, but it does ensure reflection on the implications for a corporation or individual who wants to take seriously a commitment to integrity.  

What Are the Practical Constraints of Each Alternative? As we evaluate alternatives, it

is important to consider each alternative’s practical problems before we implement it. For example, is it feasible for us to implement an alternative? Do we have the necessary money, labor, and other resources? Suppose one alternative is to maintain our manufacturing plant in Sacramento as we open a new plant in Juarez, gradually shutting down the Sacramento plant as employees retire and quit. That alternative sounds like an ethical way to protect the jobs of all existing and prospective employees, but what are the costs of having two plants? Will the expense make that alternative infeasible? Will the additional expense make it difficult for the firm to compete with other TV manufacturers? Is it practicable to have a plant in Sacramento operating with only five employees who are 40 years old and will not retire for 15 years? It is also necessary to consider potential problems with the facts that have led us to each alternative. Did we find all the facts relevant to our decision? How certain are we of some facts? For example, are we confident about our projections of labor and transportation costs if we move to Juarez? Are we sure that sales of our products will drop insubstantially due to consumer boycotts?

What Course of Action Should Be Taken and How Do We Implement It? Ultimately, we

have to stop our analysis and make a decision by choosing one alternative. Yet even then our planning is not over. We must determine how to put the alternative into action. How do we implement it? Who announces the



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

decision? Who is told of the decision and when? Do some people, like our employee’s labor union, receive advance notice of our plans and have an opportunity to negotiate a better deal for our Sacramento employees? When do we tell shareholders, government officials, lenders, suppliers, investments analysts, and the media, and in what order? Do we antagonize a friend or an enemy and risk killing a deal if we inform someone too soon or too late? Finally, we have to prepare for the worst-case scenario. What do we do if, despite careful investigation, analysis, and planning, our course of action fails? Do we have backup plans? Have we anticipated all the possible ways our plan may fail and readied responses to those failures? In 1985, the Coca-Cola Company decided to change the flavor of Coke in response to Coke’s shrinking share of the cola market. Despite careful market research, Coca-Cola failed to anticipate Coke drinkers’ negative response to the new Coke formula and was caught without a response to the outcry. Within three months, Coca-Cola realized it had to revive the old Coke formula under the brand name Coca-Cola Classic. In the meantime, Coke lost significant market share to rival Pepsi. Today, one would expect Coke executives introducing a reformulated drink to predict more consumers’ reactions to the drink and to prepare a response to each reaction.

Knowing When to Use the Guidelines  You can probably see that following these factors will result in better decisions in a variety of contexts, including some that appear to have no ethical concerns. For example, in the next few years, most of you will consider what major course of study to select at college or what job to take with which firm in which industry. This framework can help you make a better analysis that should result in a better decision. The Guidelines can be used also to decide mundane matters in your personal life, such as whether to eat a high-fat hamburger or a healthful salad for lunch, whether to spend the next hour exercising at the gym or visiting a friend in the hospital, and whether or not to brush your teeth every day after lunch. But for most of us, using the Guidelines every day for every decision would occupy so much of our time that little could be accomplished, what is sometimes called “paralysis by analysis.” Practicality, therefore, requires us to use the Guidelines only for important decisions and those that create a potential for ethical problems. We can identify decisions requiring application of the Guidelines if we carefully reflect from time to time about what we have done and are doing. This requires us to examine our past, current, and future actions. It may not surprise you how seldom people, including business executives, carefully preview and review their

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actions. The pressures and pace of daily living give us little time to examine our lives critically. Most people are reluctant to look at themselves in the mirror and ask themselves whether they are doing the right thing for themselves, their families, their businesses, and their communities. Few know or follow the words of Socrates, “The unexamined life is not worth living.” Ask yourself whether you believe that mortgage brokers used anything like the Guidelines for Ethical Decision Making before signing low-income borrowers to loans exceeding $500,000. Did executives at bankrupt energy trader Enron consider any ethical issues before creating off-balance-sheet partnerships with no economic value to Enron? Do you think the employees at accounting firm Arthur Andersen carefully examined their decision to accept Enron’s accounting for off-balance-sheet partnerships? Merely by examining our past and prospective actions, we can better know when to apply the Guidelines. In the next to last section of this chapter, Resisting Requests to Act Unethically, you will learn additional tools to help you identify when to apply the Guidelines.

LOG ON Go to www.scu.edu/ethics This website maintained by the Markkula Center for Applied Ethics at the University of Santa Clara has links to business ethics resources and guides for ethical/moral decision making.

Thinking Critically Legal reasoning and ethical decision making both require one to think critically—that is, to evaluate arguments logically, honestly, and without bias in favor of your own arguments and against those of others. Thinking critically is a skill, and as with any skill, one can improve through greater awareness of common mistakes and intentional practice of those methods that will lead to improvement. LO4-3

Recognize critical thinking errors in your own and others’ arguments.

Even if someone uses the Guidelines for Ethical Decision Making, there is a risk that they have been misapplied if a person makes errors of logic or uses fallacious arguments. In this section, we want to help you identify when your arguments and thinking may be flawed and how to correct them. Equally important, we want to help you

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identify flaws in others’ thinking. The purpose is to help you think critically and not to accept at face value everything you read or hear and to be careful before you commit your arguments to paper or voice them. This chapter’s short coverage of critical thinking covers only a few of the errors of logic and argument that are covered in a college course or book devoted to the subject. Here are 15 common fallacies and errors in reasoning that, if learned, can help you become a more rigorous and careful thinker.

Non Sequiturs A non sequitur is a conclusion that

does not follow from the facts or premises one sets out. The speaker is missing the point or coming to an irrelevant conclusion. For example, suppose a consumer uses a corporation’s product and becomes ill. The consumer argues that because the corporation has lots of money, the corporation should pay for his medical expenses. Clearly, the consumer is missing the point. The issue is whether the corporation’s product caused his injuries, not whether money should be transferred from a wealthy corporation to a poor consumer. You see this also used when employees attempt to justify stealing pens, staplers, and paper from their employers. The typical non sequitur goes like this: “I don’t get paid enough, so I’ll take a few supplies. My employer won’t even miss them.” Business executives fall prey to this fallacy also. Our firm may consider which employees to let go during a downturn. Company policy may call for retaining the best employees in each department, yet instead we release those employees making the highest salary in each position in order to save more money. Our decision does not match the standards the company set for downsizing decisions and is a non sequitur, unless we admit that we have changed company policy.

Appeals to Pity A

common fallacy seen in the American press is the appeal to pity or compassion. This argument generates support for a proposition by focusing on a victim’s predicament. It usually is also a non sequitur. Examples are news stories about elderly, retired people who find it hard to afford expensive, life-prolonging drugs. None of these stories point out that many of these people squandered their incomes when working rather than saving for retirement. Appeals to pity are effective because humans are compassionate. We have to be careful, however, not to be distracted from the real issues at hand. For example, in the trial against accused 9/11 co-conspirator Zacarias Moussaoui, federal prosecutors wanted to introduce testimony by the families of the victims. While what the families of

9/11 suffered is terrible, the victims’ families hold no evidence of Moussaoui’s role in 9/11. Instead, their testimonies are appeals to pity likely to distract the jury from its main task of determining whether Moussaoui was a part of the 9/11 conspiracy. American presidents and other politicians often use appeals to pity, such as having a press conference with children behind the president while he opines about income inequality. Moreover, you see many appeals to pity used against corporations. Here is a typical argument: A corporation has a chemical plant near a neighborhood; children are getting sick and dying in the neighborhood; someone should pay for this suffering; the corporation should pay. You can also see that this reasoning is a non sequitur. Better reasoning requires one to determine not whether two events are coincidental or correlated, but whether one (the chemical plant) caused the other (the children’s illnesses).

False Analogies An analogy essentially argues that

because something is like something else in one or more ways, it is also like it in another respect. Arguers often use analogies to make a point vividly, and therefore analogies have strong appeal. Nonetheless, while some analogies are apt, we should make sure that the two situations are sufficiently similar to make the analogy valid. Suppose an executive argues that our bank should not make loans to lower-income borrowers because the bank will suffer huge losses like Countrywide Financial. This analogy may be invalid because we may do a better job verifying a borrower’s income and ability to repay a loan than did Countrywide. Analogies can also be used to generate support for a proposal, such as arguing that because Six Sigma worked for General Electric, it will work for our firm also. It is probable that factors other than Six Sigma contributed to GE’s success, factors our firm may or may not share with GE. Nonetheless, analogies can identify potential opportunities, which we should evaluate prudently to determine whether the analogy is valid. Analogies can also suggest potential problems that require us to examine a decision more carefully before committing to it.

Begging the Question An arguer begs the ques-

tion when she takes for granted or assumes the thing that she is setting out to prove. For example, you might say that we should tell the truth because lying is wrong. That is circular reasoning and makes no sense because telling the truth and not lying are the same things. Another example is arguing that democracy is the best form of government because the majority is always right. Examples of begging the question are difficult to identify sometimes because they are hidden in the language of



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

the speaker. It is best identified by looking for arguments that merely restate what the speaker or questioner has already stated, but in different words. For an example in the business context, consider this interchange between you and someone working under you. You: Can I trust these numbers you gave to me? Coworker: Yes, you can trust them. You: Why can I trust them? Coworker: Because I’m an honest person. The coworker used circular reasoning because whether the numbers can be trusted is determined by whether he is honest, yet he provided no proof of his honesty, such as his numbers being backed by facts.

Argumentum ad Populum Argumentum

ad populum means argument to the people. It is an emotional appeal to popular beliefs, values, or wants. The fallacy is that merely because many or all people believe something does not mean it is true. It is common for newspapers to poll its readers about current issues, such as support for a presidential decision. For example, a newspaper poll may show that 60 percent of Americans support the president. The people may be right, but it is also possible that the president’s supporters are wrong: They may be uninformed or base their support of the president on invalid reasoning. Arguments to the people are commonly used by corporations in advertisements, such as beer company ads showing friends having a good time while drinking beer. The point of such ads is that if you want to have a good time with friends, you should drink beer. While some beer drinkers do have fun with friends, you probably can also point to other people who drink beer alone.

Bandwagon Fallacy The

bandwagon fallacy is similar to argumentum ad populum. A bandwagon argument states that we should or should not do something merely because one or more other people or firms do or do not do it. Sports Illustrated quoted basketball player Diana Taurasi’s objection to being arrested for driving drunk: “Why me? Everyone drives drunk!” Some people justify cheating on their taxes for the same reason. This reasoning can be fallacious because probably not everyone is doing it, and even if many or all people do something, it is not necessarily right. For example, while some baseball players do use steroids, there are serious negative side effects including impotency and acute psychosis, which make its use risky. Cheating on taxes may be common, but it is still illegal and can result in the cheater’s imprisonment. Bandwagon thinking played a large part in the current credit crunch as many loan buyers like Bear Stearns bought

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high-risk loans only because their competitors were buying the loans, thereby encouraging lenders to continue to make high-risk loans.

Argumentum ad Baculum Argumentum

ad baculum means argument to club. The arguer uses threats or fear to bolster his position. This is a common argument in business and family settings. For example, when a parent asks a child to take out the garbage, the child may ask, “Why?” Some parents respond, “Because if you don’t, you’ll spend the rest of the afternoon in your room.” Such an argument is a non sequitur as well. In the business context, bosses explicitly and implicitly use the club, often generating support for their ideas from subordinates who fear they will not be promoted unless they support the boss’s plans. An executive who values input from subordinates will ensure that they do not perceive that the executive is wielding a club over them. Enron’s CFO Andrew Fastow used this argument against investment firm Goldman Sachs when it balked at lending money to Enron. He told Goldman that he would not do anything with a presentation Goldman had prepared unless it made the loan. By threatening to boycott a company’s products, consumers and other interest groups use this argument against corporations perceived to act unethically. It is one reason that profit maximization requires decision makers to consider a decision’s impact on all stakeholders.

Argumentum ad Hominem Argumentum ad ho-

minem means “argument against the man.” This tactic attacks the speaker, not his reasoning. For example, a Republican senator criticizes a Democratic senator who supports the withdrawal of American troops from a war zone by saying, “You can’t trust him. He never served in the armed forces.” Such an argument attacks the Democratic senator’s character, not the validity of his reasons for withdrawing troops. When a CEO proposes a new compensation plan for corporate executives, an opponent may argue, “Of course he wants the new plan. He’ll make a lot of money from it.” Again, this argument doesn’t address whether the plan is a good one or not; it only attacks the CEO’s motives. While the obvious conflict of interest the CEO has may cause us to doubt the sincerity of the reasons he presents for the plan (such as to attract and retain better management talent), merely pointing out this conflict does not rebut his reasons. One form of ad hominem argument is attacking a speaker’s consistency, such as, “Last year you argued for something different.” Another common form is appealing to personal circumstances. One woman may say to another, “As a woman, how can you be against corporate policies that

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set aside executive positions for women?” By personalizing the argument, the speaker is trying to distract the listener from the real issue. A proper response to the personal attack may be, “As a woman and a human, I believe in equal opportunity for all people. I see no need for any woman or me to have special privileges to compete with men. I can compete on my own. By having quotas, the corporation cheapens my accomplishments by suggesting that I need the quota. Why do you, as a woman, think you need a quota?” Guilt by association is the last ad hominem argument we will consider. This argument attacks the speaker by linking her to someone unpopular. For example, if you make the libertarian argument that government should not restrict or tax the consumption of marijuana, someone may attack you by saying, “Mass murderer Charles Manson also believed that.” Your attacker suggests that by believing as you do, you are as evil as Charles Manson. Some corporate critics use guilt by association to paint all executives as unethical people motivated to cheat their corporations. For example, if a CEO asks for stock options as part of her compensation package, someone may say, “Enron’s executives wanted stock options also.” The implication is that the CEO should not be trusted because some Enron executives who were corrupt also wanted stock options. No ad hominem argument is necessarily fallacious because a person’s character, motives, consistency, personal characteristics, and associations may suggest further scrutiny of a speaker’s arguments is necessary. However, merely attacking the speaker does not expose flaws in her arguments.

Argument from Authority Arguments

from authority rely on the quality of an expert or person in a position of authority, not the quality of the expert’s or authority’s argument. For example, if someone says, “The president says we need to stop drug trafficking in the United States, and that is good enough for me,” he has argued from authority. He and the president may have good reasons to stop drug trafficking, but we cannot know that from his statement. Another example is “Studies show that humans need to drink 10 glasses of water a day.” What studies? What were their methodologies? Did the sample sizes permit valid conclusions? A form of argument to authority is argument to reverence or respect, such as “Who are you to disagree with the CEO’s decision to terminate 5,000 employees?” The arguer is trying to get you to abandon your arguments, not because they are invalid, but because they conflict with the views of an authority. Your response to this question should not attack the CEO (to call the CEO an idiot would be ad hominem and also damage your prospects in the firm), but state the reasons you believe the company would be better off not terminating 5,000 employees.

It is natural to rely on authorities who have expertise in the area on which they speak. But should we give credibility to authorities speaking on matters outside the scope of their competency? For example, does the fact that Julia Roberts is an Academy Award–winning actress have any relevance when she is testifying before Congress about Rett Syndrome, a neurological disorder that leaves infants unable to communicate and control body functions? Is she any more credible as a Rett Syndrome authority because she narrated a film on the Discovery Health Channel about children afflicted with the disease? This chapter includes several examples of arguments from authority when we cite Kant, Bentham, Aristotle, and others who have formulated ethical theories. What makes their theories valid, however, is not whether they are recognized as experts, but whether their reasoning is sound.

False Cause This fallacy results from observing two

events and concluding that there is a causal link between them when there is no such link. Often we commit this fallacy because we do not attempt to find all the evidence proving or disproving the causal connection. For example, if as a store manager you change the opening hour for your store to 6 A.M. from 8 A.M, records for the first month of operation under the new hours may show an increase in revenue. While you may be tempted to infer that the revenue increase is due to the earlier opening hour, you should not make that conclusion until at the very least you examine store receipts showing the amount of revenue generated between 6 A.M. and 8 A.M. The increase in revenue could have resulted from improved general economic conditions unconnected to the new hours: People just had more money to spend. The fallacy of false cause is important to businesses, which need to make valid connections between events in order to judge the effectiveness of decisions. Whether, for example, new products and an improved customer relations program increase revenues and profits should be subjected to rigorous testing, not some superficial causal analysis. Measurement tools you learn in other business classes help you eliminate false causes.

The Gambler’s Fallacy This

fallacy results from the mistaken belief that independent prior outcomes affect future outcomes. Consider this example. Suppose you flip a coin five times and each time it comes up heads. What is the probability that the next coin flip will be heads? If you did not answer 50 percent, you committed the gambler’s fallacy. Each coin flip is an independent event, so no number of consecutive flips producing heads will reduce the likelihood that the next flip will also be heads. That individual probability is true even though the probability of flipping six consecutive heads is 0.5 to the sixth power, or only 1.5625 percent.



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

What is the relevance of the gambler’s fallacy to business? We believe and are taught that business managers and professionals with higher skills and better decision-making methods are more likely to be successful than those with lesser skills and worse methods. Yet we have not discussed the importance of luck or circumstance to success. When a corporation has five years of profits rising by 30 percent, is it due to good management or because of expanding consumer demand or any number of other reasons? If a mutual fund has seven years of annual returns of at least 15 ­percent, is the fund’s manager an investment genius or is she lucky? If it is just luck, one should not expect the luck to continue. The point is that you should not be seduced by a firm’s, manager’s, or even your own string of successes and immediately jump to the conclusion that the successes were the result of managerial excellence. Instead, you should use measurement tools taught in your finance, marketing, and other courses to determine the real reasons for success.

Reductio ad Absurdum Reductio ad absurdum

carries an argument to its logical end, without considering whether it is an inevitable or probable result. This is often called the slippery slope fallacy. For example, if I want to convince someone not to eat fast food, I might argue, “Eating fast food will cause you to put on weight. Putting on weight will make you overweight. Soon you will weigh 400 pounds and die of heart disease. Therefore, eating fast food leads to death. Don’t eat fast food.” In other words, if you started eating fast food, you are on a slippery slope and will not be able to stop until you die. Although you can see that this argument makes some sense, it is absurd for most people who eat fast food. Scientist Carl Sagan noted that the slippery slope argument is used by both sides of the abortion debate. One side says, “If we allow abortion in the first weeks of pregnancy, it will be impossible to prevent the killing of a full-term infant.” The other replies, “If the state prohibits abortion even in the ninth month, it will soon be telling us what to do with our bodies around the time of conception.” Business executives face this argument frequently. Human resource managers use it to justify not making exceptions to rules, such as saying, “If we allow you time off to go to your aunt’s funeral, we have to let anyone off any time they want.” Well, no, that was not what you were asking for. Executives who reason this way often are looking for administratively simple rules that do not require them to make distinctions. That is, they do not want to think hard or critically. Pushing an argument to its limits is a useful exercise in critical thinking, often helping us discover whether a claim has validity. The fallacy is carrying the argument to its extreme without recognizing and admitting that there are many steps along the way that are more likely consequences.

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Appeals to Tradition Appeals to tradition infer

that because something has been done a certain way in the past, it should be done the same way in the future. You probably have heard people say, “I don’t know why we do it, but we’ve always done it that way, and it’s always worked, so we’ll continue to do it that way.” Although there is some validity to continuing to do what has stood the test of time, the reasons a business strategy has succeeded in the past may be independent of the strategy itself. The gambler’s fallacy would suggest that perhaps we have just been lucky in the past. Also, changed circumstances may justify departing from previous ways of doing business. In November 2013, many retailers like Kmart, Walmart, Sears, and The Gap were criticized for opening their retail stores on Thanksgiving Day. Arguments against the openings were mostly appeals to tradition and to pity, that is, that workers in the past have been and should in the future be able to enjoy Thanksgiving Day with family instead of working. The arguments were also non sequiturs because critics of the openings continued to consume sports programming, TV shows, electricity, heat, gasoline, and other services provided by employees working on Thanksgiving Day.

The Lure of the New The opposite of an appeal

to tradition is the lure of the new, the idea that we should do or buy something merely because it is “just released” or “improved.” You see this common theme in advertising that promotes “new and improved” Tide or iPhone 11. Experience tells us that sometimes new products are better. But we can also recount examples of new car models with defects and new software with bugs that were fixed in a later version. The lure of the new is also a common theme in management theories as some managers have raced to embrace one new craze after another, depending on which is the hottest fad, be it Strategic Planning, Total Quality Management, Reengineering the Corporation, or Customer Relationship Management. The point here is the same. Avoid being dazzled by claims of newness. Evaluations of ideas should be based on substance.

Sunk Cost Fallacy The sunk cost fallacy is an at-

tempt to recover invested time, money, and other resources by spending still more time, money, or other resources. It is sometimes expressed as “throwing good money after bad.” Stock market investors do this often. They invest $30,000 in the latest tech stock. When the investment declines to $2,000, rather than evaluate whether it is better to withdraw that $2,000 and invest it elsewhere, an investor who falls for the sunk cost fallacy might say, “I can’t stop investing now, otherwise what I’ve invested so far will be lost.” While the latter part of the statement is true, the fallacy is in the first part. Of the money already invested, $28,000 is lost whether

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or not the investor continues to invest. If the tech stock is not a good investment at this time, the rational decision is to withdraw the remaining $2,000 and not invest more money. There are other statements that indicate business executives may fall victim to the sunk cost fallacy: “It’s too late for us to change plans now.” Or “If we could go back to square one, then we could make a different decision.” The best way to spend the firm’s remaining labor and money may be to continue a project. But that decision should be unaffected by a consideration of the labor and money already expended. The proper question is this: What project will give the firm the best return on its investment of money and other resources from this point forward? To continue to invest in a hopeless project is irrational and may be a pathetic attempt to delay having to face the consequences of a poor decision. A decision maker acts irrationally when he attempts to save face by throwing good money after bad. If you want a real-world example of ego falling prey to the sunk cost fallacy, consider that President Lyndon Johnson committed American soldiers to the Vietnam Conflict after he had determined that America and South Vietnam could never defeat the Viet Cong. By falling for the sunk cost fallacy, the United States lost billions of dollars and tens of thousands of soldiers in the pursuit of a hopeless cause.

LOG ON Go to www.fallacyfiles.org Maintained by Gary Curtis, The Fallacy Files cover more than 150 fallacies with links to explanations and valuable resources. Go to www.ethicsunwrapped.utexas.edu Ethics Unwrapped uses a fun and accessible video format to present the latest research from psychology, neuroscience, and behavioral economics explaining how biases and pressures can cloud our thinking and compromise our ethical decision making.

Common Characteristics of Poor Decision Making Most business managers during the course of their formal education in school or informal education on the job have learned most of the techniques we have discussed in this chapter for making ethical and well-reasoned decisions. Yet business managers continue to make unethical and poor decisions, most often in disregard of the very principles that they otherwise view as essential to good decision making. Each of us can also point to examples when we have failed to analyze a situation properly before making a decision, even though, at the time, we possessed the ability to make better decisions.

Why do we and other well-intentioned people make bad decisions? What is it that interferes with our ability to use all the decision-making tools at our disposal, resulting sometimes in unethical and even catastrophic decisions? What causes a basically honest accountant to agree to cook the books for his corporation? What causes a drug company to continue to market a drug when internal tests and user experience show a high incidence of harmful side effects? What causes a corporation to continue to operate a chemical plant when its safety systems have been shut down? While business scholars and other writers have suggested several attributes that commonly interfere with good decision making, we believe they can be distilled into three essential traits that are useful to you, a decision maker who has already learned the Guidelines for Ethical Decision Making and the most common critical thinking errors.

Failing to Remember Goals Friedrich

Nietzsche wrote, “Man’s most enduring stupidity is forgetting what he is trying to do.” If, for example, our company’s goal as a retailer is to garner a 30 percent market share in the retail market in five years, you may think that would translate into being dominant in each segment of our business, from housewares to video games. But should our retailer strive to dominate a market segment that is declining, such as portable cassette players, when the consumer market has clearly moved to smartphones and other digital recorders? If we focus on the wrong goal—dominating the cassette player market, which may not exist in five years—we have failed to remember our goal of acquiring a 30 percent overall market share. In another example, suppose we are a luxury homebuilder with two goals that go hand-in-hand: producing high-quality housing and maintaining an annual 15 percent return on equity. The first goal supports the second goal: By having a reputation for producing high-quality housing, we can charge more for our houses. Suppose, however, one of our project managers is under pressure to bring her development in line with cost projections. She decides, therefore, to use lower-quality, lower-cost materials. The consequence is we meet our profit target in the short run, but in the long run, when the shoddy materials are detected and our reputation is sullied, both of our goals of building high-quality housing and achieving a 15 percent return on equity will be compromised. Again, we have failed to remember the most important goal, maintaining high quality, which allowed us to achieve our ROE goal.

Overconfidence The

phenomenon known as overconfidence bias leads us to be more confident than we should be about the extent of our knowledge and our problem-solving skills. To the extent that this “been there, done that” mindset takes hold in a leader, her ability to



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

learn helpful lessons from the experiences of others may be compromised. In the realm of ethical decision making, the leader who thinks she has mastered everything important and has nothing more to learn may end up teaching those in the organization unfortunate lessons and may unknowingly influence the organization’s culture in an undesirable way. While confidence is a personal trait essential to success, overoptimism is one of the most common reasons for bad decisions. We all have heard ourselves and others say, “Don’t worry. Everything will work out OK.” That statement is likely a consequence of overconfidence, not careful analysis that is necessary to make sure everything will work out as we hope. There are several corollaries or other ways to express this overoptimism. Sometimes, business executives will do something that they know to be wrong with the belief that it is only a small or temporary wrong that will be fixed next year. They may rationalize that no one will notice the wrongdoing and that only big companies and big executives get caught, not small companies and little managers like them. Many major accounting scandals started small, rationalized as temporary attempts to cook the books that would be corrected in the following years when business turned around. As we now know, finance managers and accountants who thought things would turn around were being overconfident about the economy and their companies. Another aspect of overconfidence is confirmation bias; that is, we must be doing things the right way because all has gone well in the past. Or at least we have not been caught doing something wrong in the past, so we will not be caught in the future. In part, this reveals a thinking error we have studied: appeal to tradition. In the earlier homebuilder example, the project manager’s cutting quality in years past may not have been detected by homeowners who knew nothing about construction quality. And none of the project manager’s workers may have told top management about the project manager’s actions. That past, however, does not guarantee the future. New homeowners may be more knowledgeable, and future workers may inform management of the project manager’s quality-cutting actions.  If we are not careful, confirmation bias can also cause us to see what we want to see in a given situation and to engage in subconscious favorable spinning of potentially relevant facts even if those facts might fairly be treated as pointing in the other direction. Confirmation bias can cause us to miss the real lessons from an example that we think we are viewing objectively. To guard against the negative effects of confirmation bias and to learn as much as we can from an example or situation, we need to seek out and pay attention to possible disconfirming evidence: evidence indicating that our preferred position or view may not be correct.  

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Another consequence of overoptimism is believing that complex problems have simple solutions. That leads to the next common trait of bad decision making.

Complexity of the Issues Closely

aligned to and aggravated by overconfidence is the failure of decision makers to understand the complexity of an issue. A manager may perceive that the facts are simpler than reality and, therefore, not see that there is little margin for error. Consequently, the executive has not considered the full range of possible solutions and has failed to find the one solution that best matches the facts. Restated, the decision maker has not done all the investigation and thinking required by the Guidelines for Ethical Decision Making and, therefore, has not discovered all the facts and considered all the reasonable courses of action necessary to making a prudent decision. The impediments to knowing all the facts, understanding the complexity of a problem, and doing the hard work to create and evaluate all possible solutions to a problem are known to all of us. Fatigue, laziness, overconfidence, and forgetting goals play roles in promoting ignorance of critical facts. We may also want to be team players, by following the lead of a colleague or the order of a boss. These human tendencies deter us from making the effort to find the facts and to consider all options.

Resisting Requests to Act Unethically Even if we follow the Guidelines for Ethical Decision Making and avoid the pitfalls of fallacious reasoning, not everyone is a CEO or his own boss and able to make decisions that others are expected to follow. Sure, if you control a firm, you will do the right thing. But the reality is that for most people in the business world, other people make many decisions that you are asked to carry out. What do you do when asked to do something unethical? How can you resist a boss’s request to act unethically? What could employees at WorldCom have done when its CFO instructed them to falsify the firm’s books or mortgage brokers when their bosses asked them to falsify borrowers’ incomes? LO4-4

Utilize a process to make ethical decisions in the face of pressure from others.

Recognizing Unethical Requests and Bosses A person must recognize whether he has been asked to do something unethical. While this sounds simple considering we have spent most of this chapter helping you

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make just that kind of decision, there are structural problems that interfere with your ability to perform an ethical analysis when a boss or colleague asks you to do something. Many of us are inclined to be team players and “do as we are told” by a superior. Therefore, it is important to recognize any tendency to accept appeals to authority and to resist the temptation to follow orders blindly. We do not want to be like the Enron accounting employee who returned to his alma mater and was asked by a student, “What do you do at Enron?” When considering that question, a question he never posed to himself, he realized that his only job was to remove liabilities from Enron’s balance sheet. For most bosses’ orders, such an analysis will be unnecessary. Most of the time, a boss is herself ethical and will not ask us to do something wrong. But there are exceptions that require us to be on the lookout. Moreover, some bosses have questionable integrity, and they are more likely to give us unethical orders. Therefore, it will be helpful if we can identify bosses who have shaky ethics, for whom we should put up our ethical antennae when they come to us with a task. Business ethicists have attempted to identify executives with questionable integrity by their actions. Ethical bosses have the ability to “tell it like it is,” while those with less integrity say one thing and do another. Ethical bosses have the ability to acknowledge that they have failed, whereas those with low integrity often insist on being right all the time. Ethical bosses try to build a consensus before making an important decision; unethical bosses may generate support for their decisions with intimidation through anger and threats. Ethical bosses can think about the needs of others besides themselves. Bosses with low integrity who misuse their workers by asking them to act unethically often mistreat other people also, like secretaries and servers. If we pay attention to these details, we will be better able to consider the “source” when we are asked to do something by a boss and, therefore, more sensitive to the need to scrutinize the ethics of a boss’s request.

Buying Time If

we think a requested action is or might be unethical, what is done next? How can we refuse to do something a boss has ordered us to do? One key is to buy some time before you have to execute the boss’s order. Buying time allows you to find more facts, understand an act’s impact on the firm’s stakeholders, and evaluate the ethics of the action. It also lets you find other alternatives that achieve the boss’s objectives without compromising your values. Delay also gives you time to speak with the firm’s ethics officer and other confidants. How do you buy time? If the request is in an e-mail, you might delay responding to it. Or you could answer that you

have received the e-mail and will give your attention to it when you finish with the task you are working on. Similar tactics can be used with phone calls and other direct orders. Even a few hours can help your decision. Depending on the order and your ability to stack delay on top of delay, you may be able to give yourself days or weeks to find a solution to your dilemma. The most important reason for buying time is it allows you to seek advice and assistance from other people, especially those in the firm. That brings us to the next tactic for dealing with unethical requests.

Find a Mentor and a Peer Support Group  Having a support system is one of the most important keys to survival in any organization, and it is best to put a system in place when you start working at the firm. Your support system can improve and help defend your decisions. It can also give you access to executives who hold the power to overrule your boss. Your support system should include a mentor and a network of other employees with circumstances similar to your own. A mentor who is well established, well respected, and highly placed in the firm will help you negotiate the pitfalls that destroy employees who are ignorant of a firm’s culture. A mentor can be a sounding board for your decisions; she can provide information on those who can be expected to help you and those who could hurt you; she can advise you of the procedures you should follow to avoid antagonizing potential allies. A mentor can also defend you and provide protection when you oppose a boss’s decision. Many firms have a mentorship program, but if not or if your assigned mentor is deficient, you should find an appropriate mentor soon after you join the firm. Be sure to keep her updated regularly on what you are doing. By letting a mentor know that you care to keep her informed, she becomes invested in you and your career. You should also build a community of your peers by creating a network of other workers who share your values and interests. You may want to find others who joined the firm at about the same time you did, who are about the same age, who share your passion for the firm’s products and services, and who have strong ethical values. To cement the relationship, your peer support group should meet regularly, such as twice a week at work during 15-minute coffee breaks. This group can give you advice, help with difficult decisions, and unite to back up your ethical decisions.

Find Win–Win Solutions As

we learned from the Guidelines for Ethical Decision Making, many times there are more than the two options of doing and not doing something. There are a number of choices in between those



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

extremes, and the best solution may be one unconnected to them. For example, suppose your boss has ordered you to fire someone who works under you. The worker’s productivity may be lagging, and perhaps he has made a few costly mistakes. Yet you think it would be wrong to fire the worker at this time. What do you do? Find a win–win solution—that is, a compromise that works for you and your boss. First, discover your boss’s wants. Probably you will find that your boss wants an employee who makes no or few mistakes and has a certain level of productivity. Next determine what is needed for the affected employee to reach that level. If you find the employee is having emotional problems that interfere with his work, are they temporary or can we help him handle them? Can we make him more productive by giving him more training? Is the employee unmotivated or is he unaware that he lags behind other workers? Should we give him a warning and place him on probationary status for a month, releasing him if there is no satisfactory improvement? These alternatives may address your boss’s concerns about the employee without compromising your ethical values. In other contexts, you may need to approach your boss directly and show that her order is not right for the firm. Using the Guidelines for Ethical Decision Making and

valid arguments, you may be able to persuade your boss to accept your perspective and avoid an otherwise unethical decision. Finding a win–win solution is possible only when there is room for compromise. The Ethical Guidelines and logical arguments are effective when your boss respects reason and wants to act ethically. However, when you face an intractable executive demanding you do something illegal, a different response is needed.

Work within the Firm to Stop the Unethical Act Suppose you receive an order from an executive you

know or suspect to be corrupt. For example, a CFO is motivated to increase the price of the firm’s stock in order to make her stock options more valuable. She orders you to book in the current year revenue that, in fact, will not be received for at least two years, if ever. Booking that revenue would be fraudulent, unethical, and illegal. You are convinced the CFO knows of the illegality and will find someone else to book the revenue if you refuse. You probably will lose your job if you do not cooperate. What do you do? This is when your mentor, peer support group, and corporate ethics officer can help you. Your mentor may have access to the CEO or audit committee, who, if honest, should back you and fire the CFO. Your peer support group might

CONCEPT REVIEW Resisting Requests to Do Unethical Acts

Buy Time

Have a Mentor

Recognize Unethical Requests

Find Win–Win Solutions

Create a Peer Support Group

YOU

Work within the Firm to Stop Unethical Acts

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Consult the Firm's Ethics Officer

Be Willing to Lose Your Job

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have similar access. The corporate ethics officer, especially if she is a lawyer in the firm’s legal department, can also provide her backing and that of the legal department. There is one large caveat, however. While the situation just described should and probably will result in your support system rallying to your support, in other situations that are ethically ambiguous, you, your mentor, and your support group may find that fighting a battle against a top corporate executive ineffectively expends your and your colleagues’ political capital. In other words, you need to pick your battles carefully lest you and your colleagues at the firm be labeled whiners and troublemakers who unnecessarily seek intervention from higher-level corporate executives. This is why we have listed this alternative near the end of our discussion. In most situations, it is better to rely on your colleagues as advisors and to execute win–win solutions in cooperation with your boss. But if neither compromise nor other intrafirm tactics protect you from unethical requests, you are left with a final tactic.

Prepare to Lose Your Job This is the last tactic

because by quitting or losing your job, you are deprived of your ability to help the firm make ethical decisions. Only as an employee can you craft win–win solutions or work within the firm to do the right thing. But if a firm’s executives and its internal governance are so corrupted that neither compromise nor reason can steer the firm away from an unethical and illegal course, you must be willing to walk away from your job or be fired for standing up for your values. Do not want your job and the status it brings so much that you are willing to compromise more important values. It is tough losing a job when one has obligations to family, banks, and other creditors as well as aspirations for a better life. But if you prepare yourself financially from day one, putting away money for an ethical rainy day, you will protect more important values.

Leading Ethically The examples set by an organization’s leaders have a profound effect on the culture of an organization. If the examples are good, a healthy culture can result. But if the examples reflect little seriousness about ethics, a cornercutting culture may follow. Someday, perhaps today, you will be in charge of other people in your business organization. You may be managing a four-person team, you may be a vice president of marketing in charge of a department, or you may eventually be a CEO directing an entire company. You give the people under your charge tasks to complete, supervise their work, help them complete the tasks, and provide motivation and

feedback to ensure that the current job will be done well and that future work will be done better. So how do you also ensure that all those people under your charge act ethically? This is the daily challenge of ethical business leaders, who must not only act ethically themselves, but also promote ethical behavior of their workers.

Be Ethical LO4-5 Be an ethical leader.

No one can lead ethically who does not attempt—and mostly succeed—in behaving ethically in her business and personal life. Few underlings respect an unethical leader, and many will be tempted to rationalize their own unethical conduct when they see their leaders acting unethically. They fall prey to the bandwagon fallacy, arguing, for example, that because the CFO is doing something wrong, so may they. For the same reason, ethical behavior by good managers encourages ethical behavior by underlings, who often view their bosses as role models and guides for advancing in the corporation. If they see an ethical boss moving up in the business, they will believe that the system is fair and that they, too, by acting ethically, can advance at the firm. As Harvard business ethics professor Lynn Sharp Paine has noted, “Managers who fail to provide leadership and to institute systems that facilitate ethical conduct share responsibility with those who conceive, execute, and knowingly benefit from corporate misdeeds.”

Communicate the Firm’s Core Ethical Values For CEOs, creating, communicating, and em-

phasizing the firm’s core values are essential to creating an ethical environment that rubs off on all employees. For other managers, recommunicating and reemphasizing the firm’s value are also important. All public companies today have ethics codes, as do many smaller companies. Yet the CEO who leads ethically must continually emphasize in written messages and speeches the importance and necessity that everyone comply with the code. Other top-level managers, such as the vice president of finance, should ensure that their staffs understand the ethics code’s application to their corporate tasks and make ethical reviews part of the staffs’ annual evaluations. A lower-level manager who supervises a small staff for a single project should also do his part to encourage compliance with the ethics code by pointing out how the code relates to the project assignment and including ethics in the project team’s progress reports.



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

Connect Ethical Behavior with the Firm’s and Workers’ Best Interests It is one thing

to educate your staff about ethical behavior and another to obtain compliance. One good way to increase compliance with the firm’s core ethical values is to convince the staff that their best interests—and the firm’s—are met by acting ethically. Management should help employees understand that the firm’s profitability and the employee’s advancement in the firm are optimized by each employee taking responsibility for acting ethically. Staff must understand that adverse publicity caused by unethical conduct harms a firm’s ability to promote itself and its products and services. The ethical manager also clearly establishes ethical behavior as a prerequisite for salary increases and promotions, or at least that unethical behavior is a disqualifier. 

Reinforce Ethical Behavior When a manager

knows a staff member has acted ethically in a situation in which employees in less ethical firms would be tempted to act unethically, the manager should congratulate and find other ways to reinforce the staff member’s behavior. For example, if a staff member reports that a supplier has attempted to bribe him in order to do business with the firm, the ethical manager will praise the staff member and may include a letter commending him in his employment file. In addition, management should set up a mechanism for its employees to report instances of unethical behavior by the staff. While some employees will view whistle-blowing as an act of disloyalty, management should recharacterize whistle-blowing as necessary to the protection of the firm’s decision-making processes and reputation. Undetected ethical decisions often lead to poor decisions and harm corporate profits. While management does not want witch hunts, good managers must garner evidence of alleged unethical

Problems and Problem Cases 1. You are a middle manager with responsibility over a staff of 16 workers. One of your workers is six months pregnant. Over the last month, she has missed work an average of two days a week and seems to be frequently distracted at work. You are concerned about her welfare and about her work performance, but are unsure what to do. What do the Guidelines for Ethical Decision Making suggest you do first? 2. You are an outside director of Crowler Inc., a manufacturer of kitchen and bathroom fixtures such as faucets, shower heads, and shower doors. Crowler has 29,000 employees worldwide, including 18,000 manufacturing

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behavior so they may investigate and stop conduct that is harmful to the firm. A necessary corollary is not reinforcing unethical behavior, including behavior that may lead to an unethical act or foster an environment that appears tolerant of ethical missteps. It is usually not acceptable to ignore bad behavior. The ethical leader must reprimand staff for unethical actions and must not tolerate statements that suggest the firm should engage in unethical conduct. For example, if, during discussions about how to increase revenue for a product line, one staff member suggests obtaining competitors’ agreements to fix prices, a manager running the meeting should make clear that the firm will not engage in that or any other conduct that is illegal. To let the price-fixing comment pass without comment may send the message that the manager and the firm condone illegal or unethical acts. Additionally, managers should work to create a culture in which employees feel a sense of “ownership” in the organization. Employees who invest themselves in the organization are more likely to be employees with both a greater sense of satisfaction and higher commitment to the overall mission of the firm. Consider the difference between how most people treat an owned car versus a rental car. No one changes the oil, rotates the tires, or washes and waxes a rental car. A rental car serves a short-term, instrumental purpose and carries with it no long-term commitment or investment. Ownership of a vehicle, on the other hand, is accompanied by routine maintenance and proactive attention to any unusual sounds or dashboard indicators. Leaders who can inspire an ownership mentality among their employees are less likely to confront employees content to perform at the bare minimum level or tempted to cut corners.  Collectively, these reinforcing mechanisms should create a culture in which ethical practices define the firm and its employees rather than being imposed on them.

employees in the United States, Canada, and Mexico. Its headquarters is in Eden Prairie, Minnesota. The CEO has proposed that Crowler increase its manufacturing capacity by adding a large facility to manufacture kitchen faucets, thereby increasing manufacturing employment by 3,000 workers. The board of directors is considering whether Crowler should expand its manufacturing facility in Brownsville, Texas; open a new factory in Indonesia; or close the Brownsville facility and move its current operations and the new operations to Indonesia. Using the Guidelines for Ethical Decision Making, what do you want to know before you make a decision? 3. You are a debt collections officer for a credit card issuer, NationalOne Corporation. NationalOne generates

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Part One Foundations of American Law

73 percent of its profits from credit card fees and interest charged to consumers with annual incomes between $15,000 and $125,000. NationalOne’s business model is to charge its credit card customers a low initial interest rate of 10 percent and a nominal annual fee of $10. If a customer defaults on one payment, however, the interest rate jumps to 22 percent, and the annual fee to $100. In the course of collecting debts for NationalOne, you have noticed that once the typical customer defaults, she is able to pay about 50 percent of the original debt had the interest rate and annual fee not changed. NationalOne’s policy is not to accept anything less than 100 percent of the amount of the debt until the debtor has been in default for at least two years, by which time you find the customers typically can pay only about 10 percent of the now much larger debt. Many customers threaten to file and do file for bankruptcy protection. Would a rights theorist suggest any changes in NationalOne’s policies? Would a profit maximizer suggest changes?

5. Marigold Dairy Corporation sells milk products, including powdered milk formula for infants. Marigold hopes to increase sales of its powdered milk formula in Liberia and other African nations where mothers are often malnourished due to drought and civil war. Marigold’s marketing department has created a marketing plan to convince mothers and expectant mothers not to breastfeed their babies and to, instead, use Marigold formula. Doctors generally favor breastfeeding as beneficial to mothers (it helps the uterus return to normal size), to babies (it is nutritious and strengthens the bonds between the infant and the mother), and to families (it is inexpensive). Marigold’s marketing plan stresses the good nutrition of its formula and the convenience to parents of using it, including not having to breastfeed.  You are the senior vice president of marketing for Marigold. Do you approve this marketing plan? What would a rights theorist do? What would a utilitarian do? What would a profit maximizer do?

4. When is it appropriate to give a job applicant, employee, associate, colleague, or partner a second chance? Consider the following situations:

6. During World War II, the insecticide DDT was used successfully to halt a typhus epidemic spread by lice and to control mosquitoes and flies. After World War II, it was used extensively to control agricultural and household pests. Today, DDT may not be used legally in the United States and most other countries. Although DDT has a rather low immediate toxicity to humans and other vertebrates, it becomes concentrated in fatty tissues of the body. In addition, it degrades slowly, remaining toxic in the soil for years after its application. But there has never been any credible evidence that this residue has caused any harm. Even so, DDT has been blamed for the near extinction of bald eagles, whose population has increased greatly since DDT was banned, although evidence tends to point to oil, lead, mercury, stress from noise, and other factors as the likely causes.  In 2013, more than 2,469 people in the United States were infected by and 119 people killed after contracting West Nile virus, which is carried to humans by mosquitoes. CDC director Julie Gerberding called West Nile virus an “emerging, infectious disease epidemic” that could be spread all the way to the Pacific Coast by birds and mosquitoes. Pesticides such as malathion, resmethrin, and sumithrin can be effective in killing mosquitoes but are significantly limited because they do not stay in the environment after spraying. In Mozambique, indoor spraying of DDT has caused malaria rates to drop 88 percent among children.  As an executive for Eartho Chemical Company, you have been asked by Eartho’s CEO to study whether Eartho should resume the manufacture of DDT. What would a utilitarian decide? What would a profit maximizer do?

a. A manager is very effective in getting maximum efforts and results from her staff. However, the staff complains about suffering continual verbal abuse from the manager, including receiving belittling comments both privately and in public. Should her employer fire the manager or seek to rehabilitate her? b. An employee is a recovering cocaine addict. Since successfully completing rehabilitation, he has received a college degree and been drug-free for three years. Would you hire him? c. Donald Sterling, co-owner of the Los Angeles Clippers, a team in the National Basketball Association, made racist remarks in a private conversation that was recorded secretly by his girlfriend. Should the other NBA owners have attempted to oust him from team ownership? d. Jerry Sandusky, a coach for the Penn State football program, was observed engaging in same-sex relations with a youth attending his program for underprivileged youths. In 2012, he was convicted of 52 counts of sexual abuse of young boys over a 15-year period. Should Penn State have fired him as a coach when it had first notice of one instance of abuse, or should it have attempted to rehabilitate him? After the full extent of his crimes have become known, would it be appropriate for Penn State or any other employer to hire him for a position in which he has contact with young boys? Are there jobs for which you would hire him? Why or why not?



Chapter Four Business Ethics, Corporate Social Responsibility, Corporate Governance, and Critical Thinking

7. This American Life is an American Public Media radio program conceived, produced, written, and performed by Ira Glass. In 2012, Episode 454, “Mr. Daisey and the Apple Factory,” chronicled the investigation of Apple’s Foxconn factory in China by author and monologist Mike Daisey. The episode ran portions of Daisey’s monologue that detailed Apple’s exploitation of Chinese workers. The episode was the most downloaded episode in the show’s history. Less than two months later, Ira Glass and his staff discovered that Daisey had fabricated the claim that the plant guards had guns and exaggerated the number of underage workers with whom he met. Daisey also falsely represented that a man with a mangled hand was injured at Foxconn making iPads and that Daisey’s iPad was the first one the man ever saw in operation. What did Ira Glass do with the new information? What would you have done? 8. Jordan Belfort founded Stratton Oakmont, a brokerage firm that focused on selling very risky penny stocks— stocks selling at very low prices—to investors. Belfort encouraged his brokers to use high-pressure tactics to sell the stocks. Belfort paid his brokers handsomely, with commissions reaching 25 percent of the purchase price. As a result, many Stratton Oakmont brokers were able to improve their lives and support their families. Many of the stocks peddled by the brokers were investments in small companies with little chance of becoming profitable. Some of the investors were pressured into buying more stock than they should have purchased, considering their levels of wealth and other security holdings. The investors could have insisted on receiving more information about the stocks before purchasing them. However, the investors’ desires to make a large, quick profit deterred them from taking steps to protect themselves. Assess the ethical behavior of both the brokers and the investors. 9. In 2007, NFL commissioner Roger Goodell determined that the New England Patriots and its head coach, Bill Belichick, had violated NFL rules by videotaping opposing teams’ sideline signals during games. Goodell docked the Patriots a 2008 first-round draft pick, and he fined Belichick $500,000 and the team $250,000. In 2008, Goodell interviewed the Patriots’ employee who had done the videotaping and concluded that the employee’s information was consistent with the behavior for which the Patriots and Belichick had been disciplined in 2007. Therefore, Goodell termed the matter over and said it was not necessary to discipline further the Patriots or Belichick. Immediately thereafter, Arlen Specter, a U.S. senator from Pennsylvania, called the NFL investigation “neither objective nor adequate.” Specter stated, “If the commissioner doesn’t move for

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an independent investigation, . . . depending on the public reaction, I may ask the Senate Judiciary Committee to hold hearings on the NFL antitrust exemption.” Specter further stated that Goodell has made “ridiculous” assertions that wouldn’t fly “in kindergarten.” The senator said Goodell was caught in an “apparent conflict of interest” because the NFL doesn’t want the public to lose confidence in the league’s integrity. Terming the videotaping of opposing teams’ signals a form of cheating equivalent to steroid use, Specter called for an independent investigation similar to the 2007 Mitchell Report on performance-enhancing drugs in baseball.  Can you identify the fallacies in Senator Specter’s arguments? 10. You are hired as a corporate accountant for Ryco Industries, a public company with shares traded on the New York Stock Exchange. The company has enjoyed consistently higher earnings each quarter, meeting or exceeding the expectations of Wall Street analysts every quarter for the past seven years. Soon after being hired, you discover a “reserve” account in the accounting records. Your inquiry shows that the account is designed to accumulate earnings deficiencies or excesses, that is, to permit Ryco to adjust its earnings each quarter such that earnings not increase too little or too much. You bring your findings to the attention of Ryco’s chief accounting officer, who tells you that the account merely allows Ryco to smooth or manage its earnings, something that Wall Street analysts want to see. If earnings fluctuated, she explains, analysts would make less optimistic estimates about the prospects of Ryco, and its stock price would take a hit. The CAO tells you, “Look, we’re just doing this to avoid getting hammered in the stock market. Every company does this. And we’re not making up earnings. When actual earnings are too high, we just withhold recognizing some of those earnings until we need them in the future. When actual earnings are too low, we know we’ll have better quarters in the future from which we can borrow earnings now. It all evens out.”  Can you identify the critical thinking errors and the characteristics of poor decision making that the CAO is exhibiting? Create a plan that will help you resist the CAO’s request for you to continue to manage earnings as Ryco has done in the past. 11. You have been a director of sales at Privation Insurance Company for the last five years. Next week, you will be promoted to the position of vice president of sales, leading a staff of 35 sales professionals. Your immediate superior is the senior vice president of marketing and sales. What plan do you adopt for ethically leading your 35-person staff in your new position? List five things you’ll do to lead your staff ethically.

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Chapter 5

Criminal Law and Procedure

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Crimes and Torts

Chapter 6

Intentional Torts

Chapter 7

Negligence and Strict Liability

Chapter 8

Intellectual Property and Unfair Competition

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CHAPTER 5

Criminal Law and Procedure

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icolai Caymen worked as a desk clerk at a hotel in Ketchikan, Alaska. After a woman called a Ketchikan business supply store and complained that the store had charged her credit card for a laptop computer she did not purchase, the store discovered that Caymen had used a credit card in placing a telephone order for the laptop and that when he picked up the computer, the store clerk had not asked for identification. Store personnel then contacted the Ketchikan police department to report the incident and to pass along information, acquired from other stores, indicating that Caymen may have attempted similar credit card fraud elsewhere. In order to look for the laptop and other evidence of credit card fraud, the police obtained a search warrant for the house where Caymen rented a room. Caymen, who was present while his room was searched, denied the allegation that he had used someone else’s credit card to acquire the laptop. Instead, he stated that he had bought it with his own credit card. During the search, the police found the laptop and a tower computer. It was later determined that Caymen had rented the tower computer from a store but had never made any of the required payments. In Caymen’s wallet, which the police examined in connection with the search of his room, the officers found receipts containing the names and credit card information of guests who had stayed at the hotel where Caymen was employed. The police seized the laptop and contacted the store where Caymen had acquired it to ask whether officers could examine the laptop’s hard drive before they returned the computer to the store. The store’s owner consented. In examining the laptop’s hard drive for evidence of credit card fraud, the police found evidence indicating Caymen’s probable commission of federal crimes unrelated to credit card fraud. The police then temporarily suspended their search of the hard drive and obtained another search warrant because they had probable cause to believe that Caymen had committed federal offenses. Under that search warrant, officers checked the hard drives and storage media from the laptop and tower computers and found further evidence pertaining to the federal crimes. Caymen was prosecuted in state court for credit card fraud and was indicted in federal court for the separate federal offenses. In the federal proceeding, he asked the court to suppress (i.e., rule inadmissible) the evidence obtained by the police in their examinations of the hard drives of the laptop and tower computers. Caymen based his suppression request on this multipart theory: that the police had no valid warrant for their initial look at the laptop’s hard drive; that in the absence of a valid warrant, his consent (rather than the store owner’s) was needed to justify a search of the laptop’s hard drive; that the evidence obtained during the initial examination of the laptop’s hard drive was the result of an unconstitutional search and was therefore inadmissible; and that the evidence obtained in the later examinations of the hard drives of the laptop and tower computers amounted to inadmissible “fruit of the poisonous tree.” As you read Chapter 5, consider these questions: • On what constitutional provision was Caymen basing his challenge to the validity of the searches conducted by the police? • Must law enforcement officers always have a warrant before they conduct a search, or are warrantless searches sometimes permissible? If warrantless searches are sometimes permissible, when?

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Part Two Crimes and Torts

• What is the usual remedy when law enforcement officers conduct an unconstitutional search? • Did Caymen succeed with his challenge to the validity of the searches conducted by the police? Why or why not? • What if a guilty person goes free as a result of a court’s ruling that he was subjected to an unconstitutional search by law enforcement officers? From an ethical perspective, how would utilitarians view that outcome? What about rights theorists?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 5-1 5-2 5-3 5-4 5-5

Describe the difference between a felony and a misdemeanor. Explain why the First Amendment may sometimes serve as a defense to criminal  liability. Identify the constitutional provisions at issue when a criminal law is challenged as being excessively vague. Identify the standard of proof that the government must meet in a criminal prosecution, as well as the constitutional sources of that requirement. Identify the major steps in a criminal  prosecution.

THE LIST FEATURES FAMILIAR corporate names: Enron, Arthur Andersen, WorldCom, Adelphia, ImClone, Volkswagen, Wells Fargo, and Tyco. Individuals such as Bernard Ebbers, John and Timothy Rigas, and Dennis Kozlowski also make the list. Don’t forget about Bernie Madoff. These names sometimes dominated the business headlines during recent years, but not for reasons any corporation or executive would find desirable. Instead, they acquired the notoriety associated with widely publicized financial scandals, related civil litigation, and criminal prosecutions that were pursued by the government, seriously contemplated by prosecutors, or argued for by the public and political figures of varying stripes. For instance, former WorldCom CEO Bernie Ebbers was sentenced to 25 years in prison for his role in an $11 billion accounting and securities fraud. The Rigases were sentenced to substantial prison terms because of their involvement in bank and securities fraud while serving as high-level executives at Adelphia. Kozlowski, convicted of financial wrongdoing in connection with his former

5-6 Describe the basic protections afforded by the Fourth, Fifth, and Sixth Amendments. 5-7 Describe major exceptions to the Fourth Amendment’s usual preference that the government have a warrant before conducting a search. 5-8 Explain what the exclusionary rule is. 5-9 List the components of the Miranda warnings and state when law enforcement officers must give those warnings. 5-10 Describe the major elements that must be proven in order to establish a violation of the Computer Fraud and Abuse Act.

position as Tyco’s CEO, also faced incarceration. Madoff received a 150-year prison sentence and extensive public scorn after being convicted of crimes associated with the Ponzi scheme through which he defrauded investors. Criminal convictions because of financial wrongdoing led to the above-mentioned notoriety of certain individuals and the corporations with which they were affiliated, but other sorts of business-related activity may also result in criminal charges. In 2012, for instance, the oil company BP pleaded guilty to offenses connected with the Deepwater Horizon oil-drilling disaster that occurred off the Gulf Coast and caused the deaths of 11 persons as well as extensive environmental damage. A criminal fine of approximately $1.3 billion was imposed on BP, along with even more in civil penalties. During recent years, the U.S. Department of Justice considered whether to file criminal charges against General Motors for allegedly misleading federal regulators regarding an ignition switch problem that led to crashes in which persons were injured or killed. Volkswagen pleaded guilty in



Chapter Five Criminal Law and Procedure

2017 to criminal charges in connection with its employees’ scheme to install devices in vehicles so that the cars would receive false and deceptively positive results on governmentrequired emissions tests. In 2019, Wells Fargo agreed to pay $3 billion to resolve the company’s potential criminal and civil liability stemming from a decade-long practice of pressuring employees to meet unrealistic sales goals. That practice led over 5,000 employees to provide millions of accounts and products to customers under false pretenses, often by creating false records or misusing customers’ identities. The BP, GM, Volkswagen, and Wells Fargo sagas also featured civil consequences because of regulatory penalties and lawsuits, but there seems little doubt that criminal charges or the possibility of them weighed especially heavily on the minds of those companies’ executives and employees. In an earlier edition of this text, the first paragraph of Chapter 5 noted the importance of studying criminal law as part of a business manager’s education but conceded that “[w]hen one lists legal topics relevant to business, criminal law comes to mind less readily than contracts, torts, agency, corporations, and various other subjects dealt with in this text.” That statement was written some 25 years ago. Given the media, public, and governmental attention devoted to recent corporate scandals, it might be argued that criminal law now comes to mind more readily than certain other subjects on the list of legal topics relevant to business. At the very least, events involving high-profile firms and executives have demonstrated that business managers create considerable risk for themselves and their firms if they ignore the criminal law or lack a working understanding of it.

Role of the Criminal Law This century has witnessed society’s increasing tendency to use the criminal law as a major device for controlling corporate behavior. Many regulatory statutes establish criminal and civil penalties for statutory violations. The criminal penalties often apply to individual employees as well as to their organizational employers. Advocates of using the criminal law in this way typically argue that doing so achieves a deterrence level superior to that produced by damage awards and other civil remedies. Corporations may be inclined to treat damage awards as simply a business cost and to violate regulatory provisions when doing so makes economic sense. Criminal prosecutions, however, threaten corporations with the reputation-harming effect of a criminal conviction. In some cases, the criminal law allows society to penalize wrongdoing employees who would not be directly affected by a civil judgment against their employer. Moreover, by alerting private parties to a

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violation that could also give rise to a civil lawsuit for damages, criminal prosecutions may increase the likelihood that a corporation will bear the full costs of its actions. Proponents of using criminal law against corporations may also point to its expressive function. In other words, in addition to offering higher penalties, the criminal law signals society’s moral outrage in a way that a money judgment—even a multibillion-dollar one—cannot. Our examination of the criminal law’s role in today’s business environment begins with consideration of the nature and essential components of the criminal law. Next, the chapter discusses procedural issues in criminal prosecutions and explains constitutional issues that may arise in such cases. The chapter then explores various problems encountered in applying the criminal law to the corporate setting.

Nature of Crimes LO5-1

Describe the difference between a felony and a misdemeanor.

Crimes are public wrongs—acts prohibited by the state or federal government. Criminal prosecutions are initiated by a prosecutor (an elected or appointed government employee) in the name of the state or the United States, whichever is appropriate. Persons convicted of crimes bear the stigma of a criminal conviction and face the punitive force of the criminal sanction, which may include incarceration. Our legal system also contemplates noncriminal consequences for violations of legal duties. The next two chapters deal with torts, private wrongs for which the wrongdoer must pay money damages to compensate the harmed victim. In some tort cases, the court may also assess punitive damages in order to punish the wrongdoer. Only the criminal sanction, however, combines the threat to life or liberty with the stigma of conviction. Crimes are typically classified as felonies or misdemeanors. A felony is a serious crime such as murder, sexual assault, arson, drug-dealing, or a theft or fraud offense of sufficient magnitude. Most felonies involve significant moral culpability on the offender’s part. Felonies are punishable by lengthy confinement of the convicted offender to a penitentiary, as well as by a fine. A person convicted of a felony may experience other adverse consequences, such as disenfranchisement (loss of voting rights) and disqualification from the practice of certain professions (e.g., law or medicine). A misdemeanor is a lesser offense such as disorderly conduct or battery resulting in minor physical harm to the victim. Misdemeanor offenses usually involve less—sometimes much less—moral culpability than felony offenses. As such,

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misdemeanors are punishable by lesser fines or limited confinement in jail. Depending on their seriousness and potential for harm to the public, traffic violations are classified either as misdemeanors or as less serious infractions. Really only quasi-criminal, infractions usually are punishable by fines but not by confinement in jail.

Purpose of the Criminal Sanction Disagree-

ments about when the criminal sanction should be employed sometimes stem from a dispute over its purpose. Persons accepting the utilitarian view believe that prevention of socially undesirable behavior is the only proper purpose of criminal penalties. This prevention goal includes three major components: deterrence, rehabilitation, and incapacitation. Deterrence theorists maintain that the threat or imposition of punishment deters the commission of crimes in two ways. The first, specific deterrence, occurs when punishment of an offender deters him from committing further crimes. The second, general deterrence, results when punishment of a wrongdoer deters other persons from committing similar offenses. Factors influencing the probable effectiveness of deterrence include the respective likelihoods that the crime will be detected, that detection will be followed by prosecution, and that prosecution will result in a conviction. The severity of the probable punishment also serves as a key factor. A fundamental problem attending deterrence theories is that we cannot be certain whether deterrence works because we cannot determine reliably what the crime rate would be in the absence of punishment. Similarly, high levels of crime and recidivism (repeat offenses by previously punished offenders) may indicate only that sufficiently severe and certain criminal sanctions have not been employed, not that criminal sanctions in general cannot effectively deter. Deterrence theory’s other major problem is its assumption that potential offenders are rational beings who consciously weigh the threat of punishment against the benefits derived from an offense. The threat of punishment, however, may not deter the commission of criminal offenses produced by irrational or unconscious drives. Additionally, deterrence theories presuppose that would-be offenders even know the law and its sanctions, a suspect notion at best.

Rehabilitation of convicted offenders—changing their attitudes or values so that they are not inclined to commit future offenses—serves as another way to prevent undesirable behavior. Rehabilitation was the dominant model of criminal law for much of this nation’s history but was called into question in the 1970s and fell out of favor. Critics of rehabilitation commonly point to high rates of recidivism as evidence of the general failure of rehabilitation efforts to date. Incapacitation of convicted offenders may also contribute to the goal of prevention. While incarcerated, offenders may also have much less ability to commit other crimes. This excludes crimes committed against other inmates and guards. It also ignores the downstream impacts of incarceration on families and communities. Prevention is not the only asserted goal of the criminal sanction. Some persons see retribution—the infliction of deserved suffering on violators of society’s most fundamental rules—as the central focus of criminal punishment. Under this theory, punishment satisfies community and individual desires for revenge and reinforces important social values. As a general rule, state laws on criminal punishments seek to further equally the deterrence, rehabilitation, and incapacitation purposes just discussed. State statutes usually set forth ranges of sentences (e.g., minimum and maximum amounts of fines and imprisonment) for each crime established by law. The court sets the convicted offender’s sentence within the appropriate range unless the court places the defendant on probation or otherwise non-carceral sentence. Probation is effectively a conditional sentence that suspends the usual imprisonment and/or fine if the offender “toes the line” and meets other judicially imposed conditions for the period specified by the court. It is sometimes granted to first-time offenders and other convicted defendants deemed suitable candidates by the court. In deciding whether to order probation or an appropriate sentence within the statutory range, the court normally places considerable reliance on information contained in a presentence investigation conducted by the probation office. Figure 5.1 explains how federal law approaches the proper determination of a convicted offender’s punishment.

Figure 5.1 The Federal Sentencing Guidelines and the Booker Decision The federal approach to sentencing closely resembled the typical state approach discussed in the text until the Federal Sentencing Guidelines took effect in 1987. The significantly different sentencing model contemplated by the Sentencing Guidelines was largely upended, however, by the U.S.

Supreme Court’s decision in United States v. Booker, 543 U.S. 220 (2005), and decisions that followed it. To understand Booker, one must first know how the Sentencing Guidelines operated for the approximately 20 years preceding the Supreme Court’s decision.



Chapter Five Criminal Law and Procedure

In the Sentencing Reform Act of 1984, Congress created the U.S. Sentencing Commission and authorized it to develop the Sentencing Guidelines. Congress took this action to reduce judicial discretion in sentencing and to minimize disparities among sentences imposed on defendants who committed the same offenses. Although pre–Sentencing Guidelines statutes setting forth sentencing ranges for particular crimes generally remained on the books, the Sentencing Guidelines developed by the Sentencing Commission assumed a legally controlling status under provisions of the Sentencing Reform Act. The Guidelines contain a table with more than 40 levels of seriousness of offense. Where an offender’s crime and corresponding sentence range are listed on the table depends on the offender’s prior criminal history and on various factors associated with the offense. The Sentencing Reform Act established that federal courts were bound by the table and usually were required to sentence convicted defendants in accordance with the range set in the table for the crime at issue. However, if the court found the existence of certain additional circumstances to be present (such as a leadership role in a crime committed by more than one person or similar facts seeming to enhance the defendant’s level of culpability), the Guidelines required the court to sentence the defendant to a harsher penalty than would otherwise have been the maximum under the Guidelines. Many federal judges voiced displeasure with the Guidelines because their mandatory nature deprived judges of the sentencing discretion they believed they needed in order to do justice in individual cases. In another key effect, the Guidelines led to the imposition of more severe sentences than had previously been imposed. Although the prospect of probation for certain offenses was not eliminated, the Guidelines led to an increased use of incarceration of individuals convicted of serious crimes. (A special subset of rules known as the Organizational Sentencing Guidelines, discussed later in the chapter, pertains to the sentencing of organizations convicted of federal crimes.) Approximately 20 years ago, questions began arising about the constitutionality of the Sentencing Guidelines. The questions focused on the cases in which the Guidelines effectively required—if the requisite additional circumstances were present—a sentence higher than what would otherwise have been the maximum called for by the Guidelines. These cases were troublesome because nearly always the additional circumstances triggering the enhanced sentence were identified by the trial judge on the basis of evidence submitted to him or her at a post-trial sentencing hearing. The jury, on the other hand, would have heard and seen only the evidence produced at the trial—evidence that went toward guilt and presumably the standard range of punishment, but not toward an enhanced punishment harsher than the usual maximum. All of this was problematic, critics contended, in view of criminal defendants’ Sixth Amendment right to a jury trial. In 2005, United States v. Booker provided the Supreme Court an opportunity to address the concerns raised by

critics of the Guidelines. A jury had convicted Booker of the offense of possessing, with intent to distribute, at least 50 grams of crack cocaine. The evidence the jury heard at trial was to the effect that Booker possessed approximately 90 grams of crack. The Sentencing Guidelines called for a sentence of 20 to 22 years in prison for possessing at least 50 grams. However, evidence presented to the judge at the sentencing hearing indicated that Booker possessed some 650 grams. Possession of a much larger amount of crack than the amount for which he was convicted was a special circumstance that, under the Guidelines, necessitated a harsher sentence. Upon finding by a preponderance of the evidence that Booker possessed 650 grams (rather than the smaller quantity about which the jury heard evidence), the judge was required by the Guidelines to sentence Booker to at least 30 years in prison—even though the evidence presented to the jury would have justified a lesser sentence of 20 to 22 years. The judge imposed a 30-year sentence on Booker, who contended on appeal that the enhanced sentence required by the Guidelines violated his Sixth Amendment jury trial right. In the Booker decision, the Supreme Court held that in view of the Sixth Amendment, any facts calling for the imposition of a sentence harsher than the usual maximum must be facts found by a jury rather than merely a judge (unless a jury has been validly waived by the defendant or the defendant agreed to the facts in a plea agreement). The Federal Sentencing Guidelines and the statute contemplating their creation were thus unconstitutional insofar as they mandated a sentence going beyond the usual maximum if a judge’s factual findings supporting such a sentence were made on the basis of evidence that the jury had not heard. To remedy the constitutional defect, the Court determined it was necessary to excise certain Sentencing Reform Act sections that made the Sentencing Guidelines mandatory. The elimination of those statutory sections caused the Sentencing Guidelines to become advisory to judges as they make sentencing decisions. Judges must still consider what the Guidelines call for in regard to sentencing, but they are not required to impose the particular sentences specified in the Guidelines. The Court also stated in Booker that when a judge’s sentencing decision is challenged on appeal, the governing standard will be one of reasonableness. After Booker, lower courts were faced with determining what the “reasonableness” standard of review meant, as well as how far trial courts’ discretion regarding the Guidelines really extended. In Rita v. United States, 551 U.S. 338 (2007), the Supreme Court held that it was permissible for courts of appeal to adopt and apply a presumption of reasonableness if the sentence imposed by the trial court fell within the range set by the Guidelines. Gall v. United States, 552 U.S. 38 (2007), made clear, however, that the converse was not true. The Court held there that courts of appeals cannot apply a presumption of unreasonableness to a sentence that departed from the range set by the Guidelines. Instead, according to Gall, consideration of the Guidelines is only “the starting point

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Part Two Crimes and Torts

and the initial benchmark” for the trial judge as he or she makes an “individualized assessment” based on the facts and circumstances. Appellate courts are to give “due deference” to the trial judge’s sentencing determinations, regardless of whether the sentence fell within or outside the Guidelines’s range. In Kimbrough v. United States, 552 U.S. 85 (2007), a companion case to Gall, the Court underscored this standard of review and expressed disapproval of appellate court micromanagement of trial judges’ sentencing decisions. The Court also suggested in Kimbrough—and made explicit in Spears v. United States, 555 U.S. 261 (2009)—that considerable deference to the trial judge’s sentencing determinations remains

Essentials of Crime To

convict a defendant of a crime, the government ordinarily must (1) demonstrate that his alleged acts violated a criminal statute; (2) prove beyond a reasonable doubt that he committed those acts; and (3) prove that he had the capacity to form a criminal intent. Crimes are statutory offenses. A given behavior is not a crime unless Congress or a state legislature has criminalized it.1 Courts also carefully scrutinize, and narrowly construe, criminal statutes in an effort to make certain that they sweep

appropriate even if it appears that the sentence departed from the Guidelines because of the judge’s policy disagreement with the Guidelines. Booker and its progeny have restored to trial judges most of the sentencing latitude they had prior to the Guidelines. This latitude is subject to two constraints: First, the sentence must be consistent with relevant statutes (as opposed to the now-advisory Guidelines), and second, the sentence must be based upon facts found by the jury. Whether judges actually use this discretion, or are instead “anchored” to the Guidelines’ ranges, is an empirical question. As might be expected, it appears that as more time since Booker passes, judges seem willing to use more of their inherent discretion.

in only those behaviors specifically prohibited by the relevant legislature. In Sekhar v. United States, which follows, the U.S. Supreme Court conducts such an examination of the Hobbs Act in order to determine whether the defendant’s actions constituted extortion in violation of that federal statute. Infractions of a minor criminal or quasi-criminal nature (such as traffic offenses) are often established by city or county ordinances but will not be considered here. For discussion of ordinances as a type of law, see Chapter 1. 1

Sekhar v. United States   570 U.S. 729 (2013) New York’s Common Retirement Fund is an employee pension fund for the State of New York and its local governments. The State Comptroller chooses Common Retirement Fund investments. When the Comptroller decides to approve an investment, he issues a “Commitment.” Giridhar Sekhar was a managing partner of FA Technology Ventures (FATV). In 2009, the Comptroller’s office was considering whether to invest in a fund managed by that firm. The office’s general counsel recommended that the Comptroller decide not to invest in the FATV-managed fund. The Comptroller followed the recommendation, decided not to issue a Commitment, and notified an FATV partner about the decision. This partner had previously heard rumors that the general counsel was having an extramarital affair. The general counsel then received a series of anonymous e-mails demanding that he recommend moving forward with the investment in the FATV-managed fund. The e-mails also threatened that if the general counsel did not so recommend, the sender would disclose information about his alleged affair to his wife, government officials, and the media. The general counsel contacted law enforcement, which traced some of the e-mails to Sekhar’s home computer and other e-mails to FATV offices. Sekhar was later indicted for attempted extortion in violation of the Hobbs Act, which subjects a person to criminal liability if he “in any way or degree obstructs, delays, or affects commerce or the movement of any article or commodity in commerce, by robbery or extortion or attempts or conspires so to do.”18 U.S.C. § 1951(a). The act defines extortion to mean “the obtaining of property from another, with his consent, induced by wrongful use of actual or threatened force, violence, or fear, or under color of official right.” 18 U.S.C. § 1951(b)(2). On the verdict form used at Sekhar’s trial, the jury was asked to specify the property that Sekhar attempted to extort: (1) “the Commitment,” (2) “the Comptroller’s approval of the Commitment,” or (3) “the General Counsel’s recommendation to approve the Commitment.” The jury chose only the third option in convicting Sekhar of attempted extortion. The U.S. Court of Appeals for the Second Circuit affirmed Sekhar’s conviction. The Second Circuit held that the general counsel “had a property right in rendering sound legal advice to the Comptroller and, specifically, to recommend—free from threats—whether the Comptroller should issue a Commitment.” In addition, the Second Circuit concluded that Sekhar not only attempted to deprive the general counsel of his “property right” but also “attempted to exercise that right by forcing the general counsel to make a recommendation determined by [Sekhar].” The U.S. Supreme Court agreed to review the case.



Chapter Five Criminal Law and Procedure

Scalia, Justice We consider whether attempting to compel a person to recommend that his employer approve an investment constitutes “the obtaining of property from another” under 18 U.S.C. § 1951(b)(2). Whether viewed from the standpoint of the common law, the text and genesis of the statute at issue here, or the jurisprudence of this Court’s prior cases, what was charged in this case was not extortion. It is a settled principle of interpretation that, absent other indication, “Congress intends to incorporate the well-settled meaning of the common-law terms it uses.” [Citation omitted.] Or as Justice Frankfurter colorfully put it [in a 1947 law journal article], “if a word is obviously transplanted from another legal source, whether the common law or other legislation, it brings the old soil with it.” The Hobbs Act punishes “extortion,” one of the oldest crimes in our legal tradition. As far as is known, no case predating the Hobbs Act—English, federal, or state—ever identified conduct such as that charged here as extortionate. Extortion required the obtaining of items of value, typically cash, from the victim. It did not cover mere coercion to act, or to refrain from acting. The text of the statute confirms that the alleged property here cannot be extorted. Enacted in 1946, the Hobbs Act defines its crime of “extortion” as “the obtaining of property from another, with his consent, induced by wrongful use of actual or threatened force, violence, or fear, or under color of official right.” Obtaining property requires “not only the deprivation but also the acquisition of property.” Scheidler v. National Organization for Women, Inc., 537 U.S. 393, 404 (2003). That is, it requires that the victim part with his property, and that the extortionist “gain possession” of it. Id. at 403 n.8. The property extorted must therefore be ­transferable—that is, capable of passing from one person to another. The alleged property here lacks that defining feature. The genesis of the Hobbs Act reinforces that conclusion. The Act was modeled after § 850 of the New York Penal Law (1909). Congress borrowed, nearly verbatim, the New York statute’s definition of extortion. The New York statute contained, in addition to the felony crime of extortion, a . . . misdemeanor crime of coercion. Whereas the former required the criminal acquisition of property, the latter required merely the use of threats “to compel another person to do or to abstain from doing an act which such other person has a legal right to do or to abstain from doing” [quoting the New York statute]. Congress did not copy the coercion provision. The omission must have been deliberate, since it was perfectly clear that extortion did not include coercion. At the time of the borrowing (1946), New York courts had consistently held that the sort of interference with rights that occurred here was coercion. And finally, this Court’s own precedent similarly demands reversal of Sekhar’s conviction. In Scheidler, we held that protesters did not commit extortion under the Hobbs Act, even though they “interfered with, disrupted, and in some instances completely deprived” abortion clinics of their ability to run their business. 537 U.S. at 404–05. We reasoned that the protesters may have deprived the clinics of an “alleged

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property right,” but they did not pursue or receive “something of value from” the clinics that they could then “exercise, transfer, or sell” themselves. Id. at 405. This case is easier than Scheidler, where one might at least have said that physical occupation of property amounted to obtaining that property. The deprivation alleged here is far more abstract. Scheidler rested its decision, as we do, on the term “obtaining.” The principle announced there—that a defendant must pursue something of value from the victim that can be exercised, transferred, or sold— applies with equal force here. Whether one considers the personal right at issue to be “property” in a broad sense or not, it certainly was not obtainable property under the Hobbs Act. The government’s shifting and imprecise characterization of the alleged property at issue betrays the weakness of its case. According to the jury’s verdict form, the “property” that Sekhar attempted to extort was “the General Counsel’s recommendation to approve the Commitment.” But the government expends minuscule effort in defending that theory of conviction. And for good reason—to wit, our decision in Cleveland v. United States, 531 U.S. 12 (2000), which reversed a business owner’s mail-fraud conviction for “obtaining money or property” through misrepresentations made in an application for a video-poker license issued by the State. We held that a “license” is not “property” while in a state’s hands and so cannot be “obtained” from the state. Even less so can an employee’s yet-to-be-issued recommendation be called obtainable property, and less so still a yet-to-be-issued recommendation that would merely approve (but not effect) a particular investment. Hence the government’s reliance on an alternative . . . description of the property. Instead of defending the jury’s description, the government hinges its case on the general counsel’s “intangible property right to give his disinterested legal opinion to his client free of improper outside interference” [quoting the government’s brief]. But what, exactly, would Sekhar have obtained for himself? A right to give his own disinterested legal opinion to his own client free of improper interference? Or perhaps, a right to give the general counsel’s disinterested legal opinion to the general counsel’s client? Either formulation sounds absurd, because it is. Clearly, Sekhar’s goal was not to acquire the general counsel’s “intangible property right to give disinterested legal advice.” It was to force the general counsel to offer advice that accorded with Sekhar’s wishes. But again, that is coercion, not extortion. No fluent speaker of English would say that Sekhar “obtained and exercised the general counsel’s right to make a recommendation,” any more than he would say that a person “obtained and exercised another’s right to free speech.” He would say that Sekhar “forced the general counsel to make a particular recommendation,” just as he would say that a person “forced another to make a statement.” Adopting the government’s theory here would not only make nonsense of words, it would collapse the longstanding distinction between extortion and coercion and ignore Congress’s choice to penalize one but not the other. That we cannot do. Second Circuit decision reversed in favor of Sekhar.

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Part Two Crimes and Torts

Constitutional Limitations on Power to Criminalize Behavior The U.S. Constitution pro-

hibits ex post facto criminal laws. This means that a defendant’s act must have been prohibited by statute at the time she committed it and that the penalty imposed must be the one provided for at the time of her offense. In Peugh v.  United States, 569 U.S. 530 (2013), for example, the U.S. Supreme Court held that a defendant convicted of bank fraud should have been sentenced under the version of the Federal Sentencing Guidelines in effect when he committed the crime rather than under a later version that the lower courts used as the basis for imposing a more severe punishment than the earlier version would have permitted. The Constitution places other limits on legislative power to criminalize behavior. If behavior is constitutionally protected, it cannot be deemed criminal. For example, the right of privacy held implicit in the Constitution caused the Supreme Court, in Griswold v. Connecticut (1965), to strike down state statutes that prohibited the use of contraceptive devices and the counseling or assisting of others in the use of such devices. This decision provided the constitutional basis for the Court’s historic Roe v. Wade (1973) decision, which limited the states’ power to criminalize abortions. First Amendment LO5-2

Explain why the First Amendment may sometimes serve as a defense to criminal liability.

By prohibiting laws that unreasonably restrict freedom of speech, the First Amendment plays a major role in limiting governmental power to enact and enforce criminal laws. As explained in Chapter 3, the First Amendment protects a broad range of noncommercial speech, including expression of a political, literary, or artistic nature as well as speech that deals with economic, scientific, or ethical issues or with other matters of public interest or concern. The First Amendment protection for noncommercial speech is so substantial that it is called “full” protection. The First Amendment may operate as a defense to a criminal prosecution concerning speech many persons would find offensive. For instance, in United States v.  Alvarez, 567 U.S. 709 (2012), the Supreme Court struck down a portion of the Stolen Valor Act, a federal law that criminalized false statements made about earning a military medal. Although the defendant had lied repeatedly about having served in the military and earning a Purple Heart, the Court found the statute broadly applied to false statements made at any time, in any place, and to any person,

which conflicted with the First Amendment. In addition, the Court held in United States v. Stevens, 559 U.S. 460 (2010), that the First Amendment protected the defendant against criminal responsibility for having violated a statute that barred distribution of videos in which a cruel killing or maiming of an actual animal was depicted. (The First Amendment safeguarded the speech present in such videos notwithstanding its offensive character, but would not protect any defendant against criminal responsibility for violating a statute prohibiting the conduct of engaging in cruelty to animals.) But First Amendment protection, despite being very substantial, is not absolute. Consider Holder v. Humanitarian Law Project, 561 U.S. 1 (2010), in which the Supreme Court rejected a multipronged attack on the constitutionality of a federal statute that criminalized the furnishing of support to foreign groups the government has labeled as terrorist organizations. In upholding the statute, the Court held that it did not violate the First Amendment even as applied to persons who wished to donate money to support and encourage the humanitarian, lawful, and nonviolent activities of those organizations (as opposed to their activities amounting to terrorism). Although donating money in support of social causes may be viewed as speech, the Court concluded that the statute did not violate the First Amendment rights of supporters of the organizations’ nonterrorist activities because the prohibition of even those supporters’ donations was suitably tailored to the furtherance of the vital government interest in combating terrorism. Commercial speech, on the other hand, receives a less substantial First Amendment shield known as “intermediate” protection. Does a speaker or writer with a profit motive (e.g., the author who hopes to make money on her book) therefore receive only intermediate First Amendment protection? No, as a general rule, because the mere presence of a profit motive does not keep expression from being fully protected noncommercial speech. Moreover, the commercial speech designation is usually reserved for what the Supreme Court has termed “speech that does no more than propose a commercial transaction.” The best example of commercial speech is an advertisement for a product, service, or business. Despite receiving less-than-full protection, commercial speech is far from a First Amendment outcast. Recent Supreme Court decisions, as noted in Chapter 3, have effectively raised commercial speech’s intermediate protection to a level near that of full protection. Therefore, regardless of whether it is full or intermediate in strength, the First Amendment protection extended to expression means that governmental attempts to hold persons criminally liable for the content of their written or spoken statements are often unconstitutional.



Chapter Five Criminal Law and Procedure

Some speech falls outside the First Amendment umbrella, however. In a long line of cases, the Supreme Court has established that obscene expression receives no First Amendment protection. Purveyors of obscene books, movies, and other similar works may therefore be criminally convicted of violating an obscenity statute even though it is the works’ content (i.e., the speech) that furnishes the basis for the conviction. Expression is obscene only if the government proves each element of the controlling obscenity test, which the Supreme Court established in Miller v. California (1973): (a) [That] the average person, applying contemporary community standards, would find that the work, taken as a whole, appeals to the prurient interest; (b) [that] the work depicts or describes, in a patently offensive way, [explicit] sexual conduct specifically defined by the applicable state law; and (c) [that] the work, taken as a whole, lacks serious literary, artistic, political, or scientific value.

If any of the three elements is not proven, the work is not obscene; instead, it receives First Amendment protection. The Miller test’s final element is the one most likely to derail the government’s obscenity case against a defendant. Books, movies, and other materials that contain explicit sexual content are not obscene if they have serious literary, artistic, political, or scientific value—and they generally do. In view of the Miller test’s final element, moreover, certain publications that might fairly be regarded as “pornographic” are likely to escape being classified as obscene. Although nonobscene expression carries First Amendment protection, Supreme Court decisions have allowed the government limited latitude to regulate indecent speech in order to protect minors from being exposed to such material. Indecent expression contains considerable sexual content but stops short of being obscene, often because of the presence of serious literary, artistic, political, or scientific value (for adults, at least). Assume that a state statute requires magazines available for sale at a store to be located behind a store counter, rather than on an unattended display rack, if the magazines feature nudity and sexual content and the store is open to minors. This statute primarily restricts indecent expression because most magazines contemplated by the law are unlikely to be obscene. If the statute is challenged on First Amendment grounds and the court concludes that it is narrowly tailored to further the protection-of-minors purpose, it will survive First Amendment scrutiny. A law that restricts too much expression suitable for adults, however, will violate the First Amendment even if the government’s aim was to safeguard minors. Recent years have witnessed decisions in which the Supreme Court determined the First Amendment fate of statutes designed to protect minors against online exposure to material that is indecent though not obscene.

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In Reno v. American Civil Liberties Union, 521 U.S. 844 (1997), the Court struck down most of the Communications Decency Act of 1996 (CDA), which sought to ban Internet distribution of indecent material in a manner that would make the material accessible by minors. The Court reasoned that notwithstanding the statute’s protection-of-minors purpose, the sweeping nature of the ban on indecent material extended too far into the realm of expression that adults were entitled to receive. In Ashcroft v. American Civil Liberties Union, 542 U.S. 665 (2004), the Court considered the constitutionality of the Child Online Protection Act (COPA), the next congressional attempt to restrict minors’ exposure to indecent material in online contexts. According to the Court, the same problem that plagued the CDA—restricting too much expression that adults were entitled to communicate and receive—doomed the COPA to a determination of unconstitutionality. As noted above, much of the material often referred to as pornography would not be considered obscene under the Miller test and thus would normally carry First Amendment protection. Safeguarding-of-minors concerns have proven critical, however, to the very different legal treatment extended to child pornography—sexually explicit visual depictions of actual minors (as opposed to similar depictions of adults). Because of the obvious dangers and harms that child pornography poses for minors, child pornography has long been held to fall outside the First Amendment’s protective umbrella. Therefore, the Supreme Court has held that there is no First Amendment bar to criminal prosecutions for purveying or possessing child pornography. Identify the constitutional provisions at issue when a

LO5-3 criminal law is challenged as being excessively vague.

Due Process Clauses In addition to limiting the sorts of behavior that may be made criminal, the Constitution limits the manner in which behavior may be criminalized. The Due Process Clauses of the Fifth and Fourteenth Amendments (discussed in Chapter 3) require that criminal statutes define the prohibited behavior precisely enough to enable law enforcement officers and ordinary members of the public to understand which behavior violates the law. Statutes that fail to provide such fair notice may be challenged as unconstitutionally vague. For example, in Skilling v. United States, 561 U.S. 358 (2010), a defendant brought a vagueness challenge to a federal statute he was convicted of violating. The statute made it a crime to deprive another person of the intangible right to the defendant’s “honest services.” To avoid

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Part Two Crimes and Torts

the potential vagueness problem suggested by the statute’s “honest services” language, the Supreme Court adopted a limited construction of the statute. The Court ruled that for a violation of the honest services law to have occurred, the defendant’s actions must have involved the offering, payment, or receipt of bribes or kickbacks. Whatever other misdeeds Skilling—an Enron executive—committed or may have committed, none of them involved bribes or kickbacks. For further discussion of the importance of clarity in criminal statutes, see Shaw v. United States, which appears later in the chapter. Equal Protection Clause The Fourteenth Amendment’s Equal Protection Clause (also discussed in Chapter 3) prohibits criminal statutes that discriminatorily treat certain persons of the same class or arbitrarily discriminate among different classes of persons. Legislatures usually are extended considerable latitude in making statutory classifications if the classifications have a rational basis. “Suspect” classifications, such as those based on race, are subjected to much closer judicial scrutiny, however. Eighth Amendment Finally, the Constitution limits the type of punishment imposed on convicted offenders. The Eighth Amendment forbids cruel and unusual punishments. This prohibition furnishes, for example, the constitutional basis for judicial decisions establishing limits on imposition of the death penalty. Although various Supreme Court cases indicate that the Eighth Amendment may bar a sentence whose harshness is disproportionate to the seriousness of the defendant’s offense, the Court has signaled that any Eighth Amendment concerns along these lines are unlikely to be triggered unless the sentence–crime disproportionality is exceedingly gross. Proof beyond a Reasonable Doubt Identify the standard of proof that the government must

LO5-4 meet in a criminal prosecution, as well as the constitutional

sources of that requirement.

The serious matters at stake in a criminal case—the life and liberty of the accused—justify our legal system’s placement of significant limits on the government’s power to convict a person of a crime. A fundamental safeguard is the presumption of innocence; defendants in criminal cases are presumed innocent until proven guilty. The Due Process Clauses require the government to overcome this presumption by proving beyond a reasonable doubt every element

of the offense charged against the defendant.2 Requiring the government to meet this high burden of proof minimizes the risk of erroneous criminal convictions. Defendant’s Criminal Intent and Capacity Most serious crimes require mens rea, or criminal intent, as an element. The level of fault required for a criminal violation depends on the wording of the relevant statute. Many criminal statutes require proof of intentional wrongdoing. Others impose liability for reckless conduct or, in rare instances, mere negligence. In the criminal context, recklessness generally means that the accused consciously disregarded a substantial risk that the harm prohibited by the statute would result from her actions. Negligence means that the accused failed to perceive a substantial risk of harm that a reasonable person would have perceived. As a general rule, negligent behavior is left to the civil justice system rather than being criminalized. Shaw v. United States, which follows shortly, addresses criminal intent and related issues.  In Arthur Andersen LLP v. United States, 544 U.S. 696 (2005), the Supreme Court issued a reminder regarding the importance of the element of criminal intent. The Andersen firm, which provided auditing and consulting services to Enron prior to its collapse in 2001, had been convicted on obstruction-of-justice charges dealing with destruction of Enron-related documents. The Supreme Court overturned the conviction because the trial judge’s instructions to the jury had not sufficiently required the jury to determine whether criminal intent was present when Andersen employees, acting at least in part under the firm’s preexisting document-retention policy, destroyed documents that would have been relevant to legal proceedings connected with the Enron debacle. Criminal intent may be inferred from an accused’s behavior because a person is normally held to have intended the natural and probable consequences of her acts. The intent requirement furthers the criminal law’s general goal of punishing conscious wrongdoers. Accordingly, proof that the defendant had the capacity to form the required intent is a traditional prerequisite of criminal responsibility. The criminal law recognizes three general types of incapacity: intoxication, infancy, and insanity. Although it is not a complete defense to criminal liability, voluntary intoxication may sometimes diminish the degree of a defendant’s responsibility. For example, many The beyond-a-reasonable-doubt standard required of the government in criminal cases contemplates a stronger and more convincing showing than that required of plaintiffs in civil cases. As explained in Chapter 2, plaintiffs in civil cases need only prove the elements of their claims by a preponderance of the evidence. 2



Chapter Five Criminal Law and Procedure

first-degree murder statutes require proof of premeditation, a conscious decision to kill. One who kills while highly intoxicated may be incapable of premeditation—meaning that he would not be guilty of first-degree murder. He may be convicted, however, of another homicide offense that does not require proof of premeditation. The criminal law historically presumed that children younger than 14 years of age (“infants,” for legal purposes) could not form a criminal intent. Today, most states treat juvenile offenders below a certain statutory age—usually 16 or 17—differently from adult offenders, with special juvenile court systems and separate detention facilities. Current juvenile law emphasizes rehabilitation rather than capacity issues. Repeat offenders or offenders charged with

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very serious offenses, however, may sometimes be treated as adults. An accused’s insanity at the time the charged act was committed may constitute a complete defense. This possible effect of insanity has generated public dissatisfaction. The controlling legal test for whether a defendant was insane varies among court systems. The details of the possible tests are beyond the scope of this text. Suffice it to say that as applied by courts, the tests make it a rare case in which the defendant succeeds with an insanity defense.  Shaw v. United States, which follows, deals with criminal intent issues and illustrates the careful attention courts pay to the particular elements required by a criminal statute.

Shaw v. United States   137 S. Ct. 462 (2016) Lawrence Shaw obtained the identifying numbers of a Bank of America account belonging to a bank customer, Stanley Hsu. Shaw used those numbers, as well as other related information, to transfer funds from Hsu’s account to other accounts at different financial institutions. Shaw then obtained, from those other accounts, the funds he had transferred from Hsu’s Bank of America account. A federal statute makes it a crime “knowingly [to] execut[e] a scheme . . . to defraud a financial institution.” 18 U.S.C.   § 1344(1). A federally insured bank such as Bank of America would be an example of a financial institution contemplated by this statute. A federal district court convicted Shaw of violating 18 U.S.C. § 1344(1). The U.S. Court of Appeals for the Ninth Circuit affirmed his conviction. In his petition for certiorari, Shaw argued that the words “scheme . . . to defraud a financial institution” require the government to prove that the defendant had “a specific intent not only to deceive, but also to cheat, a bank,” rather than “a non-bank third party.” The U.S. Supreme Court granted review.

Breyer, Justice Shaw argues that § 1344 does not apply to him because he intended to cheat only a bank depositor, not a bank. We do not accept his arguments.  Section 1344 makes it a crime: knowingly [to] execut[e] a scheme . . . (1) to defraud a financial institution; or (2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises. Shaw makes several related arguments in favor of his basic claim, namely, that the statute does not cover schemes to deprive a bank of customer deposits. First, he [argues in his brief] that subsection (1) requires “an intent to wrong a victim bank [a ‘financial institution’] in its property rights.” He adds that the property he took, money in Hsu’s bank account, belonged to Hsu, the bank’s customer, and that Hsu is not a “financial institution.” Hence, [according to this argument,] Shaw’s scheme was one “designed” to

obtain only “a bank customer’s property,” not “a bank’s own property.” The basic flaw in this argument lies in the fact that the bank, too, had property rights in Hsu’s bank account. When a customer deposits funds, the bank ordinarily becomes the owner of the funds and consequently has the right to use the funds as a source of loans that help the bank earn profits (though the customer retains the right to withdraw funds). Sometimes, the contract between the customer and the bank provides that the customer retains ownership of the funds and the bank merely assumes possession. But even then the bank is entitled to possess the deposited funds against all the world [except for the customer with which the bank contracted]. This right, too, is a property right. Thus, Shaw’s scheme to cheat Hsu was also a scheme to deprive the bank of certain bank property rights. Hence, for purposes of the bank fraud statute, a scheme fraudulently to obtain funds from a bank depositor’s account normally is also a scheme fraudulently to obtain property from a “financial institution,” at least where, as here, the defendant knew that the bank held the deposits, the funds obtained came from the deposit account, and the defendant misled the bank in order to obtain those funds.

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Part Two Crimes and Torts

Second, Shaw says he did not intend to cause the bank financial harm. Indeed, the parties appear to agree that, due to standard banking practices in place at the time of the fraud, no bank involved in the scheme ultimately suffered any monetary loss. But the statute, while insisting upon “a scheme to defraud,” demands neither a showing of ultimate financial loss nor a showing of intent to cause financial loss. Many years ago Judge Learned Hand pointed out that “[a] man is none the less cheated out of his property, when he is induced to part with it by fraud,” even if “he gets a quid pro quo of equal value.” United States v. Rowe, 56 F.2d 747, 749 (2d Cir. 1932). That is because “[i]t may be impossible to measure his loss by the gross scales available to a court, but he has suffered a wrong; he has lost,” for example, “his chance to bargain with the facts before him.” Id. See O. Holmes, The Common Law 132 (1881) (“[A] man is liable to an action for deceit if he makes a false representation to another, knowing it to be false, but intending that the other should believe and act upon it”); Neder v. United States, 527 U.S. 1 (1999) (bank fraud statute’s definition of fraud reflects the common law). It is consequently not surprising that, when interpreting the analogous mail fraud statute, we have held it “sufficient” that the victim (here, the bank) be “deprived of its right” to use of the property, even if it ultimately did not suffer unreimbursed loss. [Citation omitted.] Lower courts have explained that, where cash is taken from a bank “but the bank [is] fully insured[,] [t]he theft [is] complete when the cash [i]s taken; the fact that the bank ha[s] a contract with an insurance company enabling it to shift the loss to that company [is] immaterial.” [Citation omitted.] We have found no case from this Court interpreting the bank fraud statute as requiring that the victim bank ultimately suffer financial harm, or that the defendant intend that the victim bank suffer such harm. Third, Shaw appears to argue that, whatever the true state of property law, he did not know that the bank had a property interest in Hsu’s account; hence he could not have intended to cheat the bank of its property. Shaw did know, however, that the bank possessed Hsu’s account. He did make false statements to the bank. He did correctly believe that those false statements would lead the bank to release from that account funds that ultimately and wrongfully ended up in Shaw’s pocket. And the bank did in fact possess a property interest in the account. These facts are sufficient to show that Shaw knew he was entering into a scheme to defraud the bank even if he was not aware of the niceties of bank-related property law. To require more, i.e., to require actual knowledge of those bank-related property-law niceties, would free (or convict) equally culpable defendants depending  upon their property-law expertise—an arbitrary result. We have found no case from this Court requiring legal knowledge of the kind Shaw suggests he lacked. But we have

found cases in roughly similar fraud-related contexts where this Court has asked only whether the targeted property was in fact property in the hands of the victim, not whether the defendant knew that the law would characterize the items at issue as “property.” See Pasquantino v. United States, 544 U.S. 544 (2005) (Canada’s right to uncollected excise taxes on imported liquor counted as “property” for purposes of the wire fraud statute); Carpenter v. United States, 484 U.S. 19 (1987) (a newspaper’s interest in the confidentiality of the contents and timing of a news column counted as property for the purposes of the mail and wire fraud statutes). We conclude that the legal ignorance that Shaw claims here is no defense to criminal prosecution for bank fraud. Fourth, Shaw argues that the bank fraud statute requires the Government to prove more than his simple knowledge that he would likely harm the bank’s property interest; in his view, the government must prove that such was his purpose. Shaw adds that his purpose was to take money from Hsu; taking property from the bank was not his purpose. But the statute itself makes criminal the “knowin[g] execut[ion of] a scheme . . . to defraud.” To hold that something other than knowledge is required would assume that Congress intended to distinguish, in respect to states of mind, between (1) the fraudulent scheme, and (2) its fraudulent elements. Why would Congress wish to do so? Shaw refers us to a number of cases involving fraud against the government and points to language in those cases suggesting that the relevant statutes required that the defendant’s purpose be to harm the statutorily protected target and not a third party. [However,] crimes of fraud targeting the government [fall within] an area of the law with its own special rules and protections. We have found no relevant authority in the area of mail fraud, wire fraud, financial frauds, or the like supporting Shaw’s view. [Fifth], Shaw asks us to apply the rule of lenity. We have said that the rule applies if “at the end of the process of construing what Congress has expressed,” there is “a grievous ambiguity or uncertainty in the statute.” [Citations omitted.] The statute is clear enough that we need not rely on the rule of lenity. As we have said, a deposit account at a bank counts as bank property for purposes of subsection (1). The defendant, in circumstances such as those present here, need not know that the deposit account is, as a legal matter, characterized as bank property. Moreover, in those circumstances, the government need not prove that the defendant intended that the bank ultimately suffer monetary loss. Finally, the statute as applied here requires a state of mind equivalent to knowledge, not purpose. Judgment of Ninth Circuit vacated; case remanded for further proceedings.



Chapter Five Criminal Law and Procedure

Criminal Procedure Criminal Prosecutions: An Overview LO5-5 Identify the major steps in a criminal prosecution.

Persons arrested for allegedly committing a crime are taken to the police station and booked. Booking is an administrative procedure for recording the suspect’s arrest. In some states, temporary release on bail may be available at this stage. After booking, the police file an arrest report with the prosecutor, who decides whether to charge the suspect with an offense. If she decides to prosecute, the prosecutor prepares a complaint identifying the accused and detailing the charges. Most states require that arrested suspects be taken promptly before a magistrate or other judicial officer (such as a justice of the peace or judge whose court is of limited jurisdiction) for an initial appearance. During this appearance, the magistrate informs the accused of the charges and outlines the accused’s constitutional rights. In misdemeanor cases in which the accused pleads guilty, the sentence may be (but need not be) imposed without a later hearing. If the accused pleads not guilty to a misdemeanor charge, the case is set for trial. In felony cases, as well as misdemeanor cases in which the accused pleads not guilty, the magistrate sets the amount of bail. In many states, defendants in felony cases are protected against unjustified prosecutions by an additional procedural step, the preliminary hearing. The prosecutor must introduce enough evidence at this hearing to persuade a magistrate that there is probable cause to believe the accused committed a felony.3 If persuaded that probable cause exists, the magistrate binds over the defendant for trial in the appropriate court. After a bindover, the formal charge against the defendant is filed with the trial court. The formal charge consists of either an information filed by the prosecutor or an indictment returned by a grand jury. Roughly half of the states require that a grand jury approve the decision to prosecute a person for a felony. Grand juries are bodies of citizens selected in the same manner as the members of a trial (petit) jury; often, they are chosen through random drawings from a list of registered voters. Indictment of an accused prior to a preliminary hearing normally eliminates

the need for a preliminary hearing because the indictment serves essentially the same function as a magistrate’s probable cause determination. The remainder of the states allow felony defendants to be charged by either indictment or information, at the prosecutor’s discretion. An information is a formal charge signed by the prosecutor outlining the facts supporting the charges against the defendant. In states allowing felony prosecution by information, prosecutors elect the information method in the vast majority of felony cases. Misdemeanor cases are prosecuted by information in nearly all states.4 Once an information or indictment has been filed with a trial court, an arraignment occurs. The defendant is brought before the court, informed of the charges, and asked to enter a plea. The defendant may plead guilty, not guilty, or nolo contendere. Although technically not an admission of guilt, nolo contendere pleas indicate that the defendant does not contest the charges. This decision by the defendant will lead to a finding of guilt. Unlike evidence of a guilty plea, however, evidence of a defendant’s nolo plea is inadmissible in later civil cases against that defendant based on the same conduct amounting to the criminal violation. Individuals and corporate defendants therefore may find nolo pleas attractive when their chances of mounting a successful defense to the criminal prosecution are poor and the prospect of later civil suits is likely. At or shortly after the arraignment, the defendant who pleads not guilty chooses the type of trial that will take place. Persons accused of serious crimes for which incarceration for more than six months is possible have a constitutional right to be tried by a jury of their peers. The accused, however, may waive this right and opt for a bench trial (i.e., before a judge only). Pursuant to the Supreme Court’s decision in Ramos v. Louisiana, 139 S. Ct. 1318 (2019), the Sixth Amendment requires that jury verdicts for serious crimes must be unanimous in all state and federal cases.

Role of Constitutional Safeguards The pre-

ceding text referred to various procedural devices designed to protect persons accused of crime. The Bill of Rights, the first 10 amendments to the U.S. Constitution, sets forth other rights of criminal defendants. These rights guard against unjustified or erroneous criminal convictions and serve as reminders of government’s proper role in the administration For federal crimes, a prosecutor in the relevant U.S. Attorney’s office files an information to institute the case if the offense involved carries a penalty of not more than one year of imprisonment. Federal prosecutions for more serious crimes with potentially more severe penalties are commenced by means of a grand jury indictment. 4

The state need not satisfy the beyond-a-reasonable-doubt standard of proof at the preliminary hearing stage. The prosecutor sufficiently establishes probable cause by persuading the magistrate to believe it is more likely than not that the defendant committed the felony alleged. 3

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Part Two Crimes and Torts

of justice in a democratic society. Justice Oliver Wendell Holmes aptly addressed this latter point when he said, “I think it less evil that some criminals should escape than that the government should play an ignoble part.” Although the literal language of the Bill of Rights refers only to federal government actions, the U.S. Supreme Court has applied the most important Bill of Rights guarantees to state government actions by “selectively incorporating” those guarantees into the Fourteenth Amendment’s due process protection. Once a particular safeguard has been found to be “implicit in the concept of ordered liberty” or “fundamental to the American scheme of justice,” it has been applied equally in state and federal criminal trials. This has occurred with the constitutional protections examined earlier in this chapter as well as with the Fourth, Fifth, and Sixth Amendment guarantees discussed in the following sections. LO5-6

Describe the basic protections afforded by the Fourth, Fifth, and Sixth Amendments.

The Fourth Amendment The

Fourth Amendment protects persons against arbitrary and unreasonable governmental violations of their privacy rights. It states: The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon probable cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized.

Key Fourth Amendment Questions The

Fourth Amendment’s language and judicial interpretations of it reflect the difficulties inherent in balancing citizens’ legitimate expectations of privacy against government’s important interest in securing evidence of wrongdoing. The immediately following paragraphs introduce key Fourth Amendment questions and offer answers of a general nature. More complete discussion and explanation of Fourth Amendment issues and principles will then appear in the text material and cases included later in this section of the chapter. In addition, Figure 5.2, which appears later in the chapter, provides further detail. Two basic questions arise when a government action is challenged under the Fourth Amendment. First, was there a search or seizure? If the government action did not constitute a search or seizure, there cannot have been a Fourth Amendment violation. If there was a search or seizure, this second basic question must be addressed: Was it unreasonable?  The

Fourth Amendment furnishes protection only against “unreasonable” searches and seizures. Questions about the Fourth Amendment language regarding warrants often accompany the fundamental questions noted above. Must the government have a warrant in order to comply with the Fourth Amendment when it conducts a search or seizure? The Fourth Amendment’s language stops short of making warrants mandatory in all instances. However, cases interpreting and applying the Fourth Amendment indicate that a search conducted in accordance with a properly supported warrant issued by a judge or magistrate will be considered reasonable. What is necessary for a valid warrant? “[P]robable cause” for the issuance of the warrant must exist, and the warrant’s language must “particularly descri[be]” the relevant place, persons, or things. May a warrant’s validity be challenged for lack of probable cause or on other grounds? Yes, if the challenging party has standing to do so. How are warrantless searches treated under the Fourth Amendment? They tend to be considered unreasonable. As later discussion reveals, however, the Supreme Court has identified various types of warrantless searches that do not violate the Fourth Amendment. Finally, this important question frequently presents itself: What is the usual remedy if an unreasonable search or seizure took place? The exclusionary rule is applied— meaning that evidence obtained in or as the result of the unreasonable search or seizure cannot be used in a criminal case against the party whose Fourth Amendment rights were violated. We now look in greater depth at the questions introduced above. Whether a search took place for Fourth Amendment purposes depends to a great extent on whether the affected person (whether human or corporate) had a reasonable expectation of privacy that was invaded. The Supreme Court has stated that the Fourth Amendment protects persons rather than places. However, consideration of places and items often becomes necessary because of the amendment’s reference to “the right of the people to be secure in their persons, houses, papers, and effects” and because reasonable expectations of privacy often are connected with places and things. Accordingly, the Supreme Court has held that the Fourth Amendment’s protection extends to such places or items as private dwellings and immediately surrounding areas (often called the curtilage), offices, sealed containers, mail, and telephone booths (nearly a relic of the past). The Court has denied Fourth Amendment protection to places, items, or matters as to which it found no reasonable expectations of privacy, such as open fields, bank records, and voluntary conversations



Chapter Five Criminal Law and Procedure

between government informants and criminal suspects or defendants. Even when the circumstances involve an item or area that might otherwise seem to suggest Fourth Amendment concerns, some government actions may be deemed insufficiently intrusive to constitute a search or seizure. For example, the Supreme Court held in United States v. Place, 462 U.S. 696 (1983), that it was not a search when police exposed an airline traveler’s luggage to a narcotics detection dog in a public place, given the minimally intrusive nature of the action and the narrow scope of information it revealed. Relying on Place, the Supreme Court concluded in Illinois v. Caballes, 543 U.S. 405 (2005), that no search occurred when law enforcement officers used a drug-sniffing dog on the exterior of a car whose driver had been stopped for speeding. However, in Rodriguez v.  United States, 575 U.S. 348 (2015), the Supreme Court limited Caballes in both legal and practical effect by holding that if the use of the drug-sniffing dog around the car’s exterior lengthened an otherwise lawful traffic stop beyond the time reasonably necessary to complete the purpose of the stop, a Fourth Amendment violation would be present. On the other hand, the Supreme Court concluded in Kyllo v. United States, 533 U.S. 27 (2001), that a search

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occurred when law enforcement officers, operating from a public street, aimed a thermal-imaging device at the exterior of a private home in an effort to identify heatemanation patterns that might suggest the presence of a marijuana-growing operation inside the home. The cases just noted set the stage for a later case in which the Supreme Court was faced with deciding whether a search took place when police officers, acting without a warrant, brought drug-sniffing dogs to a suspect’s home and put the dogs into service on the suspect’s porch. Would the Court rule as it did in the earlier drug-sniffing dog cases (Place and Caballes), or would it follow the lead of Kyllo? Holding that an unreasonable search occurred, the Court emphasized in Florida v. Jardines, 569 U.S. 1 (2013), as it had in Kyllo, the particular importance of the home and its curtilage when balancing the resident’s Fourth Amendment interests against the evidence-gathering interests of the government. The case that follows provides further illustration of Fourth Amendment principles noted earlier. In United States v. Jones, the Supreme Court decides whether a search took place when law enforcement officers, acting without a warrant, attached a GPS device to the underside of a suspect’s car in an effort to gather evidence pertaining to possible crimes.

United States v. Jones   565 U.S. 400 (2012) Antoine Jones, the owner and operator of a District of Columbia nightclub, came under suspicion of trafficking in narcotics. He became the target of an investigation by a joint FBI and Metropolitan Police Department task force. Officers employed various investigative techniques, including visual surveillance of the nightclub, installation of a camera focused on the front door of the club, and a pen register and wiretap covering Jones’s cell phone. In addition, the law enforcement agents installed a GPS tracking device on the undercarriage of the Jeep Grand Cherokee that Jones’s wife owned but that Jones drove exclusively. The agents installed the GPS device while it was parked in a public parking lot. They did so without a warrant to authorize such action and without informing Jones or his wife. Over the next 28 days, the government used the GPS device to track the vehicle’s movements. By means of signals from multiple satellites, the device established the vehicle’s location and communicated that location by cell phone to a government computer. It relayed more than 2,000 pages of data over the four-week period. The government ultimately obtained a multiple-count indictment charging Jones and several alleged co-conspirators with various drug-trafficking offenses. Before trial, Jones filed a motion asking a federal district court to suppress (i.e., rule inadmissible) the evidence obtained through use of the GPS device. The court denied the motion because “‘[a] person traveling in an automobile on public thoroughfares has no reasonable expectation of privacy in his movements from one place to another’” [quoting the district court’s decision, which quoted United States v. Knotts, 460 U.S. 276 (1983)]. At the trial, the government introduced as evidence GPS-derived locational data that connected Jones to the alleged conspirators’ stash house, where $850,000 in cash and large quantities of illegal drugs were found. The jury found Jones guilty. The U.S. Court of Appeals for the District of Columbia Circuit reversed the conviction. The D.C. Circuit held that the warrantless use of the GPS device violated the Fourth Amendment and that the lower court therefore should have suppressed the evidence obtained through the device’s use. The Supreme Court granted the government’s petition for a writ of certiorari.

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Part Two Crimes and Torts

Scalia, Justice The Fourth Amendment provides in relevant part that “[t]he right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated.” It is beyond dispute that a vehicle is an “effect” as that term is used in the Amendment. We hold that the government’s installation of a GPS device on a target’s vehicle, and its use of that device to monitor the vehicle’s movements, constitutes a “search.” It is important to be clear about what occurred in this case: The government physically occupied private property for the purpose of obtaining information. We have no doubt that such a physical intrusion would have been considered a “search” within the meaning of the Fourth Amendment when it was adopted. The text of the Fourth Amendment reflects its close connection to property, since otherwise it would have referred simply to “the right of the people to be secure against unreasonable searches and seizures”; the phrase “in their persons, houses, papers, and effects” would have been superfluous. Consistent with this understanding, our Fourth Amendment jurisprudence was tied to common-law trespass, at least until the latter half of the 20th century. Our later cases, of course, have deviated from that exclusively property-based approach. In Katz v.  United States, 389 U.S. 347, 351 (1967), we said that “the Fourth Amendment protects people, not places,” and found a violation in attachment of an eavesdropping device to a public telephone booth. Our later cases have applied the analysis of Justice Harlan’s concurrence in that case, which said that a violation occurs when government officers violate a person’s “reasonable expectation of privacy.” Id. at 360. The government contends that the Harlan standard shows that no search occurred here, since Jones had no “reasonable expectation of privacy” in the area of the Jeep accessed by government agents (its underbody) and in the locations of the Jeep on the public roads, which were visible to all. But we need not address the government’s contentions, because Jones’s Fourth Amendment rights do not rise or fall with the Katz formulation. As explained, for most of our history the Fourth Amendment was understood to embody a particular concern for government trespass upon the areas (“persons, houses, papers, and effects”) it enumerates. Katz did not repudiate that understanding. Less than two years [after Katz was decided,] the Court upheld defendants’ contention that the government could not introduce against them conversations between other people obtained by warrantless placement of electronic surveillance devices in their homes. The opinion rejected the dissent’s contention that there was no Fourth Amendment violation “unless the conversational privacy of the homeowner himself is invaded.” Alderman v. United States, 394 U.S. 165, 176 (1969). “[W]e [do not] believe that Katz, by holding that the Fourth Amendment protects

persons and their private conversations, was intended to withdraw any of the protection which the Amendment extends to the home. . . .” Id. at 180. More recently, in Soldal v. Cook County, 506 U.S. 56 (1992), the Court unanimously rejected the argument that although a “seizure” had occurred “in a ‘technical’ sense” when a trailer home was forcibly removed, no Fourth Amendment violation occurred because law enforcement had not “invade[d] the [individuals’] privacy.” Id. at 60. Katz, the Court explained, established that “property rights are not the sole measure of Fourth Amendment violations,” but did not “snuf[f] out the previously recognized protection for property.” Id. at 64. We have embodied that preservation of past rights in our very definition of “reasonable expectation of privacy,” which we have said to be an expectation “that has a source outside of the Fourth Amendment, either by reference to concepts of real or personal property law or to understandings that are recognized and permitted by society.” Minnesota v.  Carter, 525 U.S. 83, 88 (1998). Katz did not narrow the Fourth Amendment’s scope. The government contends that several of our post-Katz cases foreclose the conclusion that what occurred here constituted a search. It relies principally on two cases in which we rejected Fourth Amendment challenges to “beepers,” electronic tracking devices that represent another form of electronic monitoring. The first case, United States v. Knotts, 460 U.S. 276 (1983), upheld against Fourth Amendment challenge the use of a beeper that had been placed in a container of chloroform, allowing law enforcement to monitor the location of the container. We said that there had been no infringement of Knotts’ reasonable expectation of privacy since the information obtained—the location of the automobile carrying the container on public roads, and the location of the off-loaded container in open fields near Knotts’ cabin— had been voluntarily conveyed to the public. But as we have discussed, the Katz reasonable-expectation-of-privacy test has been added to, not substituted for, the common-law trespassory test. The holding in Knotts addressed only the former, since the latter was not at issue. The beeper had been placed in the container before it came into Knotts’s possession, with the consent of the thenowner. Knotts did not challenge that installation, and we specifically declined to consider its effect on the Fourth Amendment analysis. The second beeper case, United States v. Karo, 468 U.S. 705 (1984), does not suggest a different conclusion. There we addressed the question left open by Knotts, whether the installation of a beeper in a container amounted to a search or seizure. As in Knotts, at the time the beeper was installed the container belonged to a third party, and it did not come into possession of the defendant until later. Thus, the specific question we considered was whether the installation “with the consent of the



Chapter Five Criminal Law and Procedure

original owner constitute[d] a search or seizure . . . when the container is delivered to a buyer having no knowledge of the presence of the beeper.” Id. at 707 (emphasis added). We held not. The government, we said, came into physical contact with the container only before it belonged to the defendant Karo, and the transfer of the container with the unmonitored beeper inside did not convey any information and thus did not invade Karo’s privacy. That conclusion is perfectly consistent with the one we reach here. Karo accepted the container as it came to him, beeper and all, and was therefore not entitled to object to the beeper’s presence, even though it was used to monitor the container’s location. Jones, who possessed the Jeep at the time the government trespassorily inserted the information-gathering device, is on much different footing. The government also points to our exposition in New York v. Class, 475 U.S. 106 (1986), that “[t]he exterior of a car . . . is thrust into the public eye, and thus to examine it does not constitute a ‘search.’” Id. at 114. That statement is of marginal relevance here since, as the government acknowledges, “the officers in this case did more than conduct a visual inspection of respondent’s vehicle” [quoting the government’s brief, with emphasis added]. By attaching the device to the Jeep, officers encroached on a protected area. In Class  itself we suggested that this would make a difference, for we concluded that an officer’s momentary reaching into the interior of a vehicle did constitute a search. Id. at 114–15. Finally, the government’s position gains little support from our conclusion in Oliver v. United States, 466 U.S. 170 (1984), that officers’ information-gathering intrusion on an “open field” did not constitute a Fourth Amendment search even though it was a trespass at common law. Id. at 183. Quite simply, an open field, unlike the curtilage of a home, see United States v. Dunn, 480 U.S. 294, 300 (1987), is not one of those protected areas enumerated in the Fourth Amendment. The government’s physical intrusion on such an area—unlike its intrusion on the “effect” at issue here—is of no Fourth Amendment significance. Thus, our theory is not that the Fourth Amendment is concerned with [every] trespass that led to the gathering of evidence. The Fourth

Describe major exceptions to the Fourth Amendment’s LO5-7 usual preference that the government have a warrant before conducting a search.

Warrantless Searches and the Fourth Amendment Although the Fourth Amendment is sometimes described as setting up a warrant “requirement,”

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Amendment protects against trespassory searches only with regard to those items (“persons, houses, papers, and effects”) that it enumerates. The trespass that occurred in Oliver[, therefore, did not amount to a Fourth Amendment violation]. The government argues in the alternative that even if the attachment and use of the GPS device was a search, it was reasonable—and thus lawful—under the Fourth Amendment because “officers had reasonable suspicion, and indeed probable cause, to believe that [Jones] was a leader in a large-scale cocaine distribution conspiracy” [quoting the government’s brief]. We have no occasion to consider this argument. The government did not raise it below, and the D.C. Circuit therefore did not address it. We consider the argument forfeited. D.C. Circuit decision in favor of Jones affirmed. [Note: Five justices subscribed to Justice Scalia’s majority opinion. The other four justices agreed with the outcome (that the placement and use of the GPS device was a search for Fourth Amendment purposes). However, they would have reached that outcome purely on the basis of the reasonable expectation of privacy test rather than through taking trespass considerations into account.] Justice Sotomayor’s concurrence in Jones became especially important in the Court’s 2018 opinion in Carpenter v. United States, 138 S. Ct. 2206, which addressed whether the government could obtain cell phone location records without a warrant pursuant to the Stored Communications Act. The Court held that data used in tracking a person by cell towers was similar to that of using a GPS tracking device as in Jones. In addition, the “third-party doctrine,” which provides that people who voluntarily provide information to third parties like phone companies have no reasonable expectation of privacy, did not change the result because consumers do not choose to share their geographic location and movements through cell phones. In reaching this conclusion, the Court stressed “the inescapable and automatic” nature of the collection of cell phone data, and that cell phones hold the “privacies of life” for many Americans.

the amendment’s literal language does not do so. It is more accurate to say that as interpreted by courts, the Fourth Amendment contemplates a preference for a warrant but does not require one in all instances. Because a judge or magistrate must determine whether probable cause supports the request for the warrant and must ensure that the government’s intrusive action is appropriately limited, warrants serve to protect privacy interests and guard against

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Part Two Crimes and Torts

pure “fishing expeditions” by the government. The preference for warrants, therefore, gives rise not only to the rule that a search or seizure conducted in accordance with a proper warrant is reasonable for Fourth Amendment purposes but also to the assumption that a warrantless search or seizure may be unreasonable. Clearly, however, not all warrantless searches and seizures violate the Fourth Amendment. The Supreme Court has identified various instances in which a warrantless search or seizure will pass muster under the Fourth Amendment. The list of exceptions to the usual preference for a warrant includes the following: Search incident to lawful arrest. Under this longrecognized exception, officers may conduct a warrantless search of the arrestee himself, the items in his possession, and the items within his control—or to which he has access—at the time of arrest. (This is permitted regardless of whether the arrest itself occurred pursuant to a warrant or whether the arrest was otherwise lawful because there was probable cause to believe that the arrestee committed the relevant offense.) The rationale is twofold: to protect

the arresting officers in the possible event that the arrestee has a weapon and to obtain evidence that otherwise might be destroyed or go undiscovered. Weapons and evidence obtained during the search may be seized by the officers. Does the search-incident-to-arrest exception permit officers to search the content stored on a cell phone or smartphone in the arrestee’s possession at the time of the arrest? For consideration of that question, see Figure 5.2. Certain searches of motor vehicles. Law enforcement officers may conduct a warrantless search of a motor vehicle when the driver or other recent occupant of the vehicle is arrested and either (1) the arrestee is still within reaching distance of the vehicle during the search or (2) the officers have reason to believe the vehicle contains evidence of the crime for which the driver or other occupant was arrested. The rationale here is essentially the same as in the searchincident-to-arrest scenario described above. Weapons and evidence obtained during the search of the vehicle may be seized by the officers. Investigative stops upon reasonable suspicion. Officers need not have a warrant to stop a vehicle if they have a

Figure 5.2 A Note on Riley v. California Nearby discussion in the text outlines the search-incident-to-arrest exception to the usual preference for a warrant. If, as is often the case, an arrestee has a cell phone or smartphone in his or her possession, may law enforcement officers search the content stored on that phone under the search-incident-to arrest doctrine, or is a warrant to search it necessary? In recent years, police fairly routinely conducted such a search, relied on search-incident-to-arrest principles in doing so, and not infrequently  found the phone to be a treasure trove of evidence. Critics of such police action asserted that cell phones—and particularly smartphones—are different from other items an arrestee may have in his or her possession because the phones may contain huge quantities of information and because, in their view, arrestees should be seen as having reasonable expectations of privacy in regard to what those devices contain. Lower courts reached differing results when addressing the question whether a warrant is necessary in this setting. In 2014, the Supreme Court decided Riley v. California, 573 U.S. 373. In that case, the Court held unanimously that the searchincident-to-arrest doctrine does not justify a search of an arrestee’s cell phone or smartphone and that a warrant is necessary in order for such a search to be reasonable for Fourth Amendment purposes. Writing for the Court, Chief Justice Roberts made it clear that cell phones and smartphones are vastly different from other items that persons may carry with them, given those devices’ broad-ranging functions and their capacities to store enormous amounts—as well as various types—of information. The chief justice noted that these devices, on which so many persons rely, may furnish “a digital record of nearly every aspect of the [owners’] lives—from the mundane to the intimate.” The privacy interests of cell phone and smartphone owners thus carried more weight in the Court’s analysis than did countervailing law enforcement interests. The Court also emphasized the importance of having a clear rule for law enforcement officers to follow. Rejecting the government’s proposal that officers be able to conduct a warrantless search of an arrestee’s cell phone or smartphone in an effort to find evidence pertaining to the crime for which he or she was arrested (as opposed to evidence of other possible crimes), the Court regarded that proposal as unworkable. Such a rule would require too many fact-specific judgments by officers in the field and afterward by judges in court proceedings. Moreover, such a rule might be exploited by officers to an unreasonable extent. Hence, the Court stressed that the need for a warrant before searching the cell phone or smartphone exists even when officers believe that the device in the arrestee’s possession is likely to contain evidence relevant to the crime for which the arrest occurred. In addition, the Court made no distinction between older cell phones and new smartphones, even though the smartphones can do far more than the cell phones that seemed so remarkable not many years ago. Either way—cell phone or high-powered smartphone—officers are expected to know after the Riley decision that a warrant will be necessary before they can search the content of the device.



Chapter Five Criminal Law and Procedure

reasonable suspicion that the driver committed a traffic violation (for which a ticket might be issued but no arrest would be made) or if they have a reasonable suspicion of other wrongdoing on the part of the driver or other vehicle occupant. In such an investigative stop, the detention of the driver and vehicle occupants does not violate the Fourth Amendment if the stop is brief and otherwise reasonably conducted. If no arrest occurs but the officers proceed to conduct a warrantless search of the vehicle, there normally will be a Fourth Amendment violation. However, the officers may search the vehicle if the driver consents or if probable cause to search arises on the basis of the officers’ visual observations, other sensory perceptions, or further key facts that come to the officers’ attention. If evidence discovered in the search of the vehicle helps to form the basis of criminal charges against the driver or other vehicle occupants, the persons charged have legal standing to challenge the validity of the stop (by arguing that the necessary reasonable suspicion was lacking) and the ensuing search (by arguing that the search stemmed from an improper stop or was unsupported by probable cause). Stop-and-frisk searches for weapons. If law enforcement officers’ observations give them a reasonable suspicion that a person may be engaged in criminal activity, the officers may detain the person briefly for investigative purposes without violating the Fourth Amendment. During that detention—usually called a “Terry stop” because of the case in which the Supreme Court held that the Fourth Amendment permits such police action—officers may conduct a pat-down search of the detained person in order to determine whether he is carrying a weapon that could endanger the officers. Plain view. If an officer sees contraband or other evidence in plain view (meaning that the item is readily visible to the officer without any special efforts), the officer may seize the item and will not violate the Fourth Amendment in doing so. Consensual searches. Searches that occur with the consent of a person who owns or possesses the relevant place or thing are considered reasonable. Therefore, one who consents to a search of her home, office, or car will normally be regarded as having forfeited any Fourth Amendment objection she might otherwise have been able to make. If there are co-occupants of a residence and any co-occupant gives law enforcement officers consent to search the property, the permission granted by that co-occupant will normally insulate the search against a Fourth Amendment challenge brought later by a nonpresent and nonconsenting co-occupant. As the Supreme Court recognized in Georgia v. Randolph, 547 U.S. 103 (2006), however, a consent to search provided by one co-occupant of a residence does

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not protect the search against a Fourth Amendment challenge by another co-occupant who was present at the time of the search and objected to its occurrence. If the police cannot (as the Randolph decision indicates) lawfully conduct a search of a residence when an on-the-premises cooccupant refuses to consent, does the Fourth Amendment permit the police to return to the home when the nonconsenting co-occupant is no longer present, obtain consent from another co-occupant, and conduct the search? The Supreme Court said “yes”  in the 2014 case Fernandez v. California, 571 U.S. 292. Searches under exigent circumstances. Courts have upheld warrantless searches of premises that law enforcement officers enter in order to protect persons present there if the officers reasonably believe those persons are at risk of imminent serious harm. The emergency nature of such a situation obviously would not allow time to obtain a warrant. The Supreme Court has ruled that the exigent circumstances exception can also apply to warrantless searches of premises entered by officers when they are in hot pursuit of a fleeing suspect. In Kentucky v. King, 563 U.S. 452 (2011), the Court held that this exception justified officers’ warrantless entry and search of an apartment. In that case, officers who had been pursuing a fleeing suspect entered the apartment when, after knocking on the door and announcing their presence, they heard sounds that made them think evidence was being destroyed. The Court concluded that the additional exigency of preventing evidence destruction helped to make the warrantless entry and search acceptable under the Fourth Amendment, even though the officers guessed wrong about which apartment the suspect they had been chasing had actually entered. In Missouri v. McNeely, 569 U.S. 141 (2013), however, the Court rejected the state’s argument that concern about possible dissipation of evidence of blood alcohol content should justify applying the exigent circumstances doctrine to authorize a warrantless drawing of blood from a motorist suspected of driving under the influence of alcohol. Weighing that law enforcement concern against the invasive nature of a forced drawing of blood (as opposed to a noninvasive breath test) caused the Court to conclude that a warrant was necessary. Yet, in Mitchell v. Wisconsin, 139 S. Ct. 2525 (2019), the Court appears to have reopened the door of warrantless blood draws when the motorist is unconscious. The test for exigency is, according to the Court, when there is a compelling need for official action and no time to secure a warrant. In holding that the state met that test merely because the defendant was unconscious, the opinion may have created a presumption of exigent circumstances in such situations.

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Part Two Crimes and Torts

DNA swabs in the booking process. In Maryland v. King, 569 U.S. 435 (2013), the Supreme Court weighed in on a practice engaged in fairly frequently by law enforcement officers in recent years: taking a DNA sample from arrestees—­usually those charged with crimes involving violence—without a warrant and as part of the booking process. The sample tends to be taken quickly through insertion of a swab inside the arrestee’s cheek. Upholding a Maryland law that permitted such warrantless use of the DNA swab on those arrested for violent crimes, a five-justice majority of the Supreme Court regarded the bodily intrusion as minimal and stressed the usefulness of the resulting evidence in accurately identifying the arrestee. The dissenters were troubled by what they regarded as the real (though unspoken) reason why the Court permitted the gathering of DNA evidence in this way: the usefulness of the resulting evidence in solving crimes other than the ones for which the arrestee was arrested—crimes for which law enforcement authorities otherwise had no reason to suspect the arrestee. Customs searches. Given the importance of controlling the nation’s borders and regulating the passage of persons and items into the country, government agents have fairly broad authority to conduct warrantless searches in the customs and border contexts. Administrative inspections of closely regulated businesses. Various statutes and regulations subject certain types of businesses to inspections by government agents in order to safeguard public health and welfare. To the extent that these inspections come within the scope of the relevant statutes and regulations, they are considered to be reasonable for Fourth Amendment purposes even though they occur without a warrant. Exclusionary Rule LO5-8 Explain what the exclusionary rule is.

The exclusionary rule serves as the basic remedial device in cases of Fourth Amendment violations. Under this judicially crafted rule, evidence seized in illegal searches cannot be used in a subsequent trial against an accused whose constitutional rights were violated.5 In addition, if information obtained in an illegal search leads to the later discovery of further evidence, that further evidence is considered “fruit of the poisonous tree” and is therefore excluded from use at trial under the rule established in Wong Sun v. United The Supreme Court initially authorized application of the exclusionary rule in federal criminal cases only. In Mapp v. Ohio, 367 U.S. 643 (1961), the Court made the exclusionary rule applicable to state criminal cases as well. 5

States, 371 U.S. 471 (1963). Because the exclusionary rule may result in suppression of convincing evidence of crime, it has generated controversy. The rule’s supporters regard it as necessary to deter police from violating citizens’ constitutional rights. The rule’s opponents assert that it has no deterrent effect on police who believed they were acting lawfully. A loudly voiced complaint in some quarters has been that “because of a policeman’s error, a criminal goes free.” During roughly the past three decades, the Supreme Court has responded to such criticism by rendering decisions that restrict the operation of the exclusionary rule. For example, the Court has held that illegally obtained evidence may be introduced at trial if the prosecution convinces the trial judge that the evidence would inevitably have been obtained anyway by lawful means. The Court has also created a “good-faith” exception to the exclusionary rule. This exception allows the use of evidence seized by police officers who acted pursuant to a search warrant later held invalid if the officers reasonably believed that the warrant was valid. In Herring v. United States, 555 U.S. 135 (2009), the Court declined to apply the exclusionary rule to evidence obtained as a result of an arrest made pursuant to a rescinded arrest warrant where a police employee had negligently failed to remove the rescinded warrant from a law enforcement database, but the arresting officer relied in good faith on the warrant’s supposed validity. Although the Court has not extended this good-faith exception to warrantless searches in general, it has declined to apply the exclusionary rule where the search was conducted in reliance on a statute that was later declared invalid or in reliance on earlier Court decisions that gave greater Fourth Amendment leeway to law enforcement officers than an otherwise controlling later decision did.  Finally, Utah v. Strieff, 136 S. Ct. 2056 (2016), further illustrates the Supreme Court’s tendency in recent years to narrow the application of the exclusionary rule. In that case, a law enforcement officer detained a person without sufficient legal cause but quickly learned that there was an outstanding arrest warrant for the person. The officer then made the arrest, conducted a search incident to the arrest, and discovered that the arrestee was in possession of illegal drugs. In the drug possession prosecution that followed, the defendant argued that because the initial detention of him was without cause, the seized drugs should be excluded from evidence under the previously discussed fruit-of-the-poisonous-tree doctrine. The Supreme Court rejected that argument, holding instead that the detaining officer’s prompt discovery of the valid arrest warrant made the connection between the initial stop of the defendant and the officer’s discovery of the drugs too attenuated to warrant exclusion of the evidence.



Chapter Five Criminal Law and Procedure

The USA PATRIOT Act Approximately six weeks after the September 11, 2001, terrorist attacks on the United States, Congress enacted the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act. This statute, commonly known as the USA PATRIOT Act or as simply the Patriot Act, contains numerous and broad-ranging provisions designed to protect the public against international and domestic terrorism. Included in the Patriot Act are measures allowing the federal government significantly expanded ability, in terrorism-related investigations, to conduct searches of property, monitor Internet activities, track electronic communications, and obtain records regarding customers of businesses. Most, though not all, actions of that nature require a warrant from a special court known as the Foreign Intelligence Surveillance Court. The statute contemplates, however, that such warrants may be issued upon less of a showing by the government than would ordinarily be required, and may be more sweeping than usual in terms of geographic application. Moreover, warrants issued by the special court for the search of property can be of the socalled sneak and peek variety, under which the FBI need not produce the warrant for the property owner or possessor to see and need not notify an absent property owner or possessor that the search took place (unlike the rules typically applicable to execution of “regular” warrants). In addition, the Patriot Act permits warrants for “roving” wiretaps—ones that apply to various communications devices or methods that a person suspected of ties to terrorism may employ, as opposed to being restricted to a single communications device or method. The Patriot Act also calls for banks to report seemingly suspicious monetary deposits, as well as any deposits exceeding $10,000, not only to the Treasury Department (as required by prior law) but also to the Central Intelligence Agency and other federal intelligence agencies. In addition, the statute enables federal law enforcement authorities to seek a Surveillance Court warrant for the obtaining of individuals’ credit, medical, and student records, regardless of state or federal privacy laws that would otherwise have applied. Commentators critical of the Patriot Act have argued that despite the importance of safeguarding the public against acts of terrorism, the statute tips the balance too heavily in favor of law enforcement. They have characterized the statute’s definition of “domestic terrorism” as so broad that various suspected activities not normally regarded as terrorism (or as harboring or aiding terrorists) could be considered as such for purposes of the federal government’s expanded investigatory tools. If that happens,

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the critics contend, Fourth Amendment and other constitutional rights may easily be subverted. Others with reservations about the statute maintain that its allowance of expanded monitoring of Internet activities and electronic communications and its provisions for retrieval of library records and other records normally protected by privacy laws could give the government ready access to communications and private information of many wholly innocent persons. In apparent recognition of the extraordinary action it was taking in a time of national crisis, Congress included provisions stating that unless they were renewed, portions of the Patriot Act would expire at the end of 2005. Congress has since renewed the bulk of the Patriot Act on more than one occasion and has made most of its provisions permanent in the sense of not requiring a renewal (though certain provisions, such as the one dealing with roving wiretaps, continue to require periodic renewals). With most of the Patriot Act having been made permanent, those who have raised civil liberties concerns may continue to seek repeal of part or all of the statute. Repeal seems unlikely, however, in a political environment that continues to be shaped in significant ways by the events of 2001. The expanded investigatory tools provided by the Patriot Act have existed alongside those provided by an older statute, the Foreign Intelligence Surveillance Act (FISA), which was enacted long before the September 11, 2001, attacks and has been amended various times both before and since. Under FISA, monitoring of a suspected terrorist’s electronic communications generally required that an individualized warrant be obtained from the previously mentioned Foreign Intelligence Surveillance Court (FISA Court), which operates in secret and whose decisions, unlike those of other courts, are not published. Applications for warrants from the FISA Court have historically been approved a very high percentage of the time. In December 2005, it was revealed that the White House had implemented a program of monitoring telephone calls of suspected terrorists when one party to the conversation was located outside the United States. This monitoring had occurred without an attempt by the government to obtain warrants from the FISA Court. Critics of this action by the government complained that it violated not only FISA but also the Fourth Amendment. The White House took the position, however, that the monitoring program was within the inherent powers of the executive branch. Disputes over the validity of the monitoring program led to discussions over possible amendments to strengthen or loosen FISA’s requirements. These discussions resulted in an amendment under which the FISA Court could issue blanket warrants for electronic

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monitoring of groups of terrorism suspects for set periods of time (as opposed to the previous sole option of individualized warrants). With such loosening of what it saw as FISA’s constraints, the government shut down its warrantless monitoring program and resumed going to the FISA Court for warrants. In 2008, Congress enacted a further amendment to FISA. This amendment expanded the government’s ability to monitor the phone calls of suspected terrorists, established FISA’s requirement of warrants from the FISA Court as the exclusive way of exercising this surveillance power, and provided immunity from legal liability for telephone companies that had assisted the government in the phone call monitoring activities for which FISA Court warrants had not been obtained. Revelations in 2013 and 2014 by ex–Central Intelligence Agency contractor Edward Snowden about formerly secret intelligence-gathering by the federal government furnished a further chapter in the ongoing saga of anti-terrorismrelated surveillance. Snowden’s disclosures regarding the government’s collection and analysis of huge amounts of data from phone records led to debates about how much authority the government should or should not have in that sense. Later policy statements and legislative efforts have explored ways to limit and manage the government’s access to phone records and similar material in ways that would suitably account for the government’s terrorism-prevention interests and the public’s privacy interests.

The Fifth Amendment LO5-6

Describe the basic protections afforded by the Fourth, Fifth, and Sixth Amendments.

The Fifth and Fourteenth Amendments’ Due Process Clauses guarantee basic procedural and substantive fairness to criminal defendants. The Due Process Clauses are discussed earlier in this chapter and in Chapter 3. Privilege against Self-Incrimination List the components of the Miranda warnings and

LO5-9 state when law enforcement officers must give those

warnings.

In another significant provision, the Fifth Amendment protects against compelled testimonial self-incrimination by establishing that “[n]o person . . . shall be compelled in any criminal case to be a witness against himself.” This provision prevents the government from coercing a defendant

into making incriminating statements and thereby assisting in his own prosecution. In Miranda v. Arizona, 384 U.S. 436 (1966), the Supreme Court established procedural requirements—the now-familiar Miranda warnings—to safeguard this Fifth Amendment right and other constitutional guarantees. The Court did so by requiring police to inform criminal suspects, before commencing custodial interrogation of them, that they have the right to remain silent, that any statements they make may be used as evidence against them, and that during questioning they have the right to the presence and assistance of a retained or court-appointed attorney (with court appointment occurring when suspects lack the financial ability to retain counsel).6 Incriminating statements that an incustody suspect makes without first having been given the Miranda warnings are inadmissible at trial. (The exclusionary rule is thus the remedy for a Miranda violation.) If the suspect invokes her right to silence, custodial interrogation must cease. If the suspect knowingly and voluntarily waives her right to silence after having been given the Miranda warnings, her statements will be admissible. The right to silence is limited, however, in various ways. For example, the traditional view that the Fifth Amendment applies only to testimonial admissions serves as the basis for allowing the police to compel an accused to furnish nontestimonial evidence such as fingerprints, samples of body fluids, and hair. Supreme Court decisions have recognized further limitations on the right to silence. For instance, the right has been held to include a corresponding implicit prohibition of prosecutorial comments at trial about the accused’s failure to testify. Although Supreme Court decisions still support this prohibition, the Court has sometimes allowed prosecutors to use the defendant’s pretrial silence to impeach his trial testimony. For example, the Court has held that the Fifth Amendment is not violated by prosecutorial use of a defendant’s silence (either prearrest or postarrest, but in advance of any Miranda warnings) to discredit his trial testimony that he killed the victim in self-defense. More recently, in Salinas v. Texas, 570 U.S. 178 (2013), the Court held that there was no Fifth Amendment violation when the prosecutor at a murder trial commented on the defendant’s failure, during a pre-custody and prearrest interview, to answer a police officer’s question about a shotgun and shell casings found at the scene of the crime, even though he did respond to other questions posed by

The portions of the Miranda warnings dealing with the right to an attorney further Sixth Amendment interests. The Sixth Amendment is discussed later in this chapter. 6



Chapter Five Criminal Law and Procedure

the officer. Notwithstanding popular misconceptions, the Fifth Amendment does not establish a complete right to remain silent but only guarantees that criminal defendants may not be compelled to testify against themselves. Therefore, as long as police do not deprive defendants the opportunity to claim a Fifth Amendment privilege, there is no constitutional violation.

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In Berghuis v. Thompkins, which follows, a five-justice majority of the Supreme Court holds that a suspect who wishes to invoke his Miranda  right to remain silent must unambiguously invoke that right—a rule characterized by the four dissenting justices as “counterintuitively” requiring a suspect to speak up in order to indicate that he wants to remain silent.

Berghuis v. Thompkins   560 U.S. 370 (2010) Approximately a year after a Southfield, Michigan shooting in which one person was killed and another was wounded, suspect Van Chester Thompkins was arrested. While Thompkins was in custody, police officers interrogated him. At the beginning of the interrogation, one of the officers, Detective Helgert, informed Thompkins of his Miranda rights. Officers began questioning Thompkins. At no point did Thompkins state that he wished to remain silent, that he did not want to talk with the police, or that he wanted an attorney. Thompkins was largely silent during the interrogation, which lasted approximately three hours. However, he did give a few limited verbal responses such as “yeah,” “no,” or “I don’t know.” On occasion, he communicated by nodding his head. Roughly two hours and 45 minutes into the interrogation, Helgert asked Thompkins, “Do you believe in God?” Thompkins made eye contact with Helgert and said, “Yes,” as his eyes (according to the record) “well[ed] up with tears.” Helgert also asked, “Do you pray to God?” Thompkins said, “Yes.” Helgert then asked, “Do you pray to God to forgive you for shooting that boy down?” Thompkins answered, “Yes,” and looked away. Thompkins refused to make a written confession, and the interrogation ended approximately 15 minutes later. In a Michigan trial court, Thompkins was charged with first-degree murder, assault with intent to commit murder, and certain firearms-related offenses. He moved to suppress the statements made during the interrogation. He argued that he had invoked his Fifth Amendment right to remain silent, that the police officers were therefore required to end the interrogation at once, that he had not waived his right to remain silent, and that his inculpatory statements were involuntary. The trial court denied the motion, and a jury found him guilty on all counts. On appeal, Thompkins contended that the trial court erred in refusing to suppress his pretrial statements under Miranda. The Michigan Court of Appeals rejected the Miranda claim and affirmed the conviction. The Michigan Supreme Court denied discretionary review. Thompkins later filed a petition for a writ of habeas corpus in the U.S. District Court for the Eastern District of Michigan on the same grounds. The district court ruled against Thompkins. The Sixth Circuit reversed, ruling for Thompkins because his “persistent silence for nearly three hours in response to questioning and repeated invitations to tell his side of the story offered a clear and unequivocal message to the officers: Thompkins did not wish to waive his [Miranda] rights.” The U.S. Supreme Court granted certiorari.

Kennedy, Justice [In Miranda, the Court] formulated a warning that must be given to suspects before they can be subjected to custodial interrogation. The substance of the warning still must be given to suspects today. All concede that the warning given in this case was in full compliance with these requirements. The dispute centers on the response—or nonresponse—from the suspect. Thompkins makes various arguments that his answers to questions from the detectives were inadmissible. He first contends that he invoked his privilege to remain silent by not saying anything for a sufficient period of time, so the interrogation should have ceased before he made his inculpatory statements. This argument is unpersuasive. In the context of invoking the Miranda right to counsel, the Court in Davis v. United States, 512 U.S. 452, 459 (1994), held that a suspect must do so

“unambiguously.” [Davis established that if] an accused makes a statement concerning the right to counsel “that is ambiguous or equivocal” or makes no statement, the police are not required to end the interrogation, or ask questions to clarify whether the accused wants to invoke his or her Miranda rights. The Court has not yet stated whether an invocation of the right to remain silent can be ambiguous or equivocal, but there is no principled reason to adopt different standards for determining when an accused has invoked the Miranda right to remain silent and the Miranda right to counsel at issue in Davis. Both protect the privilege against compulsory self-incrimination by requiring an interrogation to cease when either right is invoked. There is good reason to require an accused who wants to invoke his or her right to remain silent to do so unambiguously. A requirement of an unambiguous invocation of Miranda rights

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Part Two Crimes and Torts

results in an objective inquiry that “avoid[s] difficulties of proof and . . . provide[s] guidance to officers” on how to proceed in the face of ambiguity. Davis, 512 U.S., at 458–459. If an ambiguous act, omission, or statement could require police to end the interrogation, police would be required to make difficult decisions about an accused’s unclear intent and face the consequence of suppression if they guess wrong. Suppression of a voluntary confession in these circumstances would place a significant burden on society’s interest in prosecuting criminal activity. Treating an ambiguous or equivocal act, omission, or statement as an invocation of Miranda rights “might add marginally to Miranda’s goal of dispelling the compulsion inherent in custodial interrogation.” Moran v. Burbine, 475 U.S. 412, 425 (1986). But “as Miranda holds, full comprehension of the rights to remain silent and request an attorney are sufficient to dispel whatever coercion is inherent in the interrogation process” [quoting Burbine]. Thompkins did not say that he wanted to remain silent or that he did not want to talk with the police. Had he made either of these simple, unambiguous statements, he would have invoked his right to cut off questioning. Here he did neither, so he did not invoke his right to remain silent. We next consider whether Thompkins waived his right to remain silent. Even absent the accused’s invocation of the right to remain silent, the accused’s statement during a custodial interrogation is inadmissible at trial unless the prosecution can establish that the accused “in fact knowingly and voluntarily waived [Miranda] rights” when making the statement. North Carolina v. Butler, 441 U.S. 369, 373 (1979). The waiver inquiry has two distinct dimensions: waiver must be “voluntary in the sense that it was the product of a free and deliberate choice rather than intimidation, coercion, or deception,” and [must be] “made with a full awareness of both the nature of the right being abandoned and the consequences of the decision to abandon it” [quoting Burbine}. Some language in Miranda could be read to indicate that waivers are difficult to establish absent an explicit written waiver or a formal, express oral statement. In addition, Miranda stated that “a heavy burden rests on the government to demonstrate that the defendant knowingly and intelligently waived his privilege against self-incrimination and his right to retained or appointed counsel.” The course of decisions since Miranda, informed by the application of Miranda warnings in the whole course of law enforcement, demonstrates that waivers can be established even absent formal or express statements of waiver. The main purpose of Miranda is to ensure that an accused is advised of and understands the right to remain silent and the right to counsel. One of the first cases to decide the meaning and import of Miranda with respect to the question of waiver was North Carolina v. Butler. Butler interpreted the Miranda language concerning the “heavy burden” to show waiver in accord with usual principles of determining waiver, which can include waiver implied from all the

circumstances. The prosecution therefore does not need to show that a waiver of Miranda rights was express. Butler made clear that a waiver of Miranda rights may be implied through “the defendant’s silence, coupled with an understanding of his rights and a course of conduct indicating waiver.” The Court in Butler therefore “retreated” from the “language and tenor of the Miranda opinion,” which “suggested that the Court would require that a waiver . . . be ‘specifically made.’” [Citation omitted.] If the state establishes that a Miranda warning was given and the accused made an uncoerced statement, this showing, standing alone, is insufficient to demonstrate a valid waiver of Miranda rights. The prosecution must make the additional showing that the accused understood these rights. Where the prosecution shows that a Miranda warning was given and that it was understood by the accused, an accused’s uncoerced statement establishes an implied waiver of the right to remain silent. The record in this case shows that Thompkins waived his right to remain silent. There is no basis in this case to conclude that he did not understand his rights; and on these facts it follows that he chose not to invoke or rely on those rights when he did speak. First, there is no contention that Thompkins did not understand his rights; and from this it follows that he knew what he gave up when he spoke. There was more than enough evidence in the record to conclude that Thompkins understood his Miranda rights. Thompkins received a written copy of the Miranda warnings; Detective Helgert determined that Thompkins could read and understand English; and Thompkins was given time to read the warnings. Thompkins, furthermore, read aloud the fifth warning, which stated that “you have the right to decide at any time before or during questioning to use your right to remain silent and your right to talk with a lawyer while you are being questioned.” He was thus aware that his right to remain silent would not dissipate after a certain amount of time and that police would have to honor his right to be silent and his right to counsel during the whole course of interrogation. Those rights, the warning made clear, could be asserted at any time. Helgert, moreover, read the warnings aloud. Second, Thompkins’ answer to Detective Helgert’s question about whether Thompkins prayed to God for forgiveness for shooting the victim is a “course of conduct indicating waiver” of the right to remain silent (quoting Butler). If Thompkins wanted to remain silent, he could have said nothing in response to Helgert’s questions, or he could have unambiguously invoked his Miranda rights and ended the interrogation. The fact that Thompkins made a statement about three hours after receiving a Miranda warning does not overcome the fact that he engaged in a course of conduct indicating waiver. Police are not required to rewarn suspects from time to time. Third, there is no evidence that Thompkins’s statement was coerced. Thompkins does not claim that police threatened or injured him during the interrogation or that he was in any way



Chapter Five Criminal Law and Procedure

fearful. Thompkins knowingly and voluntarily made a statement to police, so he waived his right to remain silent. In sum, a suspect who has received and understood the Miranda warnings, and has not invoked his Miranda rights, waives the right to remain silent by making an uncoerced statement to the police. Thompkins did not invoke his right to remain silent and stop the questioning. Understanding his rights in full, he waived his right to remain silent by making a voluntary statement to the police. Sixth Circuit’s judgment reversed; case remanded with instructions to deny petition for writ of habeas corpus.

Production of Records The preceding discussion of the privilege against self-incrimination applies to criminal defendants in general. The Fifth Amendment’s scope, however, has long been of particular concern to businesspersons charged with crimes. Documentary evidence often is quite important to the government’s case in white-collar crime prosecutions. To what extent does the Fifth Amendment protect business records? More than a century ago, the Supreme Court held, in Boyd v. United States, 116 U.S. 616 (1886), that the Fifth Amendment protects individuals against compelled production of their private papers. In more recent years, however, the Court has drastically limited the scope of the protection contemplated by Boyd. The Court has held various times that the private papers privilege is personal and thus cannot be asserted by a corporation, partnership, or other “collective entity.” Because such entities have no Fifth Amendment privilege against self-incrimination, the Court has held that when an organization’s individual officer or agent has custody of organization records, the officer or agent cannot assert any personal privilege to prevent their disclosure. This rule holds even if the contents of the records incriminate her personally. Finally, various decisions allow the government to require business proprietors to keep certain records relevant to transactions that are appropriate subjects for government regulation. These “required records” are not entitled to private papers protection. They may be subpoenaed and used against the record keeper in prosecutions for regulatory violations. The Court’s business records decisions during the past four decades cast further doubt on the future of the private papers doctrine. Instead of focusing on whether subpoenaed records are private in nature, the Court now considers whether the act of producing the records would be sufficiently testimonial to trigger the privilege against

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Sotomayor, Justice, with whom Justices Stevens, Ginsburg, and Breyer join, dissenting Today’s decision turns Miranda upside down. Criminal suspects must now unambiguously invoke their right to remain silent— which, counterintuitively, requires them to speak. At the same time, suspects will be legally presumed to have waived their rights even if they have given no clear expression of their intent to do so. Those results . . . find no basis in Miranda or our subsequent cases and are inconsistent with the fair-trial principles on which those precedents are grounded.

self-incrimination. In Fisher v. United States, 425 U.S. 391 (1976), the Court held that an individual subpoenaed to produce personal documents may assert his Fifth Amendment privilege only if the act of producing the documents would involve incriminating testimonial admissions. This is likely when the individual producing the records is in effect certifying the records’ authenticity or admitting the existence of records previously unknown to the government (demonstrating that he had access to the records and, therefore, possible knowledge of any incriminating contents). In United States v. Doe, 465 U.S. 605 (1984), the Court extended the act-of-production privilege to a sole proprietor whose proprietorship records were subpoenaed. The Court, however, held that normal business records were not themselves protected by the Fifth Amendment because they were voluntarily prepared and thus not the product of compulsion. In view of Doe’s emphasis on the testimonial and potentially incriminating nature of the act of producing business records, some observers thought that officers of collective entities under government investigation might be able to assert their personal privileges against self-incrimination as a way to avoid producing incriminating business records. Braswell v. United States, 487 U.S. 99 (1988), dashed such hopes, however, as the Court refused to extend its Doe holding to cover a corporation’s sole shareholder who acted in his capacity as custodian of corporate records. The Court held that Braswell (the sole shareholder), having chosen to operate his business under the corporate form, was bound by the rule that corporations and similar entities have no Fifth Amendment privilege. Because Braswell acted in a representative capacity in producing the requested records, the government could not make evidentiary use of his act of production. The government, however, was free to use the contents of the records against Braswell and the corporation.

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Double Jeopardy Another important Fifth Amendment provision is the Double Jeopardy Clause, which prevents a second criminal prosecution for the same offense after the defendant has been acquitted or convicted of that offense. Moreover, it bars the imposition of multiple punishments for the same offense. The Double Jeopardy Clause does not, however, preclude the possibility that a single criminal act may lead to more than one criminal prosecution. One criminal act may produce several statutory violations, all of which may give rise

to prosecution. For example, a defendant who commits sexual assault may also be prosecuted for battery, assault with a deadly weapon, and kidnapping if the facts of the case indicate that the relevant statutes were violated. In addition, the Supreme Court has long used a “same elements” test (also known as the Blockburger test for the opinion articulating it) to determine what constitutes the same offense. This means that a single criminal act with multiple victims (e.g., a restaurant robbery in which several patrons are robbed) could result in several prosecutions because the identity of

The Global Business Environment If an arrestee who is a foreign national makes incriminating statements to law enforcement authorities without having been informed of his right under an international agreement to have his detention reported to his country’s consulate, does the exclusionary rule apply? The U.S. Supreme Court confronted that question in Sanchez-Llamas v. Oregon, 548 U.S. 331 (2006). The relevant international agreement in Sanchez-Llamas was the Vienna Convention on Consular Relations, which was drafted in 1963 with the purpose, as set forth in its preamble, of “contribut[ing] to the development of friendly relations among nations, irrespective of their differing constitutional and social systems.” Approximately 170 countries have subscribed to the Vienna Convention. The United States became a party to it in 1969. Article 36 of the Vienna Convention provides that “if he so requests, the competent authorities of the receiving State shall, without delay, inform the consular post of the sending State if, within its consular district, a national of that State is arrested or committed to prison or to custody pending trial or is detained in any other manner.” Thus, when a national of one country is detained by authorities in another, the authorities must notify the consular officers of the detainee’s home country if the detainee so requests. Article 36 further provides that “[t] he said authorities shall inform the [detainee] without delay of his rights under this sub-paragraph.” The Convention also states that the rights provided by Article 36 “shall be exercised in conformity with the laws and regulations of the receiving State, subject to the proviso, however, that the said laws and regulations must enable full effect to be given to the purposes for which the rights accorded under this Article are intended.” Moises Sanchez-Llamas, a Mexican national, was arrested in Oregon in 1999 for alleged involvement in an exchange of gunfire in which a police officer was wounded. Following the arrest, police officers gave Sanchez-Llamas the Miranda warnings in both English and Spanish. However, the officers did not inform Sanchez-Llamas that he could ask to have the Mexican Consulate notified of his detention. Article 36 of the Vienna Convention was thus violated. During the interrogation that followed the issuance of the Miranda warnings, Sanchez-Llamas

made incriminating statements that led to attempted murder charges, as well as various other charges, against him. After he made the incriminating statements and the formal charges were filed, Sanchez-Llamas learned of his Article 36 rights. He then moved for suppression of his incriminating statements (i.e., for an order that those statements be excluded from evidence at the trial) because of the Article 36 violation. The Oregon trial court denied the suppression motion. Sanchez-Llamas was convicted and sentenced to prison. After the appellate courts in Oregon affirmed, the U.S. Supreme Court agreed to decide the case. Assuming that—but without deciding whether—individuals have a right to invoke Article 36 in a judicial proceeding (as opposed to nations enforcing the Convention through political or other appropriate channels), the Supreme Court held in ­Sanchez-Llamas that the exclusionary rule was not a proper remedy for an Article 36 violation. The Court noted that the Vienna Convention itself said nothing about the exclusionary rule as a remedy. Instead, through the statement that Article 36 rights are to be “exercised in conformity with the laws and regulations of the receiving State,” the Convention left the implementation of Article 36 to domestic law. The Court stated that it “would be startling” if the Convention were interpreted as requiring suppression of evidence as a remedy for an Article 36 violation because “[t]he exclusionary rule as we know it is an entirely American legal creation.” The Court stressed that there was “no reason to suppose that Sanchez-Llamas would be afforded the relief he seeks here in any of the other 169 countries party to the Vienna Convention.” (Presumably, then, a U.S. national should not assume that the exclusionary rule will apply to his case if he is arrested in another Vienna Convention nation and makes incriminating statements to law enforcement officers without having been informed of his Article 36 rights.) The Court emphasized that “[b]ecause the [exclusionary] rule’s social costs are considerable, suppression is warranted only where the rule’s ‘remedial objectives are thought most efficaciously served.’” [Case citations omitted.] The Court emphasized that “[w]e have applied the exclusionary rule primarily to deter constitutional violations”—normally those involving unreasonable searches in violation of the Fourth Amendment or incriminating



Chapter Five Criminal Law and Procedure

statements of accused persons whose Fifth Amendment rights had been violated because their confessions were not voluntary or because they had not been given the Miranda warnings. No such problems attended the incriminating statements made by Sanchez-Llamas. From the Court’s perspective, “[t]he violation of the right to consular notification . . . is at best remotely connected to the gathering of evidence” and “there is likely to be little connection between an Article 36 violation and evidence or statements obtained by police.” The Court reasoned that even if law enforcement officers fail to provide detained foreign nationals notice of their Article 36 rights, the same general interests served by Article 36 would be safeguarded by other protections available to persons in the situation in which Sanchez-Llamas found himself. The Court stressed that “[a] foreign national detained

each victim would be an additional fact or element of proof in each case. In addition, the Double Jeopardy Clause does not protect against multiple prosecutions by different sovereigns. A conviction or acquittal in a state prosecution does not prevent a subsequent federal prosecution for a federal offense arising out of the same event, or vice versa. Finally, the Double Jeopardy Clause does not bar a private plaintiff from pursuing a civil case (normally for one or more of the intentional torts discussed in Chapter 6) against a defendant who was criminally prosecuted by the government for the same alleged conduct.

The Sixth Amendment LO5-6

Describe the basic protections afforded by the Fourth, Fifth, and Sixth Amendments.

The Sixth Amendment applies to criminal cases in various ways. It entitles criminal defendants to a speedy trial by an impartial jury and guarantees them the right to confront and cross-examine the witnesses against them. The Sixth Amendment also gives the accused in a criminal case the right “to have the assistance of counsel” in her defense. This provision has been interpreted to mean not only that the accused may employ her own attorney but also that an indigent criminal defendant is entitled to court-appointed counsel. Included in the previously discussed Miranda warnings is a requirement that the police inform the accused of his right to counsel before custodial interrogation begins. Edwards v. Arizona, 452 U.S. 973 (1981), established that once the accused has requested the assistance of counsel, he may not as a general rule be interrogated further until counsel is made available to him.

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on suspicion of crime, like anyone else in our country, enjoys under our system the protections of the Due Process Clause[,] . . . is entitled to an attorney, and is protected against compelled self-incrimination.” Finally, the Court stated that Vienna Convention rights could be vindicated in ways other than suppression of evidence. The Court observed that a defendant could make an Article 36 argument “as part of a broader challenge to the voluntariness of his statements to police” and that if a defendant alludes to a supposed Article 36 violation at trial, “a court can make appropriate accommodations to ensure that the defendant secures, to the extent possible, the benefits of consular assistance.” Having concluded that the exclusionary rule was not an appropriate remedy for the Article 36 violation at issue, the Court upheld the conviction of Sanchez-Llamas.

The Supreme Court later held that the Edwards rule against further questioning is triggered only by an unambiguous request for counsel.7 In McNeil v. Wisconsin, 501 U.S. 171 (1991), the Court provided further latitude for law enforcement officers by holding that if a defendant has made an incourt request for an attorney’s assistance regarding a crime with which he has been formally charged, that request does not preclude police interrogation of him—in the absence of counsel—regarding another unrelated crime. Finally, an accused is entitled to effective assistance of counsel. This means that the accused is entitled to representation at a point in the proceedings when an attorney may effectively assist him, and to reasonably competent representation by that attorney. Inadequate assistance of counsel is a proper basis for setting aside a conviction and ordering a new trial, but the standard applied to these cases makes ineffective assistance of counsel claims difficult ones for convicted defendants to invoke successfully.

White-Collar Crimes and the Dilemmas of Corporate Control Introduction White-collar

crime is the term used to describe a wide variety of nonviolent criminal offenses committed by businesspersons and business organizations. This term includes offenses committed by employees against their employers, as well as corporate officers’ offenses that harm the corporation and its shareholders. It also includes criminal offenses committed by corporate employers and employees In Davis v. United States, 512 U.S. 452 (1994), the court concluded that “Maybe I should talk to a lawyer” was too ambiguous to trigger the Edwards rule. 7

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Ethics and Compliance in Action The highly publicized financial scandals involving Enron, WorldCom, Volkswagen, and other firms mentioned near the beginning of this chapter involved conduct that in some instances was alleged to be criminal. Regardless of whether criminal violations occurred, the alleged conduct was widely perceived to be questionable on ethical grounds and motivated by a desire for short-term gains notwithstanding the costs to others. Consider the broadranging and sometimes devastating effects of the perceived ethical lapses and the related legal proceedings (civil and criminal) faced by the firms and certain executives. These effects included:

• The crippling or near-crippling blow to the viability of the firms involved.

against society. Each year, corporate crime costs consumers billions of dollars. It takes various forms, from consumer fraud, securities fraud, mail or wire fraud, and tax evasion to price-fixing, environmental pollution, and other regulatory violations. Corporate crime presents our legal system with various problems that are unique. Corporations form the backbone of the most successful economic system in history. They dominate the international economic scene and provide us with substantial benefits in the forms of efficiently produced goods and services. Yet these same corporations, through their agents, may pollute the environment, swindle their customers, mislead investors, produce dangerously defective products, and conspire with others to injure or destroy competition. How are we to achieve effective control over these large organizations so important to our existence? Increasingly, we have come to rely on the criminal law as a major corporate control instrument. The criminal law, however, was developed with individual wrongdoers in mind. Thus, criminal prosecutions aimed at individual white collar offenders generally follow the same legal and procedural avenues as other prosecutions. But even run-of-the-mill white-collar crime usually occurs within an organizational context. And corporate crime is inherently organizational in nature. Any given corporate action may be the product of the combined actions of many individuals acting within the corporate hierarchy. It may be that no individual had sufficient knowledge to possess the mens rea necessary for criminal responsibility under usual criminal law principles. Moreover, criminally penalizing corporations raises special problems in view of the obvious inability to apply standard sanctions such as imprisonment to legal entities.

• The collapse in value of the firms’ stock and the resulting loss to disillusioned and angry shareholders who felt they had been hoodwinked. • The harm to the professional and personal reputations of the individuals involved in the business decisions that triggered legal scrutiny and raised serious ethical concerns. • The job losses experienced by large numbers of employees who had nothing whatsoever to do with the questionable actions that effectively brought down the firm or made massive layoffs necessary. • The effects on the families of those who lost their jobs. • The lack of confidence on the part of would-be investors in the profit figures and projections put forth every day by corporations—including those that have done nothing irregular. • The ripple effects of the above on the economy generally.

Evolution of Corporate Criminal Liability  The law initially rejected the notion that corporations could be criminally responsible for their employees’ actions. Early corporations, small in size and number, had little impact on public life. Their small size made it relatively easy to pinpoint individual wrongdoers within the corporation. As corporations grew in size and power, however, the social need to control their activities grew accordingly. Corporate criminal liability evolved and expanded in two ways. First, legislatures enacted statutes creating regulatory offenses that did not require proof of mens rea. Second, courts began holding corporations responsible for violating criminal laws that previously had been applied only to individuals. Although those laws required proof of mens rea, courts tended to conclude that the mens rea requirement regarding a corporate defendant could be satisfied by imputing the criminal intent of employees to the corporation in a fashion similar to the imposition of tort liability on corporations under the respondeat superior doctrine.8 The Supreme Court adopted this reasoning in its New York Central opinion, which established corporate criminal liability. See Figure 5.3. Corporations now may face criminal liability for almost any offense if the statute in question indicates a legislative intent to hold corporations responsible. This legislative intent requirement is sometimes problematic. Many state criminal statutes may contain language suggesting an intent to hold only individuals liable. For example, manslaughter statutes often define the offense as “the killing Chapter 36 discusses respondeat superior in detail.

8



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Figure 5.3 A Note on New York Central The most important case in white collar and corporate crime has to be the Supreme Court’s 1909 opinion in New York Central & Hudson River Railroad v. United States, 212 U.S. 481, because it approved the use of criminal sanctions against corporations. In New York Central, a railroad and its employee were charged and convicted of violating the Elkins Act, a statute passed in 1903 that authorized the Interstate Commerce Commission to impose heavy fines on railroads that offered rebates and on the shippers that accepted these rebates. Unlike most other statutes at the time, the Elkins Act explicitly imposed criminal liability on the corporation for acts committed by the corporate agent. The statute stated that anything done or omitted . . . by a corporation common carrier . . . which, if done or omitted . . . by any director or officer [or other agent] thereof . . . would constitute a misdemeanor under . . . this act, shall also be held to be a misdemeanor committed by such corporation. . . . In construing and enforcing the provisions of this section, the act, omission, or failure of any officer [or] agent . . . employed by any common carrier, acting within the scope of his employment, shall in every case be also deemed to be the act, omission, or failure of such carrier, as well as that of that person. The facts were “practically undisputed,” in the Court’s words, as the corporation stipulated that its agent had given shipping rebates to the American Sugar Refining Company. The agent and the railroad were fined a total of $108,000 (approximately  $3 million today). On appeal, the railroad argued its conviction violated the Amendments discussed earlier in this chapter, namely the Due Process Clause of the Fifth Amendment. The argument was twofold: First, the company’s conviction wrongly punished innocent shareholders; and, second, the conviction violated the presumption of innocence because no evidence had been presented that the company’s board of directors authorized the agent’s illegal acts. The Supreme Court unanimously rejected these arguments and upheld the convictions. The Court found “no good reason why corporations may not be held responsible for and charged with the knowledge and purposes of their agents, acting within the authority conferred upon them.” In reaching its decision, the Court focused on the dominant role that companies played in the U.S. economy. The Court reasoned that without extending the tort doctrine of respondeat superior to criminal cases, many offenses would go unpunished. According to the Court, to “give [corporations] immunity from all punishment because of the old and exploded doctrine that a corporation cannot commit a crime would virtually take away the only means of effectually controlling the subject-matter and correcting the abuses aimed at.” Thus, the concept of vicarious corporate criminal liability was cemented in U.S. law.

of one human being by the act of another.” When statutes are framed, however, in more general terms—such as by referring to “persons”—courts are generally willing to apply them to corporate defendants.

Corporate Criminal Liability Today Under

the modern rule, a corporation may be held liable for criminal offenses committed by employees who acted within the scope of their employment and for the benefit of the corporation. A major corporate criminal liability issue centers around the classes of corporate employees whose intent can be imputed to the corporation. Some commentators argue that a corporation should be criminally responsible only for offenses committed by high corporate officials or those linked to them by authorization or acquiescence. (Nearly all, if not all, courts impose criminal liability on a corporation under such circumstances.) This argument reflects fairness notions, for if any group of corporate employees can fairly be said to constitute a corporation’s mind, that group is its top officers and directors.

The problem with imposing corporate liability only on the basis of top corporate officers’ actions or knowledge is that such a policy often insulates the corporation from liability. Many corporate offenses may be directly traceable only to middle managers or more subordinate employees. It may be impossible to demonstrate that any higher-level corporate official had sufficient knowledge to constitute mens rea. Recognizing this problem, the federal courts have adopted a general rule that a corporation may be criminally liable for the actions of any of its agents, regardless of whether any link between the agents and higher-level corporate officials can be demonstrated. Problems with Punishing Corporations Despite the legal theories that justify corporate criminal liability, the punishment of corporations remains problematic. Does a criminal conviction stigmatize a corporation in the same way it stigmatizes an individual? Perhaps the only stigma resulting from a corporate criminal conviction is felt by the firm’s employees, many of whom are entirely innocent of

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wrongdoing. Is it just to punish the innocent in an attempt to punish the guilty? Consider, for instance, the effects that innocent employees of the Arthur Andersen firm experienced as a result of Andersen’s obstruction-of-justice conviction in 2002. Although the conviction was overturned by the Supreme Court in 2005 because of faulty jury instructions (see the chapter’s earlier discussion of criminal intent), the Andersen firm had already been knocked out of existence. Many partners of the firm acquired positions elsewhere, but nonpartner employees of the firm no doubt experienced hardship despite having had nothing to do with any alleged wrongdoing. Concern about preservation of the firm and minimizing hardship for employees appeared to motivate another leading accounting firm, KPMG, to take the unusual step of acknowledging possibly criminal behavior before being formally charged in connection with certain questionable tax shelters designed by the firm. By acknowledging wrongdoing, it was thought, the firm might be able to head off further criminal difficulty and remain viable as a firm. Similar motivations probably help explain BP’s decision to plead guilty to criminal charges in connection with the Deepwater Horizon oil-drilling disaster and Volkswagen’s previously noted decision to enter such a plea. (See the discussion of these cases near the outset of the chapter.) What about the cash fine, the primary punishment imposed on convicted corporations? Most critics of corporate control strategies maintain that fines imposed on convicted firms tend to be too small to provide effective deterrence. These critics urge the use of fines keyed in some fashion to the corporate defendant’s wealth. Larger fines may lead to undesirable results, however, if the corporate defendant ultimately passes along the fines to its customers (through higher prices), shareholders (through lower dividends or no dividends), or employees (through lower wages). Moreover, fines large enough to threaten corporate solvency may harm employees and those economically dependent on the corporation’s financial well-being. Most of those persons, however, neither had the power to prevent the violation nor derived any benefit from it. Moreover, the managers responsible for a violation may avoid the imposition of direct burdens on them when the fine is assessed against the corporation. In fact, many may already have left the firm at the time of the sanction, sometimes with large bonuses and previously granted stock options. Still other deficiencies make fines less-than-adequate corporate control devices. Fine strategies assume that all corporations are rationally acting profit-maximizers. Fines of sufficient size, it is argued, will erode the profit drive underlying most corporate violations. Numerous studies of actual corporate behavior suggest, however, that

corporations are not always rational actors. Moreover, many for-profit corporations may not be profit-maximizers all the time. Mature firms with well-established market shares may embrace goals other than profit maximization, such as technological prominence, increased market share, or higher employee salaries. In addition, the interests of managers who make corporate decisions and establish corporate policies may not coincide with the long-range economic interests of their corporate employers. The prospect that their employer could have to pay a substantial fine at some future point may not trouble top managers, who tend to have relatively short terms in office and are often compensated in part by large bonuses keyed to year-end profitability.

Individual Liability for Corporate Crime  Individuals who commit crimes while acting in corporate capacities have always been subjected to personal criminal liability. Many European nations reject corporate criminal liability and rely exclusively on individual criminal responsibility. In view of the problems associated with imposing criminal liability on corporations, individual liability may seem a more attractive control device. Besides being more consistent with traditional criminal law notions about the personal nature of guilt, individual liability may provide better deterrence than corporate liability if it enables society to use the criminal punishment threat against those who make important corporate decisions. The prospect of personal liability may cause individuals to resist corporate pressures to violate the law. If guilty individuals are identified and punished, the criminal law’s purposes may be achieved without harm to innocent employees, shareholders, and consumers. Problems with Individual Liability Attractive as it may sound, individual liability also poses significant problems when applied to corporate acts. Identifying responsible individuals within the corporate hierarchy becomes difficult—and frequently impossible—if we follow traditional notions and require proof of criminal intent. Business decisions leading to corporate wrongs often result from the collective actions of numerous corporate employees, none of whom had complete knowledge or specific criminal intent. Other corporate crimes are structural in the sense that they result from internal bureaucratic failures rather than the conscious actions of any individual or group. Proving culpability on the part of high-level executives may be particularly difficult. Bad news sometimes does not reach them; other times, they consciously avoid knowledge that would lead to criminal responsibility. It therefore may be possible to demonstrate culpability only on the part



Chapter Five Criminal Law and Procedure

of mid-level managers. Juries may be unwilling to convict such individuals, however, if they seem to be scapegoats for their unindicted superiors. The difficulties in imposing criminal penalties on individual employees have led to the creation of some regulatory offenses that impose strict or vicarious liability on corporate officers. Strict liability offenses dispense with the requirement of proof of criminal intent but ordinarily require proof that the defendant committed some wrongful act. Vicarious liability offenses impose criminal liability on a defendant for the acts of third parties (normally, employees under the defendant’s personal supervision), but may require proof of some form of mens rea, such as the defendant’s negligent or reckless failure to supervise. Statutes often combine these two approaches by making corporate executives liable for the acts or omissions of corporate employees without requiring proof of criminal intent on the part of the employees. Critics of strict liability offenses often argue that mens rea is a basic principle in our legal system and that it is unjust to stigmatize with a criminal conviction persons who are not morally culpable. In addition, critics doubt that strict liability statutes produce the deterrence sought by their proponents. Such statutes may reduce the moral impact of the criminal sanction if they apply it to relatively trivial offenses. Moreover, they may not result in enough convictions or sufficiently severe penalties to produce deterrence because juries and judges are unwilling to convict or punish defendants who may not be morally culpable. Although statutes creating strict liability offenses are generally held constitutional, they are disfavored by courts. Most courts require a clear indication of a legislative intent

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to dispense with the mens rea element. So far, strict liability criminal offenses applicable to white-collar corporate employees have been limited to the areas of environmental, pharmaceutical, and food safety regulations, where protecting the health and welfare of the public is paramount. Strict liability offenses are also criticized on the ground that even if responsible individuals within the corporation are convicted and punished appropriately, individual liability unaccompanied by corporate liability is unlikely to achieve effective corporate control. If immune from criminal liability, corporations could benefit financially from employees’ violations of the law. Individual liability, unlike a corporate fine, does not force a corporation to give up the profits flowing from a violation. Thus, the corporation would have no incentive to avoid future violations. Incarcerated offenders would merely be replaced by others who might eventually yield to the pressures that produced the violations in the first place. Corporate liability, however, may sometimes encourage corporate efforts to prevent future violations. When an offense has occurred but no identifiable individual is sufficiently culpable to justify an individual prosecution of him or her, corporate liability is uniquely appropriate.

New Directions The preceding discussion suggests

that future efforts at corporate control will continue to include both corporate and individual criminal liability. It also suggests, however, that new approaches are necessary if society is to gain more effective control over corporate activities. Various novel criminal penalties have been utilized in the individual liability setting. For example, white-collar

Ethics and Compliance in Action Enron employee Sherron Watkins received considerable praise from the public, governmental officials, and media commentators when she went public with her concerns about certain accounting and other business practices of her employer. These alleged practices caused Enron and high-level executives of the firm to undergo considerable legal scrutiny in the civil and criminal arenas. In deciding to become a whistleblower, Sherron Watkins no doubt was motivated by what she regarded as a moral obligation. The decision she made was more highly publicized than most decisions of that nature but was otherwise of a type that many employees have faced and will continue to face. You may be among those persons at some point in your career. Various questions, including the ones set forth below, may therefore be worth pondering. As you do so, you may find it useful

to consider the perspectives afforded by the ethical theories discussed in Chapter 4.

• When an employee learns of apparently unlawful behavior on the part of his or her employer, does the employee have an ethical duty to blow the whistle on the employer? • Do any ethical duties or obligations of the employee come into conflict in such a situation? If so, what are they, and how does the employee balance them? • What practical consequences may one face if he or she becomes a whistleblower? What role, if any, should those potential consequences play in the ethical analysis? • What other consequences are likely to occur if the whistle is blown? What is likely to happen if the whistle isn’t blown? Should these likely consequences affect the ethical analysis? If so, how?

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offenders have sometimes been sentenced to render public service in addition to, or in lieu of, being incarcerated or fined. Some have even suggested the licensing of managers, with license suspensions as a penalty for offenders. The common thread in these and other similar approaches is an attempt to create penalties that are meaningful yet not so severe that judges and juries are unwilling to impose them. A promising suggestion regarding corporate liability involves imaginative judicial use of corporate probation for convicted corporate offenders. For example, courts could require convicted corporations to do self-studies identifying the source of a violation and proposing appropriate steps to prevent future violations. If bureaucratic failures caused the violation, the court could order a limited restructuring of the corporation’s internal decision-making processes as a condition of obtaining probation or avoiding a penalty. Possible orders might include requiring the collection and monitoring of the data necessary to discover or prevent future violations and mandating the creation of new executive positions to monitor such data. Restructuring would minimize the previously discussed harm to innocent persons that often accompanies corporate financial penalties. In addition, restructuring could be a more effective way to achieve corporate rehabilitation than relying exclusively on a corporation’s desire to avoid future fines as an incentive to police itself. The Federal Sentencing Guidelines, discussed earlier in this chapter in Figure 5.1, contain good reasons for corporations to institute measures to prevent regulatory violations. This is true even though, as Figure 5.1 indicates, the Supreme Court’s 2005 decision in Booker made the Guidelines advisory rather than mandatory. Under the subset of rules known as the Organizational Sentencing Guidelines, organizations convicted of violating federal law may face greatly increased penalties for certain offenses, with some crimes carrying fines as high as roughly $300 million. The penalty that may be imposed on an organization depends on its “culpability score,” which increases (thus calling for a more severe penalty) if, for example, high-level corporate officers were involved in the offense or the organization had a history of such offenses. Even apart from the potentially severe penalties, however, the Organizational Sentencing Guidelines provide an incentive for corporations to adopt compliance programs designed “to prevent and detect violations of the law.” The presence of an effective compliance program may reduce the corporation’s culpability score for sentencing purposes. Prior to the time the Organizational Sentencing Guidelines were developed, courts generally concluded that the existence of a compliance program should not operate as a mitigating factor in the sentencing of a convicted organization.

In recent years, the Justice Department has made increased use of deferred and nonprosecution agreements (DPAs and NPAs), under which corporations avoid formal criminal charges and trials in return for their agreement to pay monetary penalties, make compliance reforms, and submit to outside monitoring of their activities. Proponents of DPAs see them as a way to encourage more responsible behavior from corporations without the “hammer” of the criminal sanction. Critics, however, see the increased use of DPAs as sending a signal to corporations that they may engage in wrongful activities but still have available, in a figurative sense, a “get-out-of-jail-almost-free” card. As noted in earlier discussion, Toyota entered into a DPA regarding its responses to the sudden acceleration problem in some of its vehicles avoiding a criminal conviction despite there being almost 90 driver deaths.

Important White-Collar Crimes Regulatory Offenses Numerous state and federal

regulatory statutes on a wide range of subjects prescribe criminal as well as civil liability for violations. For instance, the federal Food, Drug, and Cosmetic Act obligates pharmaceutical companies to report safety data regarding their medications to the Food and Drug Administration (FDA) and bars such companies from promoting their medications for uses other than those approved by the FDA. In 2012, GlaxoSmithKline pleaded guilty to criminal charges in which the government alleged that the firm had violated these obligations. The charges that the government considered filing against GM in recent years included an alleged failure to disclose material safety information to the National Highway Traffic Safety Administration under provisions in federal law that impose such a disclosure obligation. Other major federal regulatory offenses are discussed in later chapters. These include violations of the Sherman Antitrust Act, the Securities Act of 1933, the Securities Exchange Act of 1934, and certain environmental laws.

Fraudulent Acts Many

business crimes involve some fraudulent conduct. In most states, it is a crime to obtain money or property by fraudulent pretenses, issue fraudulent checks, make false credit statements, or give short weights or measures. Certain forms of fraud in bankruptcy proceedings, such as false claims by creditors or fraudulent concealment or transfer of a debtor’s assets, are federal criminal offenses. The same is true of securities fraud and extortion. Sekhar v. United States, which appears earlier in the chapter, deals with what does and does not constitute extortion under the federal Hobbs Act.



Chapter Five Criminal Law and Procedure

In addition, the federal mail fraud and wire fraud statutes make criminal the use of the mail, telephones, e-mail, or other similar means of communication to accomplish a fraudulent scheme. In United States v. Anderson, which follows, the court outlines the elements the government

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must prove in mail fraud and wire fraud prosecutions and analyzes the factual record of the case in light of those elements. The court also addresses sentencing issues under the Federal Sentencing Guidelines.

United States v. Anderson   558 F. App’x 454 (5th Cir. 2014) A federal grand jury returned a 12-count indictment against spouses Andrea and Norman Anderson. Count 1 alleged that the Andersons conspired to commit wire fraud, in violation of 18 U.S.C. § 1349. Counts 2 through 12 alleged that they committed wire fraud, in violation of 18 U.S.C. § 1343. At the Andersons’ jury trial, the government introduced evidence that the Andersons ran a Ponzi scheme under which various persons were defrauded. According to the government’s evidence, the Andersons represented to potential victims that they were successful investors and that they wanted to help others find similar success. They would usually tell their victims that Andrea Anderson had a sister, supposedly named “Lenore Lawrence,” who purportedly worked at Goldman Sachs. They also claimed that they had a sizable investment account at the firms. The Andersons further represented that “Lenore” would be the one purchasing the stocks for which the victims were paying. Victims provided their money to the Andersons’ personal bank accounts in a variety of ways, including wire transfers, cashier’s checks, personal checks, and cash. The evidence further indicated that the Andersons sent the victims e-mails confirming the making of payments and that they sometimes asked for more money in order to complete transactions. The Andersons did own a few investment accounts at TD Ameritrade. Some victims received money from their investments, but usually this was money taken from one victim and given to another. As a U.S. Secret Service special agent testified, “[t]he same day . . . that funds came in from one investor, the money went right back out to another investor.” At other times, instead of sending the principal and interest back to the victim as promised, the Andersons would claim that they had reinvested the money because “[n]ow is not the time not to invest.” Victims also received e-mails supposedly sent by Lenore Lawrence, claiming that the victims’ instructions (to sell off stocks and return their money) were being followed. No one ever met Lawrence or spoke to her on the phone, however. Some victims demanded their money back repeatedly but to no avail. Andrea Anderson sometimes responded by forwarding e-mails that were supposedly from Goldman Sachs employees. These e-mails were not genuine. According to the evidence, Andrea Anderson would meet with Goldman Sachs employees and act as though she wanted to open an account. When the Goldman Sachs employees would e-mail her to follow up on their initial meeting, Anderson would modify those e-mails and forward them to the victims. The evidence also revealed that Goldman Sachs did not employ a “Lenore Lawrence” and that the Andersons did not own an investment account at Goldman Sachs. Although the evidence showed that the Andersons did invest some of the money, they never made noteworthy returns on their investments and mostly experienced losses. The Andersons had no other source of income. It appeared that they used the victims’ money for personal expenses. Ultimately, according to the evidence, 11 victims lost a total of approximately $915,000. The jury convicted the Andersons on all 12 counts. The district court sentenced each of them to 57 months of imprisonment and ordered that they pay $915,000 in restitution. The Andersons appealed their convictions and their sentences to the U.S. Court of Appeals for the Fifth Circuit, which issued the following opinion. Per Curiam The Andersons first argue that the evidence is insufficient to sustain the jury’s verdict of guilty on the 12 counts of conviction. We must affirm [the jury’s verdict] if a rational trier of fact could have found that the evidence established the essential elements of the offense beyond a reasonable doubt. The Andersons were convicted of one count of conspiracy to commit wire fraud under 18 U.S.C. § 1349. To prove a conspiracy to commit wire fraud, the government had to prove beyond a reasonable doubt that (1) two or more persons made an agreement

to commit wire fraud; (2) that the defendant knew the unlawful purpose of the agreement; and (3) that the defendant joined in the agreement willfully, in other words, with the intent to further the unlawful purpose. The agreement may be silent and does not need to be formal or spoken. “An agreement may be inferred from concert of action, voluntary participation may be inferred from a collection of circumstances, and knowledge may be inferred from surrounding circumstances.” [Case citation omitted.] The Andersons were also convicted of 11 counts of wire fraud under 18 U.S.C. § 1343. To prove wire fraud, the government had

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to prove beyond a reasonable doubt “(1) a scheme to defraud and (2) the use of, or causing the use of, wire communications in furtherance of the scheme.” Additionally, even though not within the language of § 1343, “materiality of falsehood is an element” of the crime. “A material statement has a natural tendency to influence, or is capable of influencing, the decision of the decision-making body to which it was addressed.” “Violation of the wire-fraud statute requires the specific intent to defraud, i.e., a ‘conscious knowing intent to defraud.’” [Case citations omitted throughout paragraph.] [Regarding] the conspiracy conviction, the Andersons assert that there is insufficient evidence as to all the essential elements. However, the government points to evidence from which a rational trier of fact could have drawn the necessary inferences. Several victims testified that the Andersons worked in tandem. For example, victim Phillip Douglas was introduced to the Andersons by another victim, his ex-girlfriend Deborah Ford. “She just said [that she was investing with] Andrea and Norman, because they were like one. One person, basically. They were a couple.” Victim Rafael Green testified that he was in frequent e-mail contact with Andrea Anderson, that she forwarded him a “Goldman Sachs” e-mail, and that he later received repayment from Norman Anderson, as promised by the e-mail. [Various other victims testified that both Andersons communicated with them about their investments and in response to complaints by them.] Not only that, but both spouses were making material misrepresentations. Both spouses met with victims Tom Parrish and his wife: “They told us that they . . . had a private family hedge fund with Andrea’s sister and her cousin, her sister Lenore, and her cousin Joy. That one of them worked for Goldman Sachs, and the other worked for BlackRock in New York City.” Both statements were false. The record is replete with similar evidence. Given all this evidence, a rational trier of fact could have found all three elements of conspiracy to commit wire fraud beyond a reasonable doubt. As to the substantive crime of wire fraud, the Andersons argue there is insufficient evidence to show the specific intent to defraud. However, a rational trier of fact could have found this specific intent beyond a reasonable doubt simply from the fact that the Andersons were lying about their connection to Goldman Sachs, among other things. These lies were intended to get people to invest with them. The evidence at trial was sufficient to support the Andersons’ convictions on all counts. The Andersons claim, however, that Count 1 of the indictment should have been dismissed because it fails to state an offense. They argue that 18 U.S.C. § 1349 is a penalty provision only, and that it is unconstitutional to apply it as a criminal offense because it gives no notice to the public of what constitutes a conspiracy to commit wire fraud. Enacted as part of the Sarbanes–Oxley Act of 2002, 18 U.S.C. § 1349 provides: “Any person who attempts or conspires to

commit any offense under this chapter shall be subject to the same penalties as those prescribed for the offense, the commission of which was the object of the attempt or conspiracy.” According to the Andersons, the fatal flaw in this language is that it does not contain the requirements of a conspiracy [as set forth in certain other federal laws specifically requiring proof that two or more persons must have worked together in an effort to defraud or otherwise violate the law and that at least one of the conspirators must have engaged in some overt act in furtherance of the alleged conspiracy]. [T]he Andersons complain that § 1349 does not contain the essential elements of an overt act or even conspiratorial agreement between two or more people. Section 1349 . . . lacks an overt act requirement. But the Supreme Court has held that there is no constitutional problem with the lack of an overt act requirement in [similar statutes], and has upheld convictions under that provision. The Supreme Court has similarly found other conspiracy statutes lacking an overt act requirement constitutional. Similarly, we have clarified [in earlier decisions] that § 1349 indeed does not contain an overt act requirement, and have refused to dismiss an indictment where the defendant was arguing that being charged under both § 1349 and [another federal statute dealing with conspiracies] violated the prohibition on multiplicity. [Citations omitted throughout paragraph.] The Andersons’ contention that § 1349 is [merely a] penalty provision because of the circumstances of its legislative birth is also unpersuasive. Section 1349 was originally in Title IX of the Sarbanes–Oxley Act of 2002, which was entitled “White-Collar Crime Penalty Enhancements.” However, as the Supreme Court has previously clarified, the heading of a statute is only helpful if there is some doubt about the meaning of the statute. [Case citation omitted.] Here, this is no ambiguity. Section 1349 is clearly a freestanding criminal charge. The Andersons’ contention that the district court erred by not dismissing the indictment fails. [In challenging the sentences imposed on them,] the Andersons contend that the district court erred in calculating the number of victims. Under [the U.S. Sentencing Guidelines], if the offense involved 10 or more victims, the offense level is increased by two levels [and the potential punishment is therefore more severe]. The commentary to [the Sentencing Guidelines] defines “victim” as, among other things, “any person who sustained any part of the actual loss.” “Actual loss” is defined as “the reasonably foreseeable pecuniary harm that resulted from the offense.” [Citations omitted.] We review a district court’s application of the Sentencing Guidelines de novo and its factual findings for clear error. No clear error has occurred if the district court’s finding is plausible in light of the record as a whole. The Andersons contend that there were just 9, not 11, victims because [one investor] combined his investments with those of two other investors. At the



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sentencing hearing, the district court rejected this argument [and concluded that there were 11 victims]. This factual finding is clearly plausible in light of the record as a whole. The district court did not clearly err in finding that there were at least 10 victims, justifying the [potential penalty] enhancement [under the Sentencing Guidelines]. The Andersons also argue that the district court imposed a substantively unreasonable sentence. It is well-settled that the Sentencing Guidelines are advisory, and sentencing decisions are examined for reasonableness. “Properly calculated withinGuidelines sentences enjoy a presumption of reasonableness that is rebutted only upon a showing that the sentence does not account for a factor that should receive significant weight, it gives significant weight to an irrelevant or improper factor, or it represents a clear error of judgment in balancing sentencing factors.” [Case citation omitted.] When a district court imposes a

within-Guidelines sentence, we “infer that the judge has considered all the factors for a fair sentence . . . , and it will be rare for a reviewing court to say such a sentence is unreasonable.” [Case citation omitted.] Here, the district court sentenced the Andersons to 57 months in prison, a within-Guidelines sentence. The district court [stated that] it found the sentences reasonable “in view of the nature and circumstances of the offense.” As to both sentences, the court found that they would “serve as just punishment, promote respect for the law, and deter future violations of the law.” Given the within-Guidelines sentences and the district court’s consideration of [relevant factors], the Andersons have not overcome the presumption of reasonableness.

The Sarbanes–Oxley Act In

• Lengthened the statute of limitations period within which certain securities fraud cases may be filed. • Provided legal protections for employees who act as whistleblowers regarding instances of fraud engaged in by their employers or, as the Supreme Court held in Lawson v. FMR LLC, 571 U.S. 429 (2014), by other firms that use them on an outside-contracting basis for advice or services such as auditing. • Established substantial fines and/or imprisonment of up to 25 years as the punishment for certain securities fraud offenses. • Increased the maximum term of imprisonment for mail fraud and wire fraud to 20 years. • Made attempts and conspiracies to commit such offenses subject to the same penalties established for the offenses themselves. • Enhanced the penalties for certain criminal violations of the Securities Exchange Act of 1934. • Instructed the U.S. Sentencing Commission to review the Federal Sentencing Guidelines’ treatment of obstruction of justice offenses, white-collar crimes, and securities fraud offenses in order to ensure that deterrence and punishment purposes were being adequately served.

response to a series of highly publicized financial scandals and accounting controversies involving Enron, Arthur Andersen, Global Crossing, WorldCom, and other firms, Congress enacted the Sarbanes–Oxley Act of 2002 (SOX). SOX created the Public Company Accounting Oversight Board and charged it with regulatory responsibilities concerning public accounting firms’ audits of corporations. The statute also established various requirements designed to ensure auditor independence; bring about higher levels of accuracy in corporate reporting of financial information; and promote responsible conduct on the part of corporate officers and directors, auditors, and securities analysts. Additional portions of the broad-ranging SOX were given separate and more informative titles such as the Corporate and Criminal Fraud Accountability Act and the White-Collar Crime Penalty Enhancement Act. In those other portions of the statute, Congress: • Established substantial fines and/or a maximum of 20 years of imprisonment as punishment for the knowing alteration or destruction of documents or records with the intent to impede a government investigation or proceeding. • Made it a crime for an accountant to destroy corporate audit records prior to the appropriate time set forth in the statute and in regulations to be promulgated by the Securities and Exchange Commission. • Classified debts resulting from civil judgments for securities fraud as nondischargeable in bankruptcy.

Convictions of defendants affirmed; sentences imposed on them affirmed.

Bribery and Giving of Illegal Gratuities  State and federal law has long made it a crime to offer public officials gifts, favors, or anything of value to influence official decisions for private benefit. In 1977, Congress enacted the Foreign Corrupt Practices Act (FCPA),

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The Global Business Environment At varying times since the 1977 enactment of the Foreign Corrupt Practices Act, the United States has advocated the development of international agreements designed to combat bribery and similar forms of corruption on at least a regional, if not a global, scale. These efforts and those of other nations sharing similar views bore fruit during the past decades. In 1996, the Organization of American States (OAS) adopted the Inter-American Convention Against Corruption (IACAC). When it ratified the IACAC in September 2000, the United States joined 20 other subscribing OAS nations. The IACAC prohibits the offering or giving of a bribe to a government official in order to influence the official’s actions, the solicitation or receipt of such a bribe, and certain other forms of corruption on the part of government officials. It requires subscribing nations to make changes in their domestic laws in order to make those laws consistent with the IACAC. The United States has taken the position that given the content of the Foreign Corrupt Practices Act and other U.S. statutes prohibiting the offering and solicitation of bribes as well as various other forms of corruption, its statutes already are consistent with the IACAC. The Organization for Economic Cooperation and Development (OECD) is made up of 29 nations that are leading exporters. In 1997, the OECD adopted the Convention on Combating

which criminalized the offering or giving of anything of value to officials of foreign governments in an attempt to influence their official actions. Individuals who violate the FCPA’s bribery prohibition may be fined up to $250,000 and/or imprisoned for a maximum of five years. Corporate violators of the FCPA may be fined as much as $2 million. As explained in the nearby Global Business Environment box, the 1990s marked the emergence of international agreements as additional devices for addressing the problem of bribery of government officials. In recent years, various high-profile companies and their executives or other employees have been the subject of federal investigations for potential violations of the FCPA. Regardless of whether such investigations lead to actual criminal charges, these firms and the individuals associated with them incur substantial legal costs and may take significant hits to their reputations. The experience sometimes convinces investigated companies that enhancement of their legal-compliance programs is a prudent step to lessen the danger of future problems of a similar nature. Most states in the United States also have commercial bribery statutes. These laws prohibit offering or providing kickbacks and similar payoffs to private parties in order to secure some commercial advantage.

Bribery of Officials in International Business Transactions. The OECD Convention, subscribed to by the United States, 28 other OECD member nations, and five nonmember nations, prohibits the offering or giving of a bribe to a government official in order to obtain a business advantage from the official’s action or inaction. It calls for subscribing nations to have domestic laws that contain such a prohibition. Unlike the IACAC, however, the OECD neither prohibits the government official’s solicitation or receipt of a bribe nor contains provisions dealing with the other forms of official corruption contemplated by the IACAC. In 1999, the Council of Europe adopted the Criminal Law Convention on Corruption, which calls upon European Union (EU) member nations to develop domestic laws prohibiting the same sorts of behaviors prohibited by the IACAC. Many European Union members have signed on to this convention, as have three nonmembers of the EU. One of those is the United States. Because the IACAC, the OECD Convention, and the Criminal Law Convention are relatively recent developments, it is too early to draw firm conclusions about whether they have been effective international instruments for combating bribery and similar forms of corruption. Much depends upon whether the domestic laws contemplated by these conventions are enforced with consistency and regularity.

Computer Crime Describe the major elements that must be proven in

LO5-10 order to establish a violation of the Computer Fraud and

Abuse Act.

As computers have come to play an increasingly important role in our society, new opportunities for crime have arisen. In some instances, computers may be used to accomplish crimes such as theft, embezzlement, espionage, and fraud. In others, computers or the information stored there may be targets of crimes such as unauthorized access, vandalism, tampering, or theft of services. The law’s response to computer crimes has evolved with this new technology. For example, computer hacking—once viewed by some as a mischievous but clever activity—can now lead to significant prison sentences and fines. The technical nature of computer crime complicates its detection and prosecution. Traditional criminal statutes have often proven inadequate because they tend not to address explicitly the types of crime associated with the use of computers.



Chapter Five Criminal Law and Procedure

Almost all states have now enacted criminal statutes specifically outlawing certain abuses of computers. Common provisions prohibit such acts as obtaining access to a computer system without authorization, tampering with files or causing damage to a system (e.g., by spreading a virus or deleting files), invading the privacy of others, using a computer to commit fraud or theft, and trafficking in passwords or access codes. On the federal level, computer crime has been prosecuted with some success under existing federal statutes, primarily those forbidding mail fraud, wire fraud, transportation of stolen property, and thefts of property. As has been true at the state level, successful prosecution of these cases often depends on broad interpretation of the statutory prerequisites. Another federal law deals more directly with improper uses of computers. Among the crimes covered by this federal statute are intentionally gaining unauthorized access to a computer used by or for the U.S. government, trafficking in passwords and other access devices, and using a computer to obtain government information that is protected from disclosure. It is also a crime

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to gain unauthorized access to the computer system of a private financial institution that has a connection with the federal government (such as federal insurance for the deposits in the financial institution). In addition, the statute criminalizes the transmission of codes, commands, or information if the transmission was intended to damage such an institution’s computers, computer system, data, or programs. The federal Computer Fraud and Abuse Act (CFAA) allows the imposition of criminal and civil liability on one who “knowingly, and with intent to defraud, accesses a protected computer without authorization, or exceeds authorized access, and by means of such conduct furthers the intended fraud and obtains anything of value.” In addition, the CFAA provides that criminal and civil liability may attach to one who transmits a program, information, code, or command knowingly, intentionally, and without authorization, if the act results in damage to a computer system used by the government or a financial institution or otherwise in interstate commerce. For a case applying the CFAA, see the nearby Cyberlaw in Action box.

CYBERLAW IN ACTION May an employee who violates his employer’s restrictions on computer access and use be held criminally responsible under the federal Computer Fraud and Abuse Act (CFAA)? The federal courts of appeals that have considered this question have disagreed on the correct answer to it. Here, we consider United States v. Nosal, in which the Ninth Circuit Court of Appeals ultimately rejected the government’s attempt to hold the defendant criminally responsible under the CFAA. According to other federal courts of appeal, however, the same CFAA provision addressed in Nosal contemplates criminal responsibility in cases with facts very similar to those in Nosal. For several years, David Nosal was an executive at Korn/Ferry International, an executive search firm. When Nosal left his job at Korn/Ferry, he signed a separation agreement and an independent contractor agreement. Under these contracts, he agreed to serve as an independent contractor for Korn/Ferry and promised not to compete with the firm for one year. In return, Korn/Ferry agreed to make certain payments to Nosal. Shortly after leaving the firm, Nosal recruited three Korn/Ferry employees to help him start a competing business. According to the allegations in the indictment referred to below, these employees utilized their user accounts to access the Korn/Ferry computer system and obtain trade secrets and other proprietary information belonging to Korn/Ferry. The particular information obtained by the employees—and allegedly transferred to Nosal—

included source lists, names, and contact information from a confidential Korn/Ferry database that the firm regarded as among the world’s most comprehensive databases of information regarding executive candidates. The indictment alleged that Korn/Ferry engaged in considerable efforts to keep the database confidential, required its employees to enter into agreements that confined use and disclosure of information in the database to purposes connected with Korn/Ferry’s business, and otherwise alerted employees that accessing Korn/Ferry information in the database without authority to do so was prohibited. A federal grand jury indictment charged Nosal and one of the Korn/Ferry employees with violations of the CFAA (18 U.S.C. § 1030). The CFAA prohibits a variety of computer crimes, most of which involve accessing computers without authorization or in excess of authorization and then taking some prohibited action. The particular subsection under which Nosal was charged, § 1030(a) (4), calls for criminal liability to be imposed on one who “knowingly and with intent to defraud, accesses a protected computer without authorization, or exceeds authorized access, and by means of such conduct furthers the intended fraud and obtains anything of value.” According to the indictment, Nosal’s co-conspirators exceeded their authorized access to Korn/Ferry’s computer system by obtaining information from it in order to defraud their employer and help Nosal establish a competing business. Nosal moved to dismiss the indictment, arguing that “the CFAA was aimed primarily at computer hackers and . . . does not cover

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employees who misappropriate information or who violate contractual confidentiality agreements by using employer-owned information in a manner inconsistent with those agreements.” Nosal argued that the Korn/Ferry employees could not have acted “without authorization” and could not have “exceed[ed] authorized access” because they had permission under certain circumstances to access the computer system and the information present there. A federal district court agreed with this argument, while acknowledging that courts had split on how to interpret § 1030(a)(4). Opting for the interpretation that an employee does not exceed authorized access to a computer system by accessing information unless the employee is without authority to access the information under any circumstances, the district court dismissed various counts in the indictment because the Korn/Ferry employees did have authority to access the database in question under certain circumstances. The federal government appealed to the U.S. Court of Appeals for the Ninth Circuit. A Ninth Circuit panel initially interpreted § 1030(a)(4) in a manner favorable to the government’s case (United States v. Nosal, 642 F.3d 781 (9th Cir. 2011)) but the court granted a request that it rehear the case en banc (i.e., by the full Ninth Circuit). On rehearing, the court changed course and went Nosal’s way. In United States v. Nosal, 676 F.3d 854 (9th Cir. 2012), the court stressed that the CFAA was fundamentally an anti-hacking statute and that the relevant statutory language should be interpreted in light of that statutory nature and purpose. According to the Ninth Circuit, the “exceeds authorized access” language in the relevant statutory section applied only to hacking instances in which the alleged violator did not have permission to access the computer system and its contents under any circumstances. The Ninth Circuit’s interpretation of the statute meant that Nosal and his supposed co-conspirators did not violate the statute because they did have authorization from their employer to access the relevant database, even though they then violated the employer’s restrictions on use of the database. Nosal and the Korn/Ferry employees may have misappropriated information, the court reasoned, but they did not violate the CFAA provision because it was meant to reach only hacking, not misappropriation. In rejecting the government’s argument that the “exceeds authorized access” language should be interpreted as applying to instances in which someone legitimately has access to a computer system and its contents but then exceeds the system owner’s restrictions on how the contents can be used, the Ninth Circuit expressed concern that the government’s proposed interpretation could make criminals of many employees who have access to their employer’s computer system but then sometimes

Problems and Problem Cases 1. Ahmad Ressam attempted to enter the United States by car ferry at Port Angeles, Washington. Hidden in his rental car’s trunk were explosives that he intended to detonate at the Los Angeles International Airport. After the ferry docked, a customs official questioned

use it for personal purposes such as checking Facebook, looking up scores of sporting events, or playing games. Purposes of that nature, the court noted, may be likely to violate many employers’ use policies even though such uses probably occur with considerable frequency each day. The Ninth Circuit stressed that interpreting “exceeds authorized access” as prohibiting only hacking-type behavior would avoid such anomalous results. The court conceded that other circuits (the Fifth, Seventh, and Eleventh) had adopted the government’s preferred view of the “exceeds authorized access” language and that a case such as the one before it would come out differently under those other circuits’ approach. Their approach, however, was too broad an interpretation of the statutory language for the Ninth Circuit to countenance. Hence, the court concluded, there was no CFAA violation in Nosal. (The court noted that it was not addressing whether Nosal might face responsibility on another charge brought by the government: for an alleged violation of a trade secrets statute.) The dissenting judges in Nosal vehemently disagreed. They asserted that the majority was preoccupied with unrealistic hypotheticals in which employees who were Facebook users and sports score seekers might be criminally prosecuted by the government if they made such uses of their employer’s computer system and the employer’s policy prohibited such uses. Apart from the extreme unlikelihood that the government would ever target such users for prosecution, the dissenters noted that the majority was overlooking the critical element of an intent to defraud—an element arguably present in Nosal but not in the Facebook-type hypotheticals the majority emphasized. In addition, the dissenters reasoned that instances in which employees seek to help someone else set up a business that competes with their employer (the situation in Nosal) are readily distinguishable from the hypotheticals about which the majority was worried. The split among the circuits on how to interpret the “exceeds authorized access” language in the CFAA could be resolved by the Supreme Court, of course, if the Court would agree to decide an appropriate case at some point. Note: The Court did just that. In April 2020, certiorari was granted in Van Buren v. United States, 2020 U.S.LEXIS 2336 (Apr. 20, 2020), which will address whether a police sergeant who was permitted to use a license plate database for work, but did so for the “improper purpose” of checking on an exotic dancer, violates the CFAA.

Ressam. On the customs declaration form the official instructed Ressam to complete, Ressam identified himself by a false name and falsely referred to himself as a Canadian citizen even though he was Algerian. Ressam was then directed to a secondary inspection station, where another official performed a search of his car. This search uncovered explosives and related



Chapter Five Criminal Law and Procedure

items in the car’s spare tire well. Ressam was later convicted of a number of crimes, including the felony of making a false statement to a U.S. customs official and the offense of carrying an explosive “during the commission of ” the just-noted felony, in violation of 18 U.S.C. § 844(h)(2). The latter offense was Count 9 in the indictment against Ressam. The U.S. Court of Appeals for the Ninth Circuit set aside Ressam’s conviction on Count 9 because it interpreted the word during, as used in § 844(h)(2), as including an implicit requirement that the explosive be carried in relation to the underlying felony. The Ninth Circuit concluded that because Ressam’s carrying of explosives did not relate to the underlying felony of making a false statement to a customs official, the conviction on Count 9 could not stand. Did the Ninth Circuit correctly interpret the “during the commission of” language in the statute on which Count 9 was based? 2. A California Highway Patrol officer stopped the pickup truck occupied by Lorenzo and Jose Navarette because it matched the description of a vehicle that an anonymous 911 caller had recently reported as having run her off the road. As he and a second officer approached the truck, they smelled marijuana. They searched the truck’s bed, found 30 pounds of marijuana, and arrested both Navarettes. The Navarettes moved to suppress the evidence, arguing that the anonymous call to 911 did not give rise to a reasonable suspicion on the part of the officer and that the traffic stop therefore violated the Fourth Amendment. They further argued that if the traffic stop violated the Fourth Amendment, the evidence obtained in the search should be excluded under the fruit-of-the-poisonoustree doctrine. The Navarettes’ motion was denied. They were later convicted of drug-possession offenses. On appeal, the Navarettes reiterated their objection to the traffic stop and their objection to the use of the evidence obtained in the search. Did the traffic stop violate the Fourth Amendment? Should the evidence obtained in the ensuing search have been suppressed? 3. A federal grand jury was investigating “John Doe,” president and sole shareholder of “XYZ” corporation, concerning possible violations of federal securities and money-laundering statutes. During the investigation, the government learned that XYZ had paid the bills for various telephone lines, including those used in Doe’s homes and car. Grand jury subpoenas calling for the production of documents were then served on the custodian of XYZ’s corporate records, on Doe, and on the law firm Paul, Weiss, Rifkind, Wharton

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& Garrison (Paul–Weiss), which represented Doe. These subpoenas sought production of telephone bills, records, and statements of account regarding certain telephone numbers, including those used by Doe. The district court determined after an evidentiary hearing that the documents sought were XYZ’s, and not Doe’s.   Paul–Weiss, which had received copies of these documents from its client, refused to produce them, arguing that it was exempted from doing so by Doe’s privilege against self-incrimination. Was Paul–Weiss correct in its assertion? 4. William Parks, a special agent of the U.S. Customs Service, was investigating allegations that Bet-Air Inc. (a seller of spare aviation parts and supplies) had supplied restricted military parts to Iran. Parks entered Bet-Air’s property and removed a bag of shredded documents from a garbage dumpster. The dumpster was located near the Bet-Air offices in a parking area reserved for the firm’s employees. To reach the dumpster, Parks had to travel 40 yards on a private paved road. No signs indicated that the road was private. In later judicial proceedings, Parks testified that at the time he traveled on the road, he did not know he was on Bet-Air’s property. When reconstructed, some of the previously shredded documents contained information seemingly relevant to the investigation. Parks used the shredded documents and the information they revealed as the basis for obtaining a warrant to search the Bet-Air premises. In executing the search warrant, Parks and other law enforcement officers seized numerous documents and Bet-Air records.   A federal grand jury indicted Bet-Air’s chairman, Terence Hall, and other defendants on various counts related to the alleged supplying of restricted military parts to Iran. Contending that the Fourth Amendment had been violated, Hall filed a motion asking the court to suppress (i.e., exclude) all evidence derived from the warrantless search of the dumpster and all evidence seized during the search of the Bet-Air premises (the search pursuant to the warrant). The federal district court denied Hall’s motion. Following a jury trial, Hall was convicted on all counts and sentenced to prison. He appealed, again arguing that the Fourth Amendment was violated. How did the appellate court rule? Was there a Fourth Amendment violation? 5. For approximately 20 years, Efrain Santos operated an illegal lottery in Indiana. He employed a number of helpers to run the lottery. At bars and restaurants, Santos’s runners gathered bets from gamblers, kept a

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portion of the bets as their commissions, and delivered the rest to Santos’s collectors. Collectors, one of whom was Benedicto Diaz, then delivered the money to Santos, who used some of it to pay the salaries of collectors (including Diaz) and to pay the lottery winners. These payments to runners, collectors, and winners formed the basis of a 10-count indictment against Santos and Diaz filed in the U.S. District Court for the Northern District of Indiana. A jury found Santos guilty of running and conspiring to run an illegal gambling business, as well as one count of conspiracy to launder money and two counts of money laundering. Diaz pleaded guilty to conspiracy to launder money. The relevant provision of the federal money-laundering statute reads as follows: Whoever, knowing that the property involved in a financial transaction represents the proceeds of some form of unlawful activity, conducts or attempts to conduct such a financial transaction which in fact involves the proceeds of specified unlawful activity . . . with the intent to promote the carrying on of specified unlawful activity . . . shall be sentenced to a fine of not more than $500,000 or twice the value of the property involved in the transaction, whichever is greater, or imprisonment for not more than twenty years, or both.

  After the district court sentenced Santos and Diaz to prison, the U.S. Court of Appeals for the Seventh Circuit affirmed the convictions and sentences. Santos and Diaz later attacked the validity of the convictions and sentences by seeking a writ of habeas corpus. In the habeas corpus proceeding, the district court rejected all of their claims except for one, a challenge to their money-laundering convictions. The district court concluded that the money-laundering statute’s prohibition of transactions involving criminal “proceeds” applies only to transactions involving criminal profits, not criminal receipts. Applying that holding to the cases of Santos and Diaz, the district court found no evidence that the transactions on which the money-laundering convictions were based (Santos’s payments to runners, winners, and collectors and Diaz’s receipt of payment for his collection services) involved profits, as opposed to receipts, of the illegal lottery. Accordingly, the district court vacated the money-laundering convictions. The Seventh Circuit affirmed. The U.S. Supreme Court granted the government’s petition for a writ of certiorari in order to address this question: whether the term proceeds in the federal money-laundering statute means “receipts” or, instead, “profits.” How did the Supreme Court rule?

6. Police officers arrested Rodney Gant for driving with a suspended license. After they handcuffed him and locked him in the back of a patrol car, the officers searched his car and discovered cocaine in the pocket of a jacket on the backseat. Gant was charged with possession of a narcotic drug for sale and possession of drug paraphernalia (the plastic bag in which the cocaine was found). Gant moved to suppress the evidence seized from his car on the ground that the warrantless search violated the Fourth Amendment. The state resisted Gant’s motion by arguing that the search of the car was constitutionally valid pursuant to U.S. Supreme Court decisions allowing a warrantless search incident to arrest and a warrantless search of an arrestee’s vehicle if the search was contemporaneous with the arrest. Gant argued that the search of his vehicle should be held a violation of the Fourth Amendment because he posed no threat to the officers after he was handcuffed in the patrol car and because he was arrested for a traffic offense for which no evidence could be found in his vehicle. An Arizona trial court held that the search of the car did not violate the Fourth Amendment. Therefore, the court denied Gant’s suppression motion. The case proceeded to trial, and a jury convicted Gant. He was sentenced to prison. After protracted state-court proceedings, Arizona’s highest court concluded that Gant’s conviction could not stand because the search of his car was unreasonable for Fourth Amendment purposes. The U.S. Supreme Court agreed to decide the case. How did the Supreme Court rule regarding the search of Gant’s car? Did the search violate the Fourth Amendment? 7. Muniz was arrested on a charge of driving under the influence of alcohol. He was taken to a booking center, where he was asked several questions by a police officer without first being given the Miranda warnings. Videotape (which included an audio portion) was used to record the questions and Muniz’s answers. The officer asked Muniz his name, address, height, weight, eye color, date of birth, and current age. Muniz stumbled over answers to two of these questions. The officer then asked Muniz the date of his sixth birthday, but Muniz did not give the correct date. At a later point, Muniz was read the Miranda warnings for the first time. He was later convicted of the charged offense, with the trial court denying his motion to exclude the videotape (both video and audio portions) from evidence. Assume that the video portion of the tape violated neither the Fifth Amendment nor Miranda.



Chapter Five Criminal Law and Procedure

Should all or any part of the audio portion of the tape (which contained Muniz’s stumbling responses to two questions plus his incorrect answer to the sixth birthday date question) have been excluded as a violation of either the Fifth Amendment or Miranda? 8. A federal statute, 18 U.S.C. § 1037, prohibits a variety of misleading electronic mail–related actions in commercial settings. These include instances in which a person who, with knowledge of doing so, “materially falsifies header information in multiple commercial electronic mail messages and intentionally initiates the transmission of such messages” (prohibited by § 1037(a)(3)) or “registers, using information that materially falsifies the identity of the actual registrant, for five or more electronic mail accounts or online user accounts or two or more domain names, and intentionally initiates the transmission of multiple commercial electronic mail messages from any combination of such accounts or domain names” (prohibited by § 1037(a)(4)). Violators of these prohibitions may be punished by fines or imprisonment, or both.   A federal indictment charged that Michael Twombly and Joshua Eveloff violated § 1037(a)(3) and (4). The government claimed that Twombly leased dedicated servers using an alias, including one server from Biznesshosting Inc., and that shortly after it provided logon credentials to Twombly, Biznesshosting began receiving complaints regarding spam electronic mail messages originating from its network. These spam messages allegedly numbered approximately 1 million, followed several days later by another 1.5 million. The spam messages contained computer software advertising and directed recipients to the website of a company with a Canadian address. The government maintained that this site was falsely registered under the name of a nonexistent business and that the messages’ routing information and “From” lines had been falsified. As a result, the government contended, recipients, Internet service providers, and law enforcement agencies were prevented from identifying, locating, or responding to the senders. When Biznesshosting investigated the complaints, it traced the spam to the server leased by Twombly. A search conducted by the FBI allegedly uncovered roughly 20 dedicated servers leased by Twombly using false credentials. According to the government, Twombly leased the servers for an unnamed person—later determined to be Eveloff—and received payment from that person for each set of logon credentials provided. Under the government’s theory of the case, both Twombly and Eveloff caused the spam

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messages to be sent. Twombly and Eveloff moved for dismissal of the indictment on the ground that § 1037(a)(3) and (4) were unconstitutionally vague. Did their argument have merit?  9. Suspicious that marijuana was being grown in eventual defendant DK’s home, federal agents used a thermal imaging device to scan his home from a public street. The agents sought to determine whether the amount of heat emanating from the home (which was part of a triplex) was consistent with the amount emanated from high-intensity lamps typically used for indoor marijuana growth. The scan showed that the roof and a side wall were relatively hot compared with the rest of the home and substantially warmer than the neighboring units. Based in part on the thermal imaging results, a federal magistrate judge issued a warrant to search the home, where the agents found marijuana growing. After being indicted on a federal drug charge, DK unsuccessfully moved to suppress the evidence seized from his home. He then entered a conditional guilty plea under which, on appeal, he could challenge the use of the thermal imaging device and the validity of the resulting warrant. The government took the position that the use of the device, when operated from a public street, was not a search for purposes of the Fourth Amendment and that DK therefore did not have a basis for his Fourth Amendment–based challenge. Was the government correct in this argument? 10. John Park was CEO of Acme Markets Inc., a national retail food chain with approximately 36,000 employees, 874 retail outlets, and 16 warehouses. Acme and Park were charged with five counts of violating the federal Food, Drug, and Cosmetic Act by storing food shipped in interstate commerce in warehouses where it was exposed to rodent contamination. The violations were detected during FDA inspections of Acme’s Baltimore warehouse. Inspectors saw evidence of rodent infestation and unsanitary conditions, such as mouse droppings on the floor of the hanging meat room and alongside bales of Jell-O, as well as a hole chewed by a rodent in a bale of Jell-O. The FDA notified Park of these findings by a letter. Upon checking with Acme’s vice president for legal affairs, Park learned that the Baltimore division vice president was investigating the situation immediately and would be taking corrective action. An FDA inspection three months after the first one disclosed continued rodent contamination at the Baltimore warehouse despite improved sanitation there. The criminal charges referred to above were then filed against Acme and Park. Acme pleaded

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Part Two Crimes and Torts

guilty; Park refused to do so and proceeded to trial. After being convicted on each count, Park appealed. A federal court of appeals overturned his conviction. Was the appellate court correct in doing so? 11. Patrice Seibert’s 12-year-old son, Jonathan, had cerebral palsy. When Jonathan died in his sleep, Seibert feared charges of neglect because there were bedsores on his body. In Seibert’s presence, two of her teenage sons and two of their friends devised a plan to conceal the facts surrounding Jonathan’s death by incinerating his body in the course of burning the family’s mobile home. Under the plan, the fire would be set while Donald Rector, a mentally ill teenager who lived with the family, was asleep in the mobile home. The fire and the presence of Rector’s body would eliminate any indication that Jonathan had been the victim of neglect. Seibert’s son Darian and a friend set the fire as planned, and Rector died.   Five days later, police officers awakened Seibert at 3:00 A.M. at a hospital where Darian was being treated for burns. An officer arrested Seibert but, in accordance with instructions from Officer Hanrahan, refrained from giving Miranda warnings at the time of the arrest. After Seibert had been taken to the police station and left alone in an interview room for 15 minutes, Hanrahan questioned her for 30 to 40 minutes without giving Miranda warnings. During this questioning, Hanrahan squeezed Seibert’s arm and repeated this statement: “Donald [Rector] was also to die in his sleep.” When Seibert finally admitted that she knew Rector was meant to die in the fire, she was given a 20-minute coffee and cigarette break. Hanrahan then turned on a tape recorder, gave Seibert the Miranda  warnings, and obtained a signed waiver of rights from her. He resumed the questioning with “OK, Patrice, we’ve been talking for a little while about what happened on Wednesday, the twelfth, haven’t we?” Hanrahan then confronted Seibert with her pre-Miranda-warnings statements about the plan to set the fire and the understanding that Rector would be left sleeping in the mobile home. Specifically, Hanrahan referred to Seibert’s pre-Miranda-warnings statements by asking, in regard to Rector, “[D]idn’t you tell me he was supposed to die in his sleep?” and “So he was supposed to die in his sleep?” Seibert answered “Yes” to the second of these post-warnings questions.   After being charged with murder for her role in Rector’s death, Seibert sought to have her pre-Mirandawarnings statements and her post-Miranda-warnings

statements suppressed (i.e., excluded from evidence) as the remedy for supposed Fifth Amendment and Miranda  violations. At the hearing on Seibert’s suppression motion, Hanrahan testified that he decided to withhold Miranda warnings and to resort to an interrogation technique he had been taught: question first, then give the Miranda warnings, and then repeat the question “until I get the answer that she’s already provided once.” Hanrahan acknowledged that Seibert’s ultimate statement was “largely a repeat” of information obtained prior to the giving of the Miranda warnings. The Missouri trial court suppressed Seibert’s pre-Miranda-warnings statements but permitted use of her post-warnings statements. A jury convicted Seibert, and the Missouri Court of Appeals affirmed. However, the Missouri Supreme Court reversed, holding that Seibert’s post-warnings statements should have been suppressed as well. The U.S. Supreme Court agreed to decide the case at the request of the state of Missouri. How did the Supreme Court rule on the suppression issue? 12. Police officers set up a controlled buy of crack cocaine outside an apartment complex. An undercover officer watched the deal take place from an unmarked car in a nearby parking lot. After the buy occurred, the undercover officer radioed uniformed officers to move in on the suspect. He told them that the suspect was moving toward the breezeway of an apartment building, and he urged them to get there quickly before the suspect entered an apartment. In response, the uniformed officers drove into the parking lot, left their vehicles, and ran to the breezeway. As they entered it, they heard a door shut and detected a very strong odor of burnt marijuana. At the end of the breezeway, the officers saw two apartments, one on the left and one on the right; they did not know which apartment the suspect had entered. Because they smelled marijuana smoke emanating from the apartment on the left, they approached that apartment’s door.   One of the officers who approached the door later testified that they loudly banged on the door and announced, “This is the police.” This officer said that the officers then could hear people and things moving inside the apartment. These sounds led the officers to believe that drug-related evidence was about to be destroyed. After announcing that they would enter the apartment, the officers kicked in the door and entered. They found three people in the front room, including eventual defendant HK. (The suspect they had been chasing was not among the three, however.)



Chapter Five Criminal Law and Procedure

During a protective sweep of the apartment, the officers saw marijuana and powder cocaine in plain view. In a subsequent search, they also discovered crack cocaine, cash, and drug paraphernalia. HK was later charged with drug-­possession and drug-trafficking offenses. He unsuccessfully sought to have the evidence suppressed as the result of a search that, in his view, violated the Fourth Amendment. After being convicted, he appealed and renewed his arguments about the search and the evidence obtained. Did the warrantless entry of the apartment violate HK’s Fourth Amendment rights? Should the evidence obtained in the search have been suppressed? 13. After a lengthy investigation spearheaded by the Internal Revenue Service (IRS), agents concluded that SDI Future Health, Inc. (SDI) and two of its senior ­executives—Todd Kaplan (SDI’s president) and Jack Brunk (an SDI officer)—had engaged in Medicare fraud and tax fraud. Based on the information obtained during the investigation, the federal government applied for a warrant to search SDI’s business premises. The warrant depended heavily on an IRS special agent’s affidavit, which contained information the agent had learned from former employees and business associates of SDI. The warrant stated that the premises to be searched were SDI’s corporate headquarters, principal business offices, and computers, and it listed categories of documents, records, and other items to be seized. A federal magistrate judge who reviewed the affidavit and the warrant concluded that probable cause existed for the search and therefore issued the warrant. Based on the evidence recovered, SDI, Kaplan, and Brunk were

5-45

charged with 124 counts of health care fraud; various counts of conspiracy regarding health care fraud, money laundering, and unlawful kickback payments; and other counts of attempting to evade income taxes. Did SDI have standing to challenge the warrant on Fourth Amendment grounds? What about Kaplan and Brunk? 14. Southern Union Company is a natural gas distributor. Its subsidiary stored liquid mercury, an extremely hazardous substance, at a facility in Rhode Island. A group of kids from a nearby apartment complex broke into the facility, played with the mercury, and spread it around the facility and apartment complex, leading to the complex’s residents being temporarily displaced during the cleanup. After an investigation, Southern Union was tried and convicted of storing hazardous materials without a permit in violation of the Resource Conservation and Recovery Act, which provides for “a fine of not more than $50,000 for each day of violation.” At sentencing, the government argued that the company had violated the statute for 762 days, allowing a maximum fine of $38.1 million. Southern Union objected that this calculation violated its Sixth Amendment rights because the jury was not asked to determine the precise duration of the violation. Southern Union invoked the Supreme Court’s line of cases holding that the Sixth Amendment bars judge-found facts to be used to increase a defendant’s maximum authorized sentence. The government acknowledged the Court’s line of cases but said they did not apply to criminal fines. Who has the better argument?

CHAPTER 6

Intentional Torts

T

he opening problem in Chapter 2 presented the basic facts underlying a defamation case that business executive Phil Anderson intends to pursue against Allnews Publishing Inc. The questions asked in Chapter 2 pertained to procedural matters. We now return to Anderson’s case in order to focus on substantive legal aspects of defamation, one of the torts about which you will learn in this chapter. Here, again, are the basic facts: Allnews Publishing Inc., a firm whose principal offices are located in Orlando, Florida, owns and publishes 33 newspapers. These newspapers are published in 21 different states of the United States. Among the Allnews newspapers is the Snakebite Rattler, the lone newspaper in the city of Snakebite, New Mexico. The Rattler is sold in print form only in New Mexico. However, many of the articles in the newspaper can be viewed by anyone with Internet access, regardless of his or her geographic location, by going to the Allnews website. In a recent Rattler edition, an article appeared beneath this headline: “Local Business Executive Sued for Sexual Harassment.” The accompanying article, written by a Rattler reporter (an Allnews employee), stated that a person named Phil Anderson was the defendant in the sexual harassment case. Besides being married, Anderson was a well-known businessperson in the Snakebite area. He was active in his church and in community affairs in both Snakebite (his city of primary residence) and Petoskey, Michigan (where he and his wife have a summer home). A stock photo of Anderson, which had been used in connection with previous Rattler stories mentioning him, appeared alongside the story about the sexual harassment case. Anderson, however, was not the defendant in that case. He was named in the Rattler story because of an error by the Rattler reporter. The actual defendant in the sexual harassment case was a local business executive with a similar name: Phil Anderer. Anderson plans to file a defamation lawsuit against Allnews because of the above-described falsehood in the Rattler story. He expects to seek $500,000 in damages for harm to his reputation and for other related harms. Consider the following questions as you study this chapter: • How does defamation differ from other torts addressed in this chapter? • What types of harms, and what corresponding types of money damages, are recognized in defamation cases? How do those types of harms and damages compare to the harms and damages in other tort cases? • What basic elements of a defamation claim must Anderson prove in order to have a chance of winning his case? Would he be able to prove those elements? • Because Anderson’s defamation claim would be based on speech (the erroneous statement in the Rattler article), what role will the First Amendment play in the case? • Is Anderson a public figure or, instead, a private figure? Why is the answer to that question important in determining whether Anderson is likely to win the case?

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Part Two Crimes and Torts

LEARNING OBJECTIVES After studying this chapter, you should be able to: 6-1 Explain the basic differences among the four types of wrongfulness in tort law (intent, recklessness, negligence, and strict liability). 6-2 Explain the difference between compensatory damages and punitive damages. 6-3 List and explain the elements of battery. 6-4 List and explain the elements of assault. 6-5 Explain what is necessary in order for liability to be imposed on the basis of intentional infliction of emotional distress. 6-6 List and explain the elements of false imprisonment. 6-7 List and explain the common law elements of defamation.

Explain the basic differences among the four types LO6-1 of wrongfulness in tort law (intent, recklessness, negligence, and strict liability).

A TORT IS A civil wrong that is not a breach of a contract. Tort cases identify different types of wrongfulness, culpability, or fault and define them in varying ways. In this chapter and in Chapter 7, we will refer to the four types of wrongfulness defined here. 1. Intent. We define intent as the desire to cause certain consequences or the substantial certainty that those consequences will result from one’s behavior. For example, if D pulls the trigger of a loaded handgun while aiming it at P for the purpose of killing him or with a substantial certainty that P would be killed, D intended to kill P. This chapter discusses several intentional torts, most of which require, as the name of this category of torts suggests, intent on the part of the defendant. 2. Recklessness. The form of intent involving substantial certainty blends by degrees into a different kind of fault: recklessness (sometimes called “willful and wanton conduct”). We define recklessness as a conscious indifference to a known and substantial risk of harm created by one’s behavior. Suppose that simply because he likes the muzzle flash and the sound, D fires his handgun at random in a crowded subway station. One of D’s shots injures P. D acted recklessly if he had no desire to hit P or anyone else

6-8 Explain what a public official plaintiff or a public figure plaintiff must prove, for constitutional reasons, in order to win a defamation case. 6-9 Explain what a private figure plaintiff must prove, for constitutional reasons, in order to win a defamation case. 6-10 Distinguish among the four types of invasion of privacy. 6-11 Identify circumstances in which a celebrity’s right of publicity is implicated. 6-12 Explain the difference between trespass to land and private nuisance.

and was not substantially certain that anyone would be hit but, nonetheless, knew that this could easily result from his behavior. When legal responsibility is assigned in the civil context, recklessness is often treated as a near equivalent of intentional wrongdoing. Recklessness is considered a more severe degree of fault than the next type to be discussed: negligence. 3. Negligence. We define negligence as a failure to use reasonable care, with harm to another party occurring as a result. Negligent conduct falls below the level necessary to protect others against unreasonable risks of harm. Assume that without checking, D pulls the trigger on what he incorrectly and unreasonably thinks is an unloaded handgun. If the gun goes off and wounds P, D has negligently harmed P. Chapter 7 discusses negligence law in detail. 4. Strict liability. Strict liability is liability without fault or, more precisely, liability irrespective of fault. In a strict liability case, the plaintiff need not prove intent, recklessness, negligence, or any other kind of wrongfulness on the defendant’s part. However, strict liability is not automatic liability. A plaintiff must prove certain things in any strict liability case, but fault is not one of them. Chapter 7 discusses various types of strict liability, some of which are examined more fully in other chapters. Tort law contemplates civil liability for those who commit torts. This distinguishes it from the criminal law, which also involves wrongful behavior. As you saw in Chapter 1,



Chapter Six Intentional Torts

a civil case is normally a suit between private parties. In criminal cases, a prosecutor represents the government in confronting the defendant. The standard of proof that the plaintiff must satisfy in a tort case is the preponderance of the evidence standard, not the more stringent beyond-a- reasonable-doubt standard applied in criminal cases. This means that the greater weight of the evidence introduced at the trial must support the plaintiff’s position on every element of the tort case. Finally, the remedy allowed in civil cases (most often, damages) differs from the punishment imposed in criminal cases (e.g., imprisonment or a fine). Of course, the same behavior may sometimes give rise to both civil and criminal liability. For example, one who commits a sexual assault is criminally liable and will also be liable for some or all of the torts of assault, battery, false imprisonment, and intentional infliction of emotional distress.

LO6-2

Explain the difference between compensatory damages and punitive damages.

6-3

A plaintiff who wins a tort case usually recovers compensatory damages for the harm she suffered as a result of the defendant’s wrongful act. Depending on the facts of the case, these damages may be for direct and immediate harms, such as physical injuries, medical expenses, and lost wages and benefits, or for seemingly less tangible harms, such as loss of privacy, injury to reputation, and emotional distress. If the defendant’s behavior was particularly bad, injured victims may also be able to recover punitive ­damages. Punitive damages are not intended to compensate tort ­victims for their losses. Instead, they are designed to punish flagrant wrongdoers and to deter them, as well as others, from engaging in similar conduct in the future. Punitive damages are reserved for the worst kinds of wrongdoing and thus are not routinely assessed against the losing defendant in a tort case. Certainly, however, some behaviors amounting to recklessness or giving rise to intentional tort liability are regarded as reprehensible enough to justify an assessment of punitive damages. The Mathias case, which follows, reviews the types of fault discussed above and explains the role that punitive damages may play in certain cases.

Mathias v. Accor Economy Lodging, Inc.   347 F.3d 672 (7th Cir. 2003) Burl and Desiree Mathias were bitten by bedbugs when they stayed at a Motel 6 in downtown Chicago. They sued the corporation that owns and operates the Motel 6 chain. Alleging that the defendant’s personnel refused to act in response to the complaints of various guests and otherwise knowingly disregarded clear evidence of a bedbug infestation problem, the plaintiffs sought compensatory and punitive damages on the theory that the defendant had engaged in “willful and wanton conduct.” A federal court jury returned a verdict in favor of the Mathiases, awarding them compensatory damages for their injuries and assessing punitive damages against the defendant. On appeal to the U.S. Court of Appeals for the Seventh Circuit, the defendant argued that any fault on its part did not amount to willful and wanton conduct and that the award of punitive damages was therefore unwarranted. Further facts pertinent to the case are discussed in the edited version of the Seventh Circuit’s opinion, which appears below.

Posner, Circuit Judge [B]edbugs  .  .  .  are making a comeback in the U.S. as a consequence of more conservative use of pesticides. The plaintiffs claim that in allowing guests to be attacked by bedbugs in a motel that charges upwards of $100 a day for a room and would not like to be mistaken for a flophouse, the defendant was guilty of “­willful and wanton conduct” and thus [should be] liable for punitive as well as compensatory damages. The jury agreed and awarded each plaintiff $186,000 in punitive damages, though only $5,000 in compensatory damages. The defendant argues that at worst it is guilty of simple negligence, and if this is right the plaintiffs were not entitled . . . to any award of punitive damages. [The defendant] also complains that

the [punitive damages] award was excessive. . . . The first ­complaint has no possible merit, as the evidence of . . . recklessness, in the strong sense of an unjustifiable failure to avoid a known risk, was amply shown. In 1998, EcoLab, the extermination service that the motel used, discovered bedbugs in several rooms in the motel and recommended that it be hired to spray every room, for which it would charge the motel only $500; the motel refused. The next year, bedbugs were again discovered in a room but ­EcoLab was asked to spray just that room. The motel tried to negotiate “a building sweep [by EcoLab] free of charge,” but, not surprisingly, the negotiation failed. By the spring of 2000, the motel’s manager “started noticing that there were refunds being given by my desk clerks and reports coming back from the guests that there were

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Part Two Crimes and Torts

ticks in the rooms and bugs in the rooms that were biting.” She looked in some of the rooms and discovered bedbugs. Further incidents of guests being bitten by insects and demanding and receiving refunds led the manager to recommend to her superior in the company that the motel be closed while every room was sprayed, but this was refused. This superior, a district manager, was a management-level employee of the defendant, and his knowledge of the risk and failure to take effective steps either to eliminate it or to warn the motel’s guests are imputed to his employer for purposes of determining whether the employer should be liable for punitive damages. The employer’s liability for compensatory damages is of course automatic on the basis of the principle of ­respondeat superior, since the district manager was acting within the scope of his employment. [Under the respondeat superior principle, employers are liable for torts committed by employees if those torts occurred within the scope of employment.] The infestation continued and began to reach farcical proportions, as when a guest, after complaining of having been bitten repeatedly by insects while asleep in his room in the hotel, was moved to another room only to discover insects there; and within 18 minutes of being moved to a third room he discovered insects in that room as well and had to be moved still again. (Odd that at that point he didn’t flee the motel.) By July, the motel’s management was acknowledging to EcoLab that there was a “major problem with bedbugs” and that all that was being done about it was “chasing them from room to room.” Desk clerks were instructed to call the “bedbugs” “ticks,” apparently on the theory that customers would be less alarmed, though in fact ticks are more dangerous than bedbugs because they spread Lyme Disease and Rocky Mountain Spotted Fever. Rooms that the motel had placed on “Do not rent, bugs in room” status nevertheless were rented. It was in November that the plaintiffs checked into the motel. They were given Room 504, even though the motel had classified the room as “DO NOT RENT UNTIL TREATED,” and it had not been treated. Indeed, that night 190 of the hotel’s 191 rooms were occupied, even though a number of them had been placed on the same don’t-rent status as Room 504. Although bedbug bites are not as serious as the bites of some other insects, they are painful and unsightly. Motel 6 could not have rented any rooms at the prices it charged had it informed guests that the risk of being bitten by bedbugs was appreciable. Its failure either to warn guests or to take effective measures to eliminate the bedbugs amounted to fraud and probably to [the intentional tort of] battery as well. There was, in short, sufficient evidence of “willful and wanton conduct” [that is, of recklessness as opposed to mere negligence] to permit an award of punitive damages in this case. But in what amount? In arguing that $20,000 was the maximum amount of punitive damages that a jury could constitutionally have awarded each plaintiff, the defendant points to the U.S.

Supreme Court’s recent statement that “few awards [of punitive damages] exceeding a single-digit ratio between punitive and compensatory damages, to a significant degree, will satisfy due process.” State Farm Mutual Automobile Insurance Co. v. Campbell, 538 U.S. 408 (2003). The Court went on to suggest that “four times the amount of compensatory damages might be close to the line of constitutional impropriety.” Hence the defendant’s proposed ceiling in this case of $20,000, four times the compensatory damages awarded to each plaintiff. The ratio of punitive to compensatory damages determined by the jury was, in contrast, 37.2 to 1. The Supreme Court did not, however, lay down a 4-to-1 or single-digit-ratio rule—it said merely that “there is a presumption against an award that has a 145-to-1 ratio”—and it would be unreasonable to do so. We must consider why punitive damages are awarded and why the Court has decided that due process requires that such awards be limited. The second question is easier to answer than the first. The term punitive damages implies punishment, and a standard principle of penal theory is that “the punishment should fit the crime” in the sense of being proportional to the wrongfulness of the defendant’s action, though the principle is modified when the probability of detection is very low (a familiar example is the heavy fines for littering) or the crime is potentially lucrative (as in the case of trafficking in illegal drugs). Another penal precept is that a defendant should have reasonable notice of the sanction for unlawful acts, so that he can make a rational determination of how to act; and so there have to be reasonably clear standards for determining the amount of punitive damages for particular wrongs. [A] third precept . . . is that sanctions should be based on the wrong done rather than on the status of the defendant; a person is punished for what he does, not for who he is, even if the who is a huge corporation. What follows from these principles, however, is that punitive damages should be admeasured by standards or rules rather than in a completely ad hoc manner, and this does not tell us what the maximum ratio of punitive to compensatory damages should be in a particular case. To determine that, we have to consider why punitive damages are awarded in the first place. [O]ne function of punitive-damages awards is to relieve the pressures on an overloaded system of criminal justice by providing a civil alternative to criminal prosecution of minor crimes. An example is deliberately spitting in a person’s face, a criminal assault but because minor readily deterrable by the levying of what amounts to a civil fine through a suit for damages for the tort of battery. Compensatory damages [unaccompanied by punitive damages] would not do the trick in such a case, . . . for three reasons: because [compensatory damages] are difficult to determine in the case of acts that inflict largely [dignity-related] harms; because in the spitting case [compensatory damages] would be too slight to give the victim an incentive to sue, and he might decide



Chapter Six Intentional Torts

6-5

instead to respond with violence—and an age–old purpose of the law of torts is to provide a substitute for violent retaliation against wrongful injury; and because to limit the plaintiff to compensatory damages would enable the defendant to commit the offensive act with impunity provided that he was willing to pay. When punitive damages are sought for billion-dollar oil spills and other huge economic injuries, the considerations that we have just canvassed fade. As the Supreme Court emphasized in Campbell, the fact that the plaintiffs in that case had been awarded very substantial compensatory damages—$1 million for a dispute over insurance coverage—greatly reduced the need for giving them a huge award of punitive damages ($145 million) as well in order to provide an effective remedy. Our case is closer to the spitting case. The defendant’s behavior was outrageous but the compensable harm done was slight and at the same time difficult to quantify because a large element of it was emotional. And the defendant may well have profited from its misconduct because by concealing the infestation it was able to keep renting rooms. Refunds were frequent but may have cost less than the cost of closing the hotel for a thorough fumigation. The hotel’s attempt to pass off the bedbugs as ticks, which some guests might ignorantly have thought less unhealthful, may have postponed the instituting of litigation to rectify the hotel’s misconduct. The award of punitive damages in this case thus serves the additional purpose of limiting the defendant’s ability to profit from its fraud by escaping detection and (private) prosecution. If a tortfeasor is “caught” only half the time he commits torts, then when he is caught he should be punished twice as heavily in order to make up for the times he gets away. Finally, if the total stakes in the case were capped at $50,000 (2 × [$5,000 + $20,000]), the plaintiffs might well have had difficulty financing this lawsuit. It is here that the defendant’s aggregate net worth of $1.6 billion becomes relevant. A defendant’s wealth is not a sufficient basis for awarding punitive damages. BMW of North America, Inc. v. Gore, 517 U.S. 559 (1996). That would be discriminatory and would violate the rule of law, as we explained earlier, by making punishment depend on status rather than conduct. Where wealth in the sense of resources enters is in

enabling the defendant to mount an extremely aggressive defense against suits such as this and by doing so to make litigating against it very costly, which in turn may make it difficult for the plaintiffs to find a lawyer willing to handle their case, involving as it does only modest stakes, for the usual 33–40 percent contingent fee. In other words, the defendant is investing in developing a reputation intended to deter plaintiffs. It is difficult otherwise to explain the great stubbornness with which it has defended this case, making a host of frivolous evidentiary arguments despite the very modest stakes even when the punitive damages awarded by the jury are included. All things considered, we cannot say that the award of punitive damages was excessive, albeit the precise number chosen by the jury was arbitrary. It is probably not a coincidence that $5,000 + $186,000 = $191,000/191 = $1,000: that is, $1,000 per room in the hotel. But as there are no [rigid] punitive-damages guidelines, . . . it is inevitable that the specific amount of punitive damages awarded .  .  . will be arbitrary. (Which is perhaps why the plaintiffs’ lawyer did not suggest a number to the jury.) The judicial function is to police a range, not a point. But it would have been helpful had the parties presented evidence concerning the regulatory or criminal penalties to which the defendant exposed itself by deliberately exposing its customers to a substantial risk of being bitten by bedbugs. That is an inquiry recommended by the Supreme Court [in Campbell]. [However,] we do not think its omission invalidates the award. We can take judicial notice that deliberate exposure of hotel guests to the health risks created by insect infestations [­potentially] exposes the hotel’s owner to [criminal fines] under Illinois and Chicago law that in the aggregate are comparable in severity to that of the punitive damage award in this case. [W]hat is much more important, a Chicago hotel that permits unsanitary conditions to exist is subject to revocation of its license, without which it cannot operate. We are sure that the defendant would prefer to pay the punitive damages assessed in this case than to lose its license.

Interference with Personal Rights

Battery

This chapter examines two categories of intentional torts: (1) those involving interference with personal rights and (2) those involving interference with property rights. A third category, business or competitive torts, will be discussed in Chapter 8.

District court’s judgment in favor of plaintiffs affirmed.

LO6-3 List and explain the elements of battery.

Battery is the intentional and harmful or offensive touching of another without his consent. Contact is harmful if it produces bodily injury. However, battery also includes

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Part Two Crimes and Torts

nonharmful contact that is offensive—calculated to offend a reasonable sense of personal dignity. The intent required for battery is either (1) the intent to cause harmful or offensive contact or (2) the intent to cause apprehension that such contact is imminent. Assume, for instance, that in order to scare Pine, Delano threatens to “shoot” Pine with a gun that Delano mistakenly believes is unloaded. If Delano ends up shooting Pine even though that had not been his specific intent, Delano is liable for battery. For battery to occur, moreover, the person who suffers the harmful or offensive contact need not be the person the wrongdoer intended to injure. Under a concept known as transferred intent, a defendant who intends to injure one person but actually injures another is liable to the person injured, despite the absence of any specific desire to injure him. So, if Dudley throws a rock at Thomas and hits Pike instead, Dudley is liable to Pike for battery. As the previous examples suggest, the touching necessary for battery does not require direct contact between the defendant’s body and the plaintiff’s body. Dudley is therefore liable if he successfully lays a trap for Pike or poisons him. There is also a touching if the defendant causes contact with anything attached to the plaintiff’s body. If the other elements of a battery are present, Dudley is thus liable to Pike if he shoots off Pike’s hat. Finally, the plaintiff

need not be aware of the battery at the time it occurs. This means that Dudley is liable if he sneaks up behind Pike and knocks Pike unconscious, without Pike’s ever knowing what hit him. There is no liability for battery, however, if the plaintiff consented to the touching. As a general rule, consent must be freely and intelligently given to be a defense to battery. Consent may also be inferred from a person’s voluntary participation in an activity, but it is ordinarily limited to contacts that are a normal consequence of the activity. A professional boxer injured by his opponent’s punches to the head, therefore, would not win a battery lawsuit against the opponent. However, a professional boxer whose ear is partially bitten off by his opponent should have a valid battery claim against the ear-biter. In addition, the law infers consent to many touchings that are customary or reasonably necessary in normal social life. Thus, Preston could not recover for battery if Dean tapped him on the shoulder to ask directions or brushed against him on a crowded street. Of course, many such contacts are neither harmful nor offensive anyway. In Banks v. Lockhart, which follows, the court applies the elements of battery to the facts and explains why battery cases may give rise to awards of punitive damages in addition to compensatory damages.

Banks v. Lockhart   119 So. 3d 370 (Miss. Ct. App. 2013) Brandon Lockhart and his friend, Lindsay Gibson, visited several Oxford, Mississippi, bars one July evening. While at the Library Bar & Grill, Lockhart and Gibson encountered Harrison Banks. For reasons unknown, Gibson slapped Banks several times. A brief altercation between Banks and Gibson ensued, but the two were quickly separated. After this altercation, Lockhart and Gibson left the Library. While Lockhart and Gibson were walking in an alleyway near Taylor’s Pub, another altercation took place between Gibson and a third party. During this altercation, the third party knocked Gibson to the ground. Lockhart knelt down to assist Gibson and was struck in the face. This blow knocked Lockhart to the ground. At the trial in the case referred to below, Lockhart testified that when he looked up, he saw Banks fleeing the scene. However, Banks testified at trial that he was not present in the alleyway and did not see Lockhart or Gibson after they left the Library. At the urging of police officers who arrived on the scene shortly after this second altercation, Lockhart went to the local hospital to have his injuries assessed and treated. According to Lockhart’s trial testimony, several hospital exams showed that the above-described blow to his face shattered a sinus bone. Lockhart also testified that he underwent several steroid injections and one invasive surgery to remove scar tissue from the side of his face, and that further treatments could be needed. Based on the above facts, Lockhart sued Banks for the alleged battery that occurred near Taylor’s Pub. A Mississippi jury returned a verdict in favor of Lockhart for $300,000 in compensatory damages and $50,000 in punitive damages. Banks filed alternative post-trial motions for a judgment notwithstanding the verdict, a new trial, or a remittitur. (In this context, a remittitur would be a ruling by the court that the amount of damages awarded to the plaintiff by the jury was excessive and that unless the plaintiff agreed to accept a lesser amount as set by the court, the judgment in favor of the plaintiff would be vacated and a new trial on damages issues would be ordered.) After the trial court denied each of these motions, Banks appealed to the Court of Appeals of Mississippi.



Chapter Six Intentional Torts

Griffis, Judge On appeal, Banks argues that: (1) the jury’s verdict is against the overwhelming weight of the evidence; (2) the trial court erred when it allowed the jury to consider punitive damages; and (3) the trial court erred when it did not grant a remittitur on compensatory and punitive damages. A battery occurs when a person intends to cause a harmful or offensive contact to another person and such contact actually occurs. To determine whether the verdict was against the overwhelming weight of the evidence, we look at the facts in the light most favorable to the verdict. It is undisputed in the record that Lockhart suffered a harmful or offensive contact [on the relevant July night]. Thus, the central elements of battery that Lockhart had to prove to the jury were that: (1) Banks intended to cause a harmful or offensive contact, and (2) Banks was responsible for the harmful or offensive contact. Both parties agree that at least one altercation took place that evening in the Library between Gibson and Banks. While Banks claims he was not a party, it is undisputed that a second altercation took place in the alleyway near Taylor’s Pub, where Lockhart was struck in the face. Lockhart claims that after he was struck, he observed Banks fleeing from the scene. Additionally, the testimonies of [two police officers who arrived on the scene] were consistent that an altercation took place in the alleyway between Gibson and another party, and that while assisting Gibson after he was knocked to the ground, Lockhart was struck in the face. Banks’s only response to these assertions is that he simply was not present and, therefore, did not strike Lockhart. A reasonable, hypothetical juror could make inferences and conclude that, based on the testimony of the witnesses and the fact that a previous altercation had occurred, Banks was a party to the second altercation in the alleyway. As for Banks’s intent, a reasonable, hypothetical juror could have concluded that, based on Banks’s own statements, involvement in the previous altercation, and involvement in the alleyway altercation, he intended to cause a harmful or offensive contact when he struck Lockhart. Given this scenario, we cannot conclude that the verdict was contrary to the overwhelming weight of the evidence. Banks argues that Lockhart’s testimony lacked credibility. Determining the credibility of a witness or the weight of their testimony is not the province of this court. The weight and credibility of the witnesses was for the jury, [which] determined that Lockhart was a more credible witness than Banks. Furthermore, when applying the standard of review to jury verdicts in civil cases, . . . the jury verdict in favor of [Lockhart means that] this court resolves all conflicts in the evidence in his favor. [Banks also challenges the damages award as unsupported by the record.] Lockhart stipulated that his medical expenses were $11,654.64. Banks claims that the difference between an

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award of $350,000 in compensatory and punitive damages and medical expenses of $11,654.64 clearly evidences bias on the part of the jury. However, medical expenses are not the only damages claimed by Lockhart. He also claims past, present, and future physical pain and suffering, and resulting mental anguish. It is clear from the record that Lockhart sustained an actual injury and incurred damages as a result. However, this court [­cannot speculate about] the reason for the difference between the damages claimed by Lockhart and the jury’s specific allotment of the award. As such, this court cannot say that a reasonable juror would have concluded otherwise. Thus, taking the evidence in this matter as a whole, we find that a reasonable, hypothetical juror could have found as the jury here found. Banks’s second assignment of error is that the trial court erred in allowing the jury to consider punitive damages. [For punitive damages to have been appropriate, Mississippi law requires a showing that the defendant] acted with . . . willful, wanton, or reckless disregard for the safety of others. [E]ven in situations where an assault or battery occurred from sudden passion, [the requisite willful, wanton, or reckless disregard] on the part of the assailant may still be present in the case [and presumed from the proven facts and circumstances]. Anderson v. ­Jenkins, 70 So. 2d 535, 540 (Miss. 1954). In Anderson, the Supreme Court of Mississippi considered whether an assailant possessed [willful, wanton, or reckless disregard] when using a weapon to defend property. The assailant in Anderson fired a shotgun, twice, at a vehicle filled with teenage trespassers and one of the teens was struck in the eye with a shotgun. The assailant had the requisite intent to cause an offensive or harmful contact and that contact actually occurred. This court cannot say that simply because fists instead of firearms were used to cause the battery here, that the Supreme Court’s presumption no longer applies. Given the facts of this case, such a presumption can be made with respect to Banks’s intent when the jury considered punitive damages. The trial court did not abuse its discretion in allowing the jury to consider the issue of punitive damages. The jury found Banks responsible for the battery to Lockhart and awarded compensatory damages. Taking the totality of the circumstances, a reasonable, hypothetical trier of fact could have found that Banks acted willfully, wantonly, or with reckless disregard by striking Lockhart. [As explained in the discussion above], a reasonable, hypothetical juror could have found as the jury here found; thus, this court finds the overwhelming weight of the evidence is not against the verdict. The trial court did not abuse its discretion in denying Banks’s motion for remittitur. Furthermore, “[a] jury award should not be disturbed unless its size, in comparison to the actual amount of damage, shocks

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Part Two Crimes and Torts

the conscience.” [Citation omitted.] The award of $300,000 in compensatory damages and $50,000 in punitive damages does appear rather substantial, given the totality of the case before the trial court and the record before us. However, this court cannot say that such an award shocks the conscience. Given that the trial

court did not abuse its discretion in denying Banks’s motion for a remittitur and that, while significant, the award does not shock the conscience, this court finds no merit in Banks’s argument.

Assault

fear of spurious or trivial claims, concerns about proving purely emotional harms, and uncertainty about the proper boundaries of an independent tort. However, increased confidence in our knowledge about emotional injuries and a greater willingness to compensate such harms have helped to overcome these judicial impediments. Most courts today allow recovery for severe emotional distress, under appropriate circumstances, regardless of whether the elements of any other tort are proven. The courts are not, however, in complete agreement on the elements of this relatively new tort. All courts do require that a wrongdoer’s conduct be outrageous before liability for emotional distress arises. The Restatement (Second) of Torts speaks of conduct “so outrageous in character, and so extreme in degree, as to go beyond all possible bounds of decency, and to be regarded as atrocious, and utterly intolerable in a civilized community.” This means that many instances of boorish, insensitive behavior are not “bad enough” to give rise to ­liability for this tort. Courts also agree in requiring severe emotional distress. The Restatement (Second) sets forth another clear majority rule: that the defendant must intentionally or ­recklessly inflict the distress in order to be liable. A few courts, however, still fear fictitious claims and require proof of some bodily harm resulting from the ­victim’s emotional distress. In addition, some courts say that the plaintiff’s distress must be distress that a reasonable person of ordinary sensibilities would suffer. The focus on whether the severely distressed person had ordinary sensibilities is sometimes minimized, however, when the defendant behaves outrageously by abusing a position or relation that gives him authority over another. Examples include employers, police officers, landlords, and school authorities. The courts also differ in the extent to which they allow recovery for emotional distress suffered as a result of witnessing outrageous conduct directed at persons other than the plaintiff. The Restatement (Second) suggests that, at minimum, plaintiffs should be allowed to recover for severe emotional distress resulting from witnessing outrageous behavior toward a member of their immediate family. In the Durham case, which follows, the court applies the elements of intentional infliction of emotional distress to a set of facts involving a manager’s alleged treatment of an employee.

LO6-4 List and explain the elements of assault.

Assault occurs when there is an intentional attempt or offer to cause a harmful or offensive contact with another person, if that attempt or offer causes a reasonable apprehension of imminent battery in the other person’s mind. The necessary intent is the same as the intent required for battery. In an assault case, however, it is irrelevant whether the threatened contact actually occurs. Instead, the key thing is the plaintiff’s apprehension of a harmful or offensive contact. Apprehension need not involve fear; it might be described as a mental state consistent with this thought: “I’m just about to be hit.” The plaintiff’s apprehension must pertain to an anticipated battery that would be imminent or immediate. Threats of some future battery, therefore, do not create liability for assault. In addition, the plaintiff must experience apprehension at the time the threatened battery occurs. For instance, if Dinwiddie fires a rifle at Porter from a great distance and misses him, and only later does Porter learn of the attempt on his life, Dinwiddie is not liable to Porter for assault. The plaintiff’s apprehension must also be reasonable. As a result, threatening words normally are not an assault unless they are accompanied by acts or circumstances indicating the defendant’s intent to carry out the threat.

Intentional Infliction of Emotional Distress LO6-5

Explain what is necessary in order for liability to be imposed on the basis of intentional infliction of emotional distress.

For many years, courts refused to allow recovery for purely emotional injuries unless the defendant had committed some recognized tort. Victims of such torts as assault, battery, and false imprisonment could recover for the emotional injuries resulting from these torts, but courts would not recognize an independent tort of infliction of emotional distress. The reasons for this judicial reluctance included a

Judgment in favor of Lockhart affirmed.



Chapter Six Intentional Torts

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Durham v. McDonald’s Restaurants of Oklahoma, Inc.    256 P.3d 64 (Okla. 2011)

Camran Durham filed an intentional infliction of emotional distress lawsuit in an Oklahoma court against his former employer, McDonald’s Restaurants of Oklahoma, Inc. Durham based his claim on the behavior of a McDonald’s manager (Durham’s former supervisor) who, during Durham’s employment, denied three requests by Durham that he be allowed to take his prescription anti-seizure medication. In the course of denying the last request, the manager called Durham a “f . . . ing retard.” Durham, who was 16 years old at the time, alleged that the manager’s refusals caused him to fear he would suffer a seizure. Durham alleged that he left work crying after the incident and did not return. McDonald’s moved for summary judgment but did not controvert Durham’s account of the incident. Instead, McDonald’s argued that the manager’s conduct did not amount to “extreme and outrageous” conduct—a required element of a claim for intentional infliction of emotional distress. In so arguing, McDonald’s relied on an earlier federal court disposition of claims made by Durham under the federal Americans with Disabilities Act (ADA). In denying Durham recovery on his ADA claims, the federal court determined that the manager’s conduct was “not severe.” The trial court in Durham’s state court case concluded that the federal court disposition of the ADA claims constituted a binding determination of the “extreme and outrageous” element of Durham’s claim for intentional infliction of emotional distress. Therefore, the trial court granted summary judgment in favor of McDonald’s. Durham appealed to the Oklahoma Court of Civil Appeals, which affirmed. Durham appealed to the Supreme Court of Oklahoma. Reif, Judge In order to prove the tort of intentional infliction of emotional distress (or outrage), a plaintiff must prove each of the following elements: (1) the alleged tortfeasor acted intentionally or recklessly; (2) the alleged tortfeasor’s conduct was extreme and outrageous; (3) the conduct caused the plaintiff emotional distress; and (4) the emotional distress was severe. In the case at hand, McDonald’s has argued that the federal court [decision regarding Durham’s ADA claims effectively] adjudicated the second and fourth elements of the tort, and, therefore, Durham’s claim is barred by [the] issue preclusion [doctrine]. The Court of Civil Appeals found that the federal court had necessarily determined that the manager’s conduct was “not severe” in disposing of the federal ADA claims. Noting that Black’s Law Dictionary treats “extreme” as a synonym for “severe,” the Court of Civil Appeals [concluded] that conduct which is not severe cannot be “extreme and outrageous” under the applicable law. [According to Oklahoma case law,] “extreme and outrageous” conduct requires the existence of conduct so extreme in degree as to go beyond all possible bounds of decency, and which is viewed as atrocious and utterly intolerable in a civilized community. In general, a defendant’s conduct must be such that an average member of the community would exclaim, “Outrageous!” [Citations omitted.] The chief problem we have with [the analysis of the Court of Civil Appeals] is that it was not necessary for the federal court to make any determination about the character of the manager’s conduct in disposing of the federal litigation. All of Durham’s claims under the ADA, including [a] hostile working environment and constructive discharge claim, were dependent upon [Durham’s being] a “disabled person.” The federal

court determined [that Durham] was not a disabled person. [Durham’s] status as a disabled person was the linchpin of federal question jurisdiction and the determination of this issue adversely to [Durham] ended the court’s jurisdiction to decide any other issue concerning the ADA claims. [Under the circumstances, the federal court did not have] power to rule on any other matter affecting the parties. The Court of Civil Appeals [therefore] erred in ruling that the federal court disposition of the ADA claims was preclusive of the extreme and outrageous element of plaintiff’s claim for intentional infliction of emotional distress. When this Court reviews a claim for intentional infliction of emotional distress that has been rejected by the Court of Civil Appeals, we will make the “gatekeeper” or threshold determination of whether the defendant’s conduct may reasonably be regarded as extreme and outrageous. The test is whether the conduct is so extreme in degree as to go beyond all possible bounds of decency, and is atrocious and utterly intolerable in a civilized community. In the case at hand, we find that the manager’s use of “f . . . ing retard” in addressing a minor employee who is filled with apprehension after being denied permission to take anti-­ seizure medication may reasonably be regarded as meeting this test. We further find that reasonable people might differ on this issue, but could nonetheless similarly conclude that such conduct meets the test of [being] extreme and outrageous. Where this threshold is satisfied, the issue of whether a defendant’s conduct is extreme and outrageous is for a jury to decide. In its motion for summary judgment, McDonald’s also asserted that Durham cannot prove the severe emotional distress element of intentional infliction of emotional distress. The motion pointed out

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Part Two Crimes and Torts

that the trial court could make the “gatekeeper” or threshold determination concerning this element [and resolve it against Durham] based on the federal court disposition of the ADA claims. [It is important to note, however, that] the federal court did not determine whether Durham suffered severe emotional distress. Our review of [Durham’s] evidentiary materials leads us to the .  .  . conclusion [that there is a substantial controversy between the parties regarding the severe emotional distress element]. Intentional infliction of emotional distress does not provide redress for every invasion of emotional serenity or every antisocial act that may produce hurt feelings. While emotional distress can include all highly unpleasant mental reactions, such as fright, horror, grief, shame, humiliation, embarrassment, anger, chagrin, disappointment, worry, and nausea, it must be so severe that no reasonable person could be expected to endure it. The intensity and duration of the distress are factors to be considered in determining severity, but the type of distress must be reasonable and justified under the circumstances. It is for the court to determine, in the first instance, whether based upon the evidence presented, severe emotional distress can be found. [Citations omitted.] At the time the manager refused permission to take the antiseizure medicine, Durham related that he “was getting scared he might die [or] he could bite off his tongue or fall and hurt himself.” After the manager called him a “f . . . ing retard,” he ran out the door crying. As a consequence of this treatment, Durham

stated he became “withdrawn” and “a recluse.” He recounted that “[h]e felt he couldn’t do anything [and] was afraid he would suffer the same experience at another job.” His mother related that he “wouldn’t go outside, slept all day, and had to be home schooled.” She stated that he “became depressed and introverted.” She reported that “he was no longer active [and] lost interest in everything.” Durham believed that a school friend who worked at McDonald’s told other school friends about the incident. They began calling plaintiff a “f . . . ing retard” and teased him by saying, “I hear you can’t even keep a job at McDonald’s because you’re a f . . . ing retard.” Viewing the evidentiary materials in a light most favorable to plaintiff Durham [(as we are required to do in reviewing the grant of summary judgment against him)], we hold that the highly unpleasant mental reactions that plaintiff Durham and his mother described are reasonable and justified under the circumstances. We also hold that they go beyond mere hurt feelings, insult, indignity, and annoyance and could be reasonably regarded to constitute emotional distress so severe that no reasonable person could be expected to endure it. In such cases, “[i]t is for the jury to determine whether, on the evidence, severe emotional distress in fact existed.” [Citation omitted.]

Most intentional infliction of emotional distress cases are based on allegedly outrageous conduct. What about allegedly outrageous speech? May it be the basis of a valid emotional distress claim? The potential First Amendment implications of allowing emotional distress liability to be based on speech—particularly when the plaintiff is a famous person who was the target or subject of the defendant’s statements—occupied the attention of the U.S. Supreme Court in Hustler Magazine, Inc. v. Falwell, 485 U.S. 46 (1988). On First Amendment grounds, the Court unanimously struck down a damages award received in the lower courts by the Rev. Jerry Falwell as a result of offensive statements about him in an adult magazine. In doing so, the Court severely restricted the ability of public figures to win speech-related intentional infliction of emotional distress cases by requiring that such plaintiffs prove the same stern First Amendment–based requirements imposed on public figure plaintiffs in defamation cases. (A  later section in this chapter includes extensive ­discussion of defamation law, including the First Amendment–­based requirements that public figures must satisfy when they sue for defamation.)

The Court had no occasion to rule in Falwell on whether the First Amendment would restrict the ability of a private figure (i.e., a person who is not well known and thus is not a public figure) to base an emotional distress claim on a defendant’s allegedly outrageous speech about him or her. The parallel drawn in Falwell to the constitutional requirements in defamation cases could signify somewhat less of a role for the First Amendment in intentional infliction of emotional distress cases brought by private figure plaintiffs regarding speech about them. The matter remains uncertain, however. What about instances in which the allegedly outrageous speech was not about the plaintiff but caused the plaintiff to experience significant emotional harm? The Supreme Court addressed such an instance in a controversial and much-publicized decision, Snyder v. Phelps, 562 U.S. 443 (2011). The plaintiff, Albert Snyder, was the father of a deceased soldier who had been killed in the line of duty. At the time of the soldier’s funeral and in relatively close proximity to where it was held, the defendants (the Rev. Fred Phelps and other individuals associated with the Westboro Baptist Church) displayed picket signs communicating

Grant of summary judgment in favor of McDonald’s reversed; case remanded for further proceedings.



Chapter Six Intentional Torts

strongly worded anti-gay messages. The plaintiff saw the signs on the way to the funeral and learned of their specific content a few hours later. He regarded the defendants’ messages and their decision to target the funeral for their protest as a distress-causing, unwelcome intrusion into an intensely personal event for the Snyder family. In his lawsuit, therefore, Snyder alleged claims for intentional infliction of emotional distress and invasion of privacy. This was not the first time the defendants had picketed at a deceased soldier’s funeral. They had done so frequently in order to express their view that God hates homosexuals and that American soldiers die because of God’s displeasure with attitudes of tolerance toward gays. The Supreme Court held in Snyder v. Phelps that Snyder could not prevail and that the defendants’ speech was fully protected under the First Amendment because it dealt with a matter of public concern. The Court acknowledged the offensive nature of the defendants’ speech, particularly under the circumstances in which the defendants communicated it, but stressed that the First Amendment protects a great deal of speech that listeners or viewers may find objectionable or unwelcome. After the decisions in Falwell and Snyder, it is fair to say that the First Amendment makes a speech-based intentional infliction of emotional distress case very hard to win. Of course, when a defendant’s conduct—as opposed to speech—serves as the basis for an emotional distress case, the First Amendment does not even potentially furnish the defendant any protection against liability.

False Imprisonment LO6-6 List and explain the elements of false imprisonment.

False imprisonment is the intentional confinement of another person for an appreciable time (a few minutes is enough) without his consent. The confinement element essentially involves the defendant’s keeping the plaintiff within a circle that the defendant has created. It may result from physical

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barriers to the plaintiff’s freedom of movement, such as locking a person in a room with no other doors or windows, or from the use or threat of physical force against the plaintiff. Confinement also may result from the unfounded assertion of legal authority to detain the plaintiff, or from the detention of the plaintiff’s property (e.g., a purse containing a large sum of money). Likewise, a threat to harm another, such as the plaintiff’s spouse or child, can also cause confinement if it prevents the plaintiff from moving. The confinement must be complete. Partial confinement of another by blocking her path or by depriving her of one means of escape where several exist, such as locking one door of a building having several unlocked doors, is not false imprisonment. The fact that a means of escape exists, however, does not relieve the defendant of liability if the plaintiff cannot reasonably be expected to know of its existence. The same is true if using the escape route would present some unreasonable risk of harm to the plaintiff or would involve some affront to the plaintiff’s sense of personal dignity. Although there is some disagreement on the subject, courts usually hold that the plaintiff must have knowledge of his confinement in order for liability for false imprisonment to arise. In addition, there is no liability if the plaintiff has consented to his confinement. Such consent, however, must be freely given; consent in the face of an implied or actual threat of force or an assertion of legal authority is not freely given. Today, many false imprisonment cases involve a store’s detention of persons suspected of shoplifting. In an attempt to accommodate the legitimate interests of store owners, most states have passed statutes giving them a conditional privilege to stop suspected shoplifters. To obtain this defense, the owner usually must act with reasonable cause and in a reasonable manner, and must detain the suspect for no longer than a reasonable length of time. These privilege statutes typically extend to other intentional torts besides false imprisonment. The Farrell case, which follows, examines the elements of false imprisonment and considers the role a privilege statute may play.

Farrell v. Macy’s Retail Holdings, Inc.   2016 U.S. App. LEXIS 6791 (4th Cir. 2016) Stephanie and William Farrell were shopping at a Macy’s department store that was located in a Maryland mall. The asset protection manager for Macy’s observed William, and then the couple, and saw what is set forth in this statement of facts. Initially, William walked around the store wearing a jacket that he had not yet purchased. Then after removing the jacket, William selected several items from sales racks, removed the items from their hangers, and placed the items into a bag. He also appeared to move away from where he selected the jacket before placing it into the bag and leaving the jacket’s hanger on a different rack. After the Farrells

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Part Two Crimes and Torts

began shopping together, the couple selected a robe for William, and he again removed it from the hanger and placed it in the bag. The Farrells then approached the exit to the mall, where two mall security officers, one of whom was wearing his security uniform, were sitting. After getting within 5 to 10 feet of the exit, the Farrells turned back into the store. Suspecting that the Farrells were attempting to shoplift store items, Macy’s employees then stopped them, detained them, and questioned them. The store employees released the Farrells after determining that they were not shoplifting. Relying on diversity of citizenship principles, the Farrells sued Macy’s in a federal district court on the theory that the abovedescribed detention constituted false imprisonment. Maryland has a so-called shopkeeper’s statute. Such a statute protects store owners and their employees against false imprisonment liability for detaining customers on suspicion of shoplifting even though the customers were innocent in that regard, if there was probable cause for the theft suspicion and the detention was conducted reasonably. Largely on the basis of the shopkeeper’s statute, the district court granted summary judgment in favor of Macy’s. The Farrells appealed to the U.S. Court of Appeals for the Fourth Circuit.

Per Curiam The district court granted summary judgment [in favor of Macy’s] based on its determination that [the Macy’s employees] had probable cause to detain William Farrell. We review de novo a district court’s order granting summary judgment. [The Federal Rules of Civil Procedure provide that summary ­judgment is to be granted] “if the movant shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.” In determining whether a genuine issue of material fact exists, “we view the facts and all justifiable inferences arising therefrom in the light most ­favorable to .  .  . the nonmoving party.” [Case citation omitted.] The Farrells argue that the Defendants’ employees lacked probable cause to detain them. Under Maryland law, “[f]or a plaintiff to succeed on a false arrest or false imprisonment claim, the plaintiff must establish that the defendant deprived the plaintiff of his or her liberty without consent and without legal justification.” State v. Roshchin, 130 A.3d 453, 459 (Md. 2016). However, [a Maryland statute provides that] a merchant cannot be held liable for false imprisonment if it “had, at the time of the detention . . . , probable cause to believe that the person committed the crime of ‘theft,’ as prohibited by [Maryland law]. [Probable cause] is defined in terms of facts and circumstances sufficient to warrant a prudent person in believing that the suspect had committed or was committing an offense.” DiPino v. Davis, 729 A.2d 354, 361 (Md. 1999). Maryland defines theft as “willfully and knowingly obtaining unauthorized control over the property or services of another; by deception or otherwise; with intent to deprive the owner of his property. . . . ” Lee v. State, 474 A.2d 537, 540–41 (Md. Ct. Spec. App. 1984). In Lee, the court noted that “several factors should be assessed to determine whether the accused [in a shoplifting case] intended to deprive the owner of property,” including “concealment of [the] goods[,]. . . . [o]ther furtive or unusual behavior[,]. . . . [t]he customer’s proximity to the store’s exits[,] . . . and

possession by the customer of a shoplifting device with which to conceal merchandise.” Id. at 542–43. Although Lee addressed these factors in determining whether sufficient evidence supported a conviction for theft, its discussion also is relevant to whether probable cause existed to believe that a person is committing theft. We conclude that [on the basis of the observations of the Macy’s asset-protection manager, as described in the above statement of facts,] the Macy’s employees had probable cause to detain the Farrells at the time of the detention. The Farrells argue that the district court did not view the evidence in the proper light because it failed to consider their deposition testimony that they intended to purchase the items at the sales counter near where they had entered the store and, therefore, that they had not passed all points of sale prior to their apprehension. However, “[w]hether probable cause exists depends upon the reasonable conclusion to be drawn from the facts known to the [detaining] officer at the time of the arrest.” Devenpeck v. Alford, 543 U.S. 146, 152 (2004). The Farrells have not argued or offered any evidence demonstrating that, at the time he detained them, the asset-protection manager knew they intended to pay for the items William Farrell had placed into the bag he was carrying. Moreover, the court’s finding that the Farrells had passed all points of sale is supported by the store’s video surveillance; the couple is seen walking toward the exit to the mall and, as Stephanie Farrell testified at her deposition, coming within approximately five to ten feet of the exit while looking at a table displaying merchandise for sale. [Because the Macy’s employees had probable cause to detain the Farrells, the statute referred to above protects Macy’s against liability for false imprisonment. The district court, therefore, correctly granted summary judgment in favor of Macy’s.] District court’s grant of summary judgment in favor of defendant affirmed.



Chapter Six Intentional Torts

Defamation LO6-7

List and explain the common law elements of defamation.

Claims for defamation are recognized in order to protect the reputational interest of the plaintiff (whether an individual person or a corporation). Defamation is ordinarily defined as the (1) unprivileged (2) publication of (3) false and defamatory (4) statements concerning another. Before examining each of these elements, we must consider the distinction between two forms of defamation: libel and slander. The Libel–Slander Distinction Libel refers to written or printed defamation or to other defamation having a physical form, such as a defamatory picture, sign, or statue. Slander refers to all other defamatory statements—mainly oral defamation. Today, however, the great majority of courts treat defamatory statements in radio and television broadcasts as libel. The same is true of defamatory statements made on the Internet. Why does the libel–slander distinction matter? Because of libel’s more permanent nature and the seriousness we usually attach to the written word, the common law has traditionally allowed plaintiffs to recover for libel without proof of actual damages (reputional injury and other harm such as emotional distress). Presumed damages have long been allowed by the common law in libel cases. Described by the U.S. Supreme Court as an “oddity of tort law,” presumed damages “compensate” for reputational harm that is presumed to have occurred but does not have to be proven by the plaintiff. Slander, on the other hand, is generally not actionable without proof of special damages, unless the nature of the slanderous statement is so serious that it can be classified as slander per se. In cases of slander per se, presumed damages are allowed by the common law. Slander per se ordinarily includes false statements that the plaintiff (1) has committed a crime involving moral turpitude or potential imprisonment, (2) has a loathsome disease, (3) is professionally incompetent or guilty of professional misconduct, or (4) is guilty of serious sexual misconduct. False and Defamatory Statement Included among the elements of defamation are the separate requirements that the defendant’s statement be both false and defamatory. Truth is a complete defense in a defamation case. A defamatory statement is one that is likely to harm the reputation of another by injuring his community’s estimation of him or by deterring others from associating or dealing with him.

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“Of and Concerning” the Plaintiff Because the defamation cause of action serves to protect reputation, an essential element of the tort is that the alleged defamatory statement must be “of and concerning” the plaintiff. That is, the statement must be about—and thus bear upon the reputation of—the party who brought the case. This requirement presents problems whose complexities are beyond the scope of this text. The rules sketched below, therefore, are sometimes subject to exceptions not explained here. What about allegedly fictional accounts whose characters resemble real people? Most courts say that fictional accounts may be defamatory if a reasonable reader would identify the plaintiff as the subject of the story. Similarly, humorous or satirical accounts ordinarily are not defamation unless a reasonable reader would believe that they purport to describe real events or actual facts. Statements of pure opinion do not amount to defamation because they are not statements of “fact” concerning the plaintiff. However, statements that mix elements of opinion with elements of supposed “fact” may be actionable. Neumann v. Liles, which follows shortly, explains and applies the factors courts take into account in deciding whether a statement is actionable as a false statement of supposed fact or is, instead, a nonactionable statement of opinion. The Obsidian Finance Group case, which appears later in the chapter, also touches on the fact-versus-opinion issue. Do defamatory statements concerning particular groups of people also defame the individuals who belong to those groups? Generally, an individual member of a defamed group cannot recover for damage to her own reputation unless the group is so small that the statement can reasonably be understood as referring to individual group members. Finally, courts have placed some limits on the persons or entities that can suffer injury to reputation. No liability attaches, for example, to defamatory statements concerning the dead. Corporations and other business entities have reputational interests and can recover for defamatory statements that harm them in their business or deter others from dealing with them. Statements about a corporation’s officers, employees, or shareholders normally are not defamatory regarding the corporation, however, unless the statements also reflect on the manner in which the corporation conducts its business.1

As Chapter 8 reveals, statements concerning the quality of a corporation’s products or the quality of its title to land or other property may be the basis of an injurious falsehood claim. 1

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Part Two Crimes and Torts

Neumann v. Liles   369 P.3d 1117 (Ore. 2016) Carol Neumann is an owner of Dancing Deer Mountain LLC, an Oregon business that arranges and performs wedding events at a property Neumann owns. Christopher Liles attended a wedding and reception held on Neumann’s property. Two days after those events, Liles posted a negative review about Neumann and her business on Google Reviews, a publicly accessible website on which individuals may post comments about services or products they have received. The review was titled “Disaster!!!!! Find a different wedding venue.” The text of the review was as follows: There are many other great places to get married, this is not that place! The worst wedding experience of my life! The location is beautiful the problem is the owners. Carol (female owner) is two faced, crooked, and was rude to multiple guest[s]. I was only happy with one thing. It was a beautiful wedding, when it wasn’t raining and Carol and Tim stayed away. The owners did not make the rules clear to the people helping with set up even when they saw something they didn’t like they waited until the day of the wedding to bring it up. They also changed the rules as they saw fit. We were told we had to leave at 9pm, but at 8:15 they started telling the guests that they had to leave immediately. The “bridal suite” was a tool shed that was painted pretty, but a shed all the same. In my opinion [s]he will find a why [sic] to keep your $500 deposit, and will try to make you pay even more. Neumann sued Liles in an Oregon court, alleging that the statements in his review constituted defamation. The court dismissed the case after concluding that Liles’s statements amounted to nonactionable opinion and were otherwise protected by the First Amendment. Neumann appealed to the Oregon Court of Appeals, which reversed the lower court’s decision. The Court of Appeals concluded that some of the statements Liles made were capable of a defamatory meaning and seemingly factual—meaning that if the statements were false, they could give rise to a valid defamation claim in favor of Neumann. Among the potentially actionable statements, according to the Court of Appeals, were the statements that Neumann was “rude to multiple guest[s],” that she is “crooked,” and that she “will find a [way] to keep your $500 deposit.” Liles then appealed to the Supreme Court of Oregon, which agreed to decide the case in order to “determine how an actionable statement of fact is distinguished from a constitutionally protected expression of opinion in a defamation claim and whether the context in which a statement is made affects that analysis.” Baldwin, Judge This case requires us to decide whether a defamatory statement made in an online business review is entitled to protection under the First Amendment. [More specifically, we must] determine whether a reasonable factfinder could conclude that an allegedly defamatory statement touching on a matter of public concern implies an assertion of objective fact and is therefore not constitutionally protected. Liles argues that his online review of Neumann’s venue is entitled to protection under the First Amendment. He contends that his review, when read in the context of informal online communication, is properly understood as expressing merely his subjective opinion about the venue that he was reviewing. He also contends that the statements in his review are not provable as true or false. Regarding the words that the Court of Appeals concluded to be capable of defamatory meaning, such as “rude” and “crooked,” he argues that those words are too vague to imply an assertion of fact. Although our determination of the legal sufficiency of Neumann’s defamation claim hinges on whether Liles’s statements are protected under the First Amendment, we begin our analysis by [noting that under the common law elements of defamation, the plaintiff must show that] a defendant made a defamatory

statement about the plaintiff and published the statement to a third party. A defamatory statement is one that would subject the plaintiff “to hatred, contempt or ridicule, [or] tend to diminish the esteem, respect, goodwill or confidence in which [the plaintiff] is held, or [tend] to excite adverse, derogatory or unpleasant feelings or opinions against [the plaintiff].” [Citation omitted.] In the professional context, a statement is defamatory if it falsely “ascribes to another conduct, characteristics, or a condition incompatible with the proper conduct of his lawful business, trade, [or] profession.” [Citation omitted.] At early common law, defamatory statements were ­generally deemed actionable regardless of whether they were statements of fact or expressions of opinion. [Over time, however, the common law began to accord some measure of protection for statements of opinion. Later,] the United States Supreme Court determined that the First Amendment places limits on the application of the state law of defamation. The protection afforded under the First Amendment to statements of opinion on matters of public concern reached what one court called its “high-water mark” in Gertz v. Robert Welch, Inc., 418 U.S. 323 (1974). Keohane v. Stewart, 882 P.2d 1293, 1298 (Colo. 1994) (so characterizing the Supreme Court’s opinion in Gertz). In Gertz, the Court stated in dictum: “Under the



Chapter Six Intentional Torts

First Amendment there is no such thing as a false idea. However pernicious an opinion may seem, we depend for its correction not on the conscience of judges and juries but on the competition of other ideas. But there is no constitutional value in false statements of fact.” 418 U.S. at 339–40. A majority of state and federal courts interpreted Gertz to have announced that expressions of opinion were absolutely privileged under the First Amendment. In Milkovich v. Lorain Journal Co., 497 U.S. 1 (1990), however, the Supreme Court dispelled the notion that it had announced a “wholesale defamation exemption for anything that might be labeled ‘opinion.’” Id. at 18. In that case, a newspaper published a column that implied that Milkovich, a high school wrestling coach, had lied under oath in a judicial proceeding after his team was involved in an altercation at a wrestling match and the coach’s team was placed on probation. Milkovich filed a libel action against the newspaper and a reporter, alleging that the defendants had accused him of committing the crime of perjury, thereby damaging him in his occupation of coach and teacher. The Supreme Court rejected the defendants’ argument that all defamatory statements that are categorized as “opinion” as opposed to “fact” enjoy blanket First Amendment protection. Id. at 17–18. The Court clarified that the oft-cited passage in Gertz had been “merely a reiteration of Justice Holmes’ classic ‘marketplace of ideas’ concept.” Id. at 18 (citing Abrams v. United States, 250 U.S. 616, 630 (1919) (Holmes, J., dissenting) (“[T]he ultimate good desired is better reached by free trade in ideas. . . . [T]he best test of truth is the power of the thought to get itself accepted in the competition of the market.”). Thus, Gertz had not created an additional separate constitutional privilege for anything that might be labeled an “opinion.” In the Court’s view, such an interpretation of Gertz would “ignore the fact that expressions of ‘­opinion’ may often imply an assertion of objective fact.” ­Milkovich, 497 U.S. at 18. Ultimately, the Court refused to create a separate constitutional privilege for “opinion,” concluding instead that existing constitutional doctrine adequately protected the “uninhibited, robust, and wide-open” debate on public issues. Id. at 20–21. Under that existing doctrine, full constitutional protection is ­afforded to statements regarding matters of public concern that are not sufficiently factual to be capable of being proved false and statements that cannot reasonably be interpreted as stating actual facts. The dispositive question in determining whether a defamatory statement is constitutionally protected, according to the Court, is whether a reasonable factfinder could conclude that the statement implies an assertion of objective fact about the plaintiff. Id. at 19–21. Applying that rule to the facts of Milkovich, the Court determined that a reasonable factfinder could conclude that the statements in the newspaper column implied a factual assertion

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that Milkovich had perjured himself in a judicial proceeding. The  Court considered various factors. First, the Court noted that the column had not used “the sort of loose, figurative, or hyperbolic language” that would negate the impression that the writer was seriously maintaining that Milkovich had committed the crime of perjury. Second, the Court concluded the “general tenor of the article” did not negate that impression. Third, in the Court’s view, the accusation that Milkovich had committed perjury was “sufficiently factual to be susceptible of being proved true or false.” Accordingly, the Court held that the column did not enjoy constitutional protection. Id. The analytical response of both lower federal courts and state courts to Milkovich has been varied. This case presents the first occasion for this court to announce a framework for analyzing whether a defamatory statement is entitled to First Amendment protection. In the absence of existing law from this court, we look to the approaches of other jurisdictions for guidance. In Unelko Corp. v. Rooney, 912 F.2d 1049 (9th Cir. 1990), decided shortly after Milkovich, the U.S. Court of Appeals for the Ninth Circuit addressed whether certain statements that Andy Rooney had made during two broadcasts of “60 ­Minutes” were protected as opinion under the First Amendment. The court concluded that, after Milkovich, “the threshold question in defamation suits is not whether a statement might be labeled ‘opinion,’ but rather whether a reasonable factfinder could conclude that the statement impl[ies] an assertion of objective fact.” Id. at 1053. To resolve that threshold question, the Ninth Circuit drew from the factors that the Supreme Court had considered in Milkovich and announced a three-part test: (1) whether the general tenor of the entire work negates the impression that the defendant was asserting an objective fact; (2) whether the defendant used figurative or hyperbolic language that negates that impression; and (3) whether the statement in question is susceptible of being proved true or false. Id. Since Unelko, the Ninth Circuit has consistently used that three-part inquiry to determine whether a reasonable ­factfinder could conclude that a statement implies an assertion of objective fact. Several other courts also have expressly adopted the Ninth Circuit’s test. We agree with those courts that have found the Ninth Circuit’s three-part inquiry to be a sound approach for determining whether a statement is entitled to First Amendment protection. The Ninth Circuit’s test appropriately considers the totality of the relevant circumstances, including the context in which particular statements were made and the verifiability of those statements. The Ninth Circuit’s test is also a reasonable interpretation of Milkovich. It explicitly incorporates the factors that the Supreme Court itself considered in deciding Milkovich. Accordingly, we follow the Ninth Circuit’s three-part framework for whether

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Part Two Crimes and Torts

a reasonable factfinder could conclude that a given statement implies a factual assertion. [We now] apply that test to the facts of this case. Initially, we conclude that, if false, several of Liles’s statements are capable of a defamatory meaning. Throughout his review, Liles ascribed to Neumann conduct that is incompatible with the proper conduct of a wedding venue operator and, as the Court of Appeals noted, “inconsistent with a positive wedding experience.” As a result, a reasonable factfinder could conclude that Liles’s statements were defamatory if he or she found that the statements were false. The question remains, however, whether they are nevertheless protected under the First Amendment. To resolve that question, we must first determine, by examining the content, form, and context of Liles’s statements, whether those statements involve matters of public concern. Neumann has not disputed that Liles’s statements involve matters of public concern, and we readily conclude that they do. Liles’s review was posted on a publicly accessible website, and the content of his review related to matters of general interest to the public, particularly those members of the public who are in the market for a wedding venue. Next, we must determine whether a reasonable factfinder could interpret Liles’s statements as implying assertions of objective fact. Applying the three-part inquiry that we articulated above, we first consider whether the general tenor of the entire work negates the impression that Liles was asserting objective facts about Neumann. From the outset, it is apparent that the review is describing Liles’s personal view of Neumann’s wedding venue, calling it a “Disaster!!!!!” The general tenor of the piece, beginning with the word Disaster, is that, in Liles’s subjective opinion, the services were grossly inadequate and that the business was poorly operated. However, read independently, two sentences in the review could create the impression that Liles was asserting an objective fact: “Carol (female owner) is two faced, crooked, and was rude to multiple guest[s]. .  .  . In my opinion [s]he will find a [way] to keep your $500 deposit, and will try to make you pay even more.” Standing alone, those statements could create the impression that Liles was asserting the fact that Neumann had wrongfully kept a deposit that she was not entitled to keep. In the context of the entire review, however, those sentences do not leave such an impression. Rather, the review as a whole reveals that Liles was an attendee at the wedding in question and suggests that he did not himself purchase wedding services from Neumann. The general tenor of the review thus reflects Liles’s negative personal and subjective impressions and reactions as a guest at the venue and negates the impression that Liles was asserting objective facts. We next consider whether Liles used figurative or hyperbolic language that negates the impression that he was asserting

objective facts. Although the general tenor of the review reveals its hyperbolic nature more clearly than do the individual statements contained therein, several statements can be characterized as hyperbolic. In particular, the title of the review—which starts with the word Disaster and is followed by a histrionic series of exclamation marks—is hyperbolic and sets the tone for the review. The review also includes the exaggerative statements that this was “The worst wedding experience of [Liles’s] life!” and that Liles was “only happy with one thing” about the wedding. Such hyperbolic expressions further negate any impression that Liles was asserting objective facts. Finally, we consider whether Liles’s review is susceptible of being proved true or false. As discussed, Liles’s statements generally reflect a strong personal viewpoint as a guest at the wedding venue, which renders them not susceptible of being proved true or false. Again, the sentences quoted above referring to Neumann as “crooked” and stating that, “[i]n my opinion [s]he will find a [way] to keep your $500 deposit, and will try to make you pay even more” could, standing alone, create the impression that Liles was asserting facts about Neumann. However, viewed in the context of the remainder of the review, those statements are not provably false. The general reference to Neumann as “crooked” is not a verifiable accusation that Neumann committed a specific crime. Moreover, in light of the hyperbolic tenor of the review, the use of the word crooked does not suggest that Liles was seriously maintaining that Neumann had, in fact, committed a crime. Similarly, Liles’s statement that “[i]n my opinion [Neumann] will find a [way] to keep your $500 deposit, and will try to make you pay even more” is not susceptible of being proved true or false. That statement is explicitly prefaced with the words, “In my opinion”—thereby alerting the reader to the fact that what follows is a subjective viewpoint. Of course, those words alone will not insulate an otherwise factual assertion from liability. See Milkovich, 497 U.S. at 19 (simply couching statements in terms of opinion does not dispel their defamatory implications). However, given that Liles—as a mere guest at the wedding—presumably did not pay the deposit for the wedding involved in this case, his speculation that Neumann would try to keep a couple’s deposit is not susceptible of being proved true or false. Based on the foregoing factors, we conclude that a reasonable factfinder could not conclude that Liles’s review implies an assertion of objective fact. Rather, his review is an expression of opinion on matters of public concern that is protected under the First Amendment. We therefore further conclude that the trial court did not err in dismissing Neumann’s claim, and we reverse the Court of Appeals determination to the contrary. Court of Appeals decision reversed; Neumann’s defamation claim dismissed.



Chapter Six Intentional Torts

Publication Liability for defamation requires publication of the defamatory statement. As a general rule, no widespread communication of a defamatory statement is necessary for publication. The defendant’s communication of the defamatory statement to one person other than the person defamed ordinarily suffices. So long as no one else receives or overhears it, however, an insulting message communicated directly from the defendant to the plaintiff is not actionable. The longstanding rule is that publication does not take place when the plaintiff herself communicates the offensive statement to another. Courts sometimes make an exception to this rule in cases where a discharged employee is forced to tell a potential future employer about false and defamatory statements made to her by her prior employer. Some courts still follow the older rule that intracorporate statements (statements by one corporate officer or employee to another officer of the same corporation) do not involve publication. Most courts, however, follow the modern trend and hold that there is publication in such situations. The general rule is that one who repeats a false and defamatory statement may be liable for defamation. This is true even if he identifies the source of the statement. A party other than the person who initially made a defamatory statement may be liable along with the original speaker or writer if that other party served as a publisher of the defamatory falsehood but not if the other party was a mere distributor. According to defamation law’s traditional publisher versus distributor distinction, a company that publishes a book or a newspaper may be held liable for defamation on the basis of statements that appear in the book or in the newspaper’s articles. The rationale is that the publishing company possessed considerable editorial control over the content of the book or the articles and would have had the ability to remove the defamatory falsehoods. (The writer of the statements, of course, would be liable as well.) Libraries and bookstores, however, are mere distributors because they lack the editorial control that publishers have. Therefore, libraries and bookstores are not liable for defamation even if defamatory falsehoods appear in books they lend to users or sell to customers. What about Internet service providers and website operators? Can they be held liable as publishers of statements posted online by other parties? The answer might initially seem to be “yes” in instances where the service provider or website operator reserved some measure of editorial control, but the actual answer is “no.” Section 230 of the federal Communications Decency Act establishes a national rule that “no provider or user of an interactive computer

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service shall be treated as the publisher or speaker of any information provided by another information content provider.” This section has been applied by courts in a significant number of defamation cases and in various other types of cases in which liability for someone else’s online statements is at issue. Defenses and Privileges Even though defamation is called an intentional tort, the common law contemplated a form of strict liability for defamation. Defenses are available, however, in certain defamation cases. Of course, the truth of the defamatory statement is a complete defense to liability. Defamatory statements may be privileged as well. Privileges to defamation liability recognize that in some circumstances, other social interests are more important than an individual’s right to reputation. Privileges can be absolute or conditional. An absolute privilege shields the author of a defamatory statement regardless of her knowledge, motive, or intent. When such a privilege applies, it operates as a complete defense to defamation liability. Absolutely privileged statements include those made by participants in judicial proceedings, by legislators or witnesses in the course of legislative proceedings, by certain executive officials in the course of their duties, and by one spouse to the other in private. In each case, the theory underlying the privilege is that complete freedom of expression is essential to the proper functioning of the relevant activity, and that potential liability for defamation would inhibit free expression. Conditional (or qualified) privileges give the defendant a defense unless the privilege is abused. What constitutes abuse varies with the privilege in question. In general, conditional privileges are abused when the statement is made with knowledge of its falsity or with reckless disregard for the truth, when the statement does not advance the purposes supporting the privilege, or when it is unnecessarily made to inappropriate people. There are various conditional privileges. One important conditional privilege involves statements made to protect or further the legitimate interests of another. One of the most common business-related examples is the employment reference. Suppose that Parker’s former employer, Dorfman, has good reason to believe—and does in fact believe—that Parker embezzled money from Dorfman’s business while Parker was a Dorfman employee. Trumbull, who is deciding whether to hire Parker, contacts Dorfman to ask about Parker’s work record and performance as an employee. During the conversation, Dorfman tells Trumbull that he believes Parker committed embezzlement while working for him. On these facts, Dorfman will be protected

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Part Two Crimes and Torts

by a conditional privilege against defamation liability to Parker because Dorfman’s statement was designed to further Trumbull’s legitimate interest in making an intelligent hiring decision. Dorfman’s reasonably based belief in the truth of his statement about Parker is critical to his ability to rely on the conditional privilege. If Dorfman had known his statement was false or had made it with reckless disregard for the truth, Dorfman would have abused the conditional privilege and would have lost its protection against liability. A second important type of conditional privilege concerns statements made to promote a common interest. Intracorporate communications serve as an example, as do communications to law enforcement agencies and professional disciplinary bodies. A further example can be found in the U.S. Supreme Court decision Air Wisconsin Airlines Corp. v. Hoeper, 134 S. Ct. 852 (2014). In that case, the Court interpreted a federal statute that establishes a conditional privilege protecting airlines and their employees from civil liability for the content of their reports on suspicious behavior to the Transportation Security Administration (TSA). Hoeper claimed he was defamed when airline officials relayed their concerns about his behavior and “mental stability” to the TSA. When they made this report, the airline officials knew that Hoeper had been visibly angry after failing (for the fourth time) a certification test he had to pass in order to keep his job as a pilot. They also knew he had made a statement to the effect that the testing program was rigged against him. In addition, the airline officials were aware that Hoeper was scheduled to board a flight to go home from the testing center. They were concerned that he could be carrying a firearm because he had been among the pilots permitted to do so. After receiving the report, the TSA had Hoeper removed from the plane he had boarded for his flight home. In rejecting Hoeper’s defamation claim, the Court ruled that the gist of the report to the TSA was not ­materially false despite the “mental stability” speculation and the report’s reference to Hoeper as a terminated ­employee (when in reality the termination would not occur until the next day). Importantly, Hoeper still would have lost the case even if the report had been materially false. In that event, the defendants would have been protected under the statute’s conditional privilege absent a ­showing—which Hoeper would not have been able to make—that they abused the privilege by making a report with knowledge of its falsity or with reckless disregard for the truth.

Finally, many courts recognize a privilege called fair comment. That privilege protects fair and accurate media reports of defamatory statements that appear in proceedings of official government action or originate from public meetings. Defamation and the Constitution Until approximately 55 years ago, the First Amendment’s guarantees of freedom of speech and press were not considered relevant to defamation cases. The common law’s strict liability approach meant that unless one of the privileges discussed earlier applied, a speaker or writer who made a false statement believing it to be true had no more protection against defamation liability than the deliberate liar had. In a series of cases dating back to 1964, however, the U.S. Supreme Court has concluded that the common law’s approach is too heavily weighted in favor of plaintiffs’ reputational interests and not sufficiently protective of defendants’ free speech and free press interests. The Court has recognized that when coupled with the potential availability of presumed damages, a strict liability regime could deter wouldbe speakers from contributing true statements to public debate out of fear of the costly liability that might result if the jury somehow concluded that the statements were false. Recognizing the need to guard against this “chilling effect” and the resulting restriction on the flow of information that is important to a free society, the Court determined in New York Times Co. v. Sullivan, 376 U.S. 254 (1964) that the First Amendment has a role to play in certain defamation cases. The Court reasoned that judicial enforcement of the legal rules of defamation served as the government action necessary to trigger application of the First Amendment. Explain what a public official plaintiff or a public figure

LO6-8 plaintiff must prove, for constitutional reasons, in order

to win a defamation case.

Public Official Plaintiff Cases In New York Times, the Court

held that when a public official brings a defamation case, he or she must prove not only the usual elements of ­defamation but also a First Amendment–based fault ­requirement known as actual malice. The Court gave actual malice a special meaning: knowledge of falsity or reckless disregard for the truth. Thus, after New York Times, a ­defendant who makes a false and defamatory statement about a public official plaintiff will not be held liable unless the public official proves



Chapter Six Intentional Torts

that the defendant made the ­statement either (1) knowing it was false or (2) ­recklessly. Moreover, the Court held in New York Times that as a ­further First ­Amendment–based safeguard, the public official plaintiff must prove actual malice by clear and convincing evidence—a higher standard of proof than the preponderance of the evidence standard applicable to every other element of a defamation claim and to civil cases generally. The public official category includes  many high-level government officials, whether elected or appointed. Public Figure Plaintiff Cases Three years after New York

Times, the Supreme Court extended the proof-of-actualmalice requirement to defamation cases in which the plaintiff is a public figure. The Court also mandated that such a plaintiff prove actual malice by clear and convincing evidence. Individual persons or corporations are public figures if they either (1) are well known to large segments of society through their own voluntary efforts or (2) have voluntarily placed themselves, in the words of the Supreme Court, at “the forefront of a particular public controversy.” The first type of public figure, sometimes given the “general-purpose” designation, includes well-known corporations, political candidates who are not already holders of public office, and ex-government officials. It also includes a diverse collection of celebrities, near celebrities, and well-known persons ranging from familiar actors, entertainers, and media figures to famous athletes or coaches and others with high public visibility in their chosen professions. The second type of public ­figure, sometimes assigned the “limited-purpose” label, is not well known by large segments of society but has chosen to take a prominent leadership role regarding a matter of public debate (e.g., the abortion rights controversy, the debate over whether certain drugs should be legalized, or disputes over the extent to which environmental regulations should restrict business activity). A general-purpose public figure must prove actual malice in any defamation case in which he, she, or it is the plaintiff. A limitedpurpose public figure, on the other hand, must prove actual malice when the statement giving rise to the case relates in some sense to the public controversy as to which the plaintiff is a public figure. The proof-of-actual-malice requirement poses a very substantial hurdle for public officials and public figures to clear. That is by design, according to the Supreme Court. Defendants have especially strong First Amendment interests in regard to statements about public officials and public figures, given the high level of public interest and

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concern that attaches almost automatically to matters involving such persons. Knowledge of falsity—one of the two forms of actual ­malice—is difficult to prove. When the defendant who made a false statement can point to an arguably credible source on which he, she, or it relied as a supposed indicator of the statement’s truth, the defendant presumably did not have knowledge of the statement’s falsity. Neither did the defendant speak or write with the other form of actual malice—reckless disregard for the truth—in such an instance. According to the Supreme Court, reckless disregard has been demonstrated when the plaintiff proves either (1) that the defendant “in fact entertained serious doubts” about the statement’s truth but made the statement anyway or (2) that the defendant consciously rejected overwhelming evidence of falsity and chose instead to rely on a much less significant bit of evidence that would have indicated truth only if the contrary evidence had not also been part of the picture. When the defendant relied on an arguably credible source that tended to indicate the statement was true, the defendant presumably did not entertain serious doubts and did not consciously reject overwhelming evidence of falsity. Such a defendant, therefore, did not display reckless disregard for the truth. If a reasonable person in the defendant’s position would not have relied on a lone source despite its credibility and would have ascertained the statement’s falsity through further investigation, the defendant who failed to investigate further has been negligent. Negligence, however, is not as severe a degree of fault as reckless disregard and does not constitute actual malice. Most defamation cases brought by public official or public figure plaintiffs are won by the defendant—if not at trial, then on appeal. That is often the result because the plaintiff was unable to prove actual malice even though the statement was false and tended to harm reputation. Sometimes, however, the public official or public figure plaintiff accomplishes the daunting task of proving actual malice. When that occurs, the First Amendment does not bar such a plaintiff from winning the case and recovering compensatory damages (including those of the presumed variety) as well as punitive damages. In Bertrand v. Mullin, which follows, the Supreme Court of Iowa focuses on the actual malice element that public official plaintiffs and public figure plaintiffs must prove if they are to win a defamation case. The decision explores the First Amendment foundations of the actual malice element and illustrates the difficulty of proving either of the forms it may take.

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Part Two Crimes and Torts

Bertrand v. Mullin   846 N.W.2d 884 (Iowa 2014) Republican Rick Bertrand and Democrat Rick Mullin were candidates for the Iowa Senate in the 2010 election. Bertrand owned businesses in Sioux City, Iowa. From 1999 until 2009, however, he served as a salesperson and district manager for Takeda Pharmaceuticals. Bertrand worked in a Takeda division that marketed the diabetes drug Actos. Another Takeda division sold Rozerem, a prescription sleep aid. Bertrand never personally sold Rozerem. In October 2010, Bertrand ran a televised campaign advertisement that contrasted Mullin’s current policy positions with positions he had taken in the past. The ad angered Mullin and, according to his campaign’s internal polling, adversely affected his support. His campaign manager told him that “Bertrand hit you hard. Hit him back harder.” Research conducted for Mullin revealed a newspaper article about a consumer group’s disclosure of a Food and Drug Administration (FDA) report finding that 388 patients had been hospitalized for heart problems after taking Actos. Research also revealed that the FDA had criticized Takeda’s marketing of Rozerem—especially an ad in which Rozerem seemingly was being marketed to children. Finally, research uncovered a newspaper article noting that a consumer advocacy group had labeled Takeda “the most unethical drug company in the world.” This research furnished the basis for a televised ad run by Mullin in response to Bertrand’s ad. When Mullin and Iowa Democratic Party staff members discussed the proposed script for the ad in mid-October, Mullin disliked its tone. In a later e-mail, Mullin called a rewrite of the script “less vile.” He eventually approved the script. The Mullin ad—titled “Secrets”—first aired on TV on October 17. The audio portion contained these statements: Rick Bertrand said he would run a positive campaign but now he is falsely attacking Rick Mullin. Why? Because Bertrand doesn’t want you to know he put his profits ahead of children’s health. Bertrand was a sales agent for a big drug company that was rated the most unethical company in the world. The FDA singled out Bertrand’s company for marketing a dangerous sleep drug to children.  Rick Bertrand. Broken promises. A record of deceit. At the bottom of the screen during one shot, this statement appeared: “BERTRAND’S COMPANY MARKETED SLEEP DRUG TO CHILDREN.” The statements in the ad cited the above-mentioned newspaper articles, which also flashed across the screen. Mullin later admitted that he did not know whether Bertrand had ever sold Rozerem or marketed dangerous drugs to children. In addition, Mullin admitted that when he approved the ad’s script, he liked the reference to profiting at the expense of children. At an October 21 public debate, Bertrand called the Mullin ad false and demanded that Mullin stop airing it. The next day, Bertrand filed a defamation lawsuit against Mullin and the Iowa Democratic Party in a state district court. Mullin kept running the ad through October 31, two days before the election. Bertrand won the election by 222 votes. The trial court ruled that of the 10 supposedly defamatory statements in the Mullin ad and in related campaign mailings, eight were not actionable as a matter of law. However, the court permitted the jury to consider two statements from the ad: “The FDA singled out Bertrand’s company for the marketing of dangerous drugs to children.” and “BERTRAND’S COMPANY MARKETED SLEEP DRUG TO CHILDREN.” According to the court, “a reasonable jury [could] find that these statements imply a false fact, namely that Rick Bertrand personally sold a dangerous sleep drug to children, or that he owns a company that sold a dangerous sleep drug to children.” Besides denying that the statements and implications were false, Mullin argued that Bertrand could not prove they were made with actual malice. At the close of the evidence, the court denied the defendants’ motion for a directed verdict. The jury returned a verdict in favor of Bertrand for $31,000 in damages against Mullin and $200,000 against the Iowa Democratic Party. In response to the defendants’ motion for judgment notwithstanding the verdict (JNOV), the court concluded that it should have granted a directed verdict for the defendants regarding the alleged implication that Bertrand owned a company that sold Rozerem. No reasonable juror could conclude that Takeda was Bertrand’s company, the court determined, because reasonable viewers of the ad could not ignore the statement that Bertrand had been a Takeda sales agent (a statement that preceded the “Bertrand’s company” line in the ad). The above ruling did not change the case’s outcome, however, because the court concluded that in view of “the language and juxtaposition of the phrases,” reasonable jurors could have regarded—and apparently did regard—the ad’s statement as implying that Bertrand personally sold Rozerem. The court reasoned that even if Mullin literally expressed a legitimate point about the company for which Bertrand had worked, reasonable persons hearing the statement could infer that Bertrand personally sold the product. In addition, the court concluded that sufficient evidence of actual malice had been presented. The court therefore allowed the jury verdict for Bertrand to stand. The defendants appealed to the Supreme Court of Iowa.



Chapter Six Intentional Torts

Cady, Chief Justice In an ordinary case, a plaintiff establishes a prima facie claim for defamation by showing the defendant (1) published a statement that (2) was false and defamatory (3) of and concerning the plaintiff, and (4) resulted in injury to the plaintiff. We have previously held the defamatory publication need not be explicit, but may be implied “by a careful choice of words in juxtaposition of statements.” [Citation omitted.] A plaintiff who is a candidate for public office [is treated, for defamation purposes, as if he were] a public official. Monitor Patriot Co. v. Roy, 401 U.S. 265, 271–72 (1971). When a plaintiff is [a public figure or a] public official, the First Amendment adds [the requirement of proving] actual malice. New York Times v. Sullivan, 376 U.S. 254, 279–80 (1964). [The public official] plaintiff bears the burden of showing actual malice by clear and convincing evidence. The burden to establish actual malice was deliberately set high . . . in New York Times [because the First Amendment contemplates] a “profound national commitment to the principle that debate on public issues should be uninhibited, robust, and wide-open, and that it may well include vehement, caustic, and sometimes unpleasantly sharp attacks on government and public officials.” Id. at 270. At its core, the First Amendment guarantee “has its fullest and most urgent application precisely to the conduct of campaigns for political office.” Monitor Patriot, 401 U.S. at 272. [C]onstitutional protection for political speech in the context of a campaign extends to “anything which might touch on an official’s fitness for office.” Garrison v. Louisiana, 379 U.S. 64, 77 (1964). A statement is made with actual malice when accompanied by “knowledge that it was false or with reckless disregard for its truth or falsity.” New York Times, 376 U.S. at 279–80. A knowing falsehood may be easy to identify in theory, but any effort to peer into the recesses of human attitudes towards the truthfulness of a statement is certain to be difficult. “Reckless disregard .  .  . cannot be fully encompassed in one infallible definition.” St. Amant v. Thompson, 390 U.S. 727, 730 (1968). Yet, in the half century the New York Times rule has preserved the First Amendment’s guarantee of uninhibited commentary regarding public officials and figures, the Supreme Court has crafted some useful guideposts. Most prominently, an early case nearly contemporaneous with New York Times opined that statements made with a “high degree of awareness of their probable falsity” may subject the speaker to civil damages. Garrison, 379 U.S. at 74. The negative implication, of course, is that a court may not award damages against one who negligently communicates a falsehood about a public official [or public figure]. Masson v. New Yorker Magazine, Inc., 501 U.S. 496, 510 (1991) (“Mere negligence does not suffice.”). The Supreme Court has explained its reasoning: [R]eckless conduct is not measured by whether a reasonably prudent man would have published, or would have investigated

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before publishing. There must be sufficient evidence to permit the conclusion that the defendant in fact entertained serious doubts as to the truth of his publication. Publishing with such doubts shows reckless disregard for truth or falsity and demonstrates actual malice. St. Amant, 390 U.S. at 731 (emphasis added). Candidly, the New York Times standard tilts the balance strongly in favor of negligent defendants. “[F]ailure to investigate before publishing, even when a reasonably prudent person would have done so, is not sufficient to establish reckless disregard.” Harte-Hanks Communications, Inc. v. Connaughton, 491 U.S. 657, 688 (1989). Similarly, “[r]eliance on a single source, in the ­absence of a high degree of awareness of probable falsity, does not constitute actual malice.” [Citation omitted.] Nor does a “shoddy” investigation constitute actual malice. [Citation omitted.] “[F]ailure to follow journalistic standards and lack of investigation may establish irresponsibility or even possibly gross irresponsibility, but not reckless disregard of truth.” [Citation omitted.] Mullin and the Iowa Democratic Party challenge the judgment entered on the claim of defamation on several grounds, including the sufficiency of evidence to support the actual malice element of the tort. In considering the actual malice element, we must decide if the evidence supports a finding that the defendants “in fact entertained serious doubts as to the truth” of the implied communication in the commercial—that Bertrand personally sold a dangerous drug—or if they had “a high degree of awareness of [its] probable falsity.” St. Amant, 390 U.S. at 731 (first quotation); Garrison, 379 U.S. at 74 (second quotation). Bertrand argues actual malice was supported by the evidence in a number of ways. First, he claims the evidence showed that the defendants knew the implication in the commercial at issue was false because they knew that none of his Sioux City companies sold drugs and [because they neither knew] which pharmaceutical company [division] Bertrand worked in [nor] which division of the company sold the drug in dispute. Second, Bertrand claims Mullin and the Iowa Democratic Party should have known the implication in the commercial was false because Mullin expressed doubts about the commercial before it aired. Third, Bertrand claims actual malice was supported by evidence that the defendants acquired ill will towards him after he aired his own hardhitting commercial. Fourth, Bertrand asserts the jury could have found actual malice because the purpose of the commercial was to curtail electoral support for Bertrand. We first consider the evidence to support a finding that Mullin and the Iowa Democratic Party had actual knowledge of the falsity of the implied statement in the commercial. In doing so, we clarify that the district court ultimately found the only actionable defamation claim was based on the implication that Bertrand sold drugs to children, reported to be dangerous, when he worked for

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Part Two Crimes and Torts

a pharmaceutical company. Thus, any knowledge by the defendants that Bertrand’s Sioux City businesses never marketed drugs to children has no impact on the pertinent question whether they knew that Bertrand never sold a dangerous drug to children when he worked for the pharmaceutical company. [T]he evidence of actual malice necessary to support the implied defamation in this case [would need to center] on knowledge of the falsity of the implied statement that Bertrand personally marketed Rozerem, not on knowledge that he did not own the company that marketed the drug or that the businesses he actually owned did not market the drug. The evidence at trial established that Mullin and the Iowa Democratic Party did not know [whether] Bertrand was personally responsible in any way for marketing or selling the drug. They conducted some research . . . and concluded from [it] that Bertrand worked for the drug company and the company marketed the drug. The research revealed that the FDA and others criticized Takeda for selling Rozerem. These statements were true and formed the basis for their claim that Bertrand was associated with an unethical business. Yet, Mullin and the Iowa Democratic Party did not look into the matter further to uncover the complete story. The truth, of course, was that Bertrand never worked in the particular division of the company that marketed the drug and never sold the drug. Nevertheless, there was no evidence that Mullin or the Iowa Democratic Party knew the implied statement that Bertrand sold the drug was false. Without evidence of actual knowledge, we consider [whether] the implied statement was made with reckless disregard for its truth or falsity. We begin by considering the degree of awareness of the probable falsity and any doubts that may have existed about the truth or falsity of the implied statement. Mullin and the Iowa Democratic Party asserted the implication that Bertrand sold a dangerous drug was made in good faith because they only wanted to inform voters that Bertrand was associated with an unethical company. While this assertion is alone insufficient to conclusively establish the absence of actual malice, it is important to recognize that the nondefamatory implication the defendants sought to communicate—Bertrand was associated with an unethical company that sold a dangerous drug—can be [inferred] from the advertisement. [Even if the false implication that Bertrand personally sold the drug is also present in the ad], the general background story from which both implications were derived was not false. Thus, the defamatory statement in this case was not built on a totally fabricated story. It is also important to observe that the sources [used in gathering] the background information for the advertisement were not so unreliable as to be unworthy of credence and indicative of reckless disregard for the truth. Some of the reports may not have been neutral, but mere reliance on sources with predisposed viewpoints does not establish actual malice.

We next consider the evidence that Mullin initially [disliked] the tone of the commercial as proof of actual malice. There was no evidence[, however,] that the concerns expressed by Mullin pertained to the falsity of any statements. The expressions of doubt were not evidence of actual malice, but were pragmatic and expedient considerations of tenor and political image-crafting with which the First Amendment is fundamentally unconcerned. We next consider the evidence that Mullin was angry at Bertrand for running his negative campaign advertisement and sought to “hit back” hard at him. This is the type of evidence, however, that demonstrates common law malice, [not] actual malice. As used in the First Amendment context, actual malice . . . “has nothing to do with bad motive or ill will.” Harte-Hanks Communications, 491 U.S. at 666 n.7. “[U]nlike the common law definition of malice, New York Times actual malice focuses upon the attitudes of defendants vis-à-vis the truth of their statements, as opposed to their attitudes towards plaintiffs.” [Citation omitted.] We next consider the claim by Bertrand that actual malice was established because the very purpose of the commercial was to attack, and thereby negatively affect, a candidate’s reputation. An intent to inflict harm is insufficient to demonstrate a reckless disregard for the truth. The very point of the trenchant public discourse protected under the legal standards of New York Times is oftentimes to weaken the support for political rivals in future elections. The standards of New York Times do not constrain First Amendment protection to political discourse of a sterile, academic character or an undiluted high-minded nature. [Although] the ordinary purpose of a defamation action is to vindicate and protect a person’s common law reputational interest[, the] First Amendment protects public discourse—even in the form of withering criticism of a political opponent’s past dealings or associations—unless the lodged attack is clearly shown to be false and made with actual malice. After all, New York Times and its progeny even reach so far as to protect pillorying barbs some may regard as offensive and outrageous. See Hustler Magazine, Inc. v. Falwell, 485 U.S. 46, 55 (1988) (rejecting an “outrageous[ness]” exception to traditional public official [and public figure] tort suit rules). Overall, we conclude the evidence failed to establish actual malice. The failure to write the advertisement in a way to avoid the false implication may have been negligence, but it did not rise to the level of reckless disregard for the truth. The evidence failed to support [the] high degree of subjective awareness of falsity needed for a public official to recover for defamation. The result of this case is not to imply that actual malice cannot exist within the rough and tumble Wild West approach to negative commercials that have seemingly become standard discourse in many political campaigns. Protection from defamatory statements does exist and should exist, but the high standards established under the First Amendment to permit a free exchange of ideas



Chapter Six Intentional Torts

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within the same discourse must also be protected. Among public figures and officials, an added layer of toughness is expected, and a greater showing of culpability is required under our governing legal standards to make sure the freedom of political speech . . . is not suppressed or chilled. [T]he protective constitutional line

of free speech in the arena of public officials is drawn at actual malice. Within this arena, speech cannot become actionable defamation until the line has been crossed. It was not in this case.

Private Figure Plaintiff Cases

In a 1985 decision, Dun & Bradstreet, Inc. v. Greenmoss Builders, Inc., 472 U.S. 749, the Court injected a public concern versus private concern distinction into at least the second, if not both, of the two Gertz rules. The Court held in Dun & Bradstreet that the second Gertz rule (the one requiring proof of actual malice as a condition of recovering presumed and punitive damages) applies only when the private figure plaintiff’s case is based on a statement that addressed a matter of public concern. If the private figure plaintiff’s case pertains to a statement that addressed a matter of only private concern, the second Gertz rule does not apply—meaning that presumed and punitive damages are recoverable instead of or in addition to damages for proven actual injury, even though the plaintiff established nothing more than the negligence presumably necessary to win the case. “Presumably necessary” is an apt characterization because it is a matter of interpretation and debate whether, after Dun & Bradstreet, the basic fault requirement of negligence still applies to a private figure plaintiff case involving a statement on a matter of private concern. Only the second Gertz rule was at issue in Dun & Bradstreet, which, according to the Court, was a private figure– private concern case. Negligence on the defendant’s part was present in the facts and was not a contested issue when the case reached the Supreme Court. Even so, it is not unreasonable to assert that if the Court was injecting a public concern qualifier into the second Gertz rule, it logically would also have been contemplating a public concern qualifier for the first Gertz rule (the rule requiring proof of at least negligence to establish liability). Under this reading of Dun & Bradstreet, the common law’s liability-without-fault approach would again govern defamation cases of the private figure– private concern variety. Those who read Dun & Bradstreet more narrowly, however, are inclined to restrict it to what the Supreme Court actually held (i.e., that a public concern element is part of the second Gertz rule) and to assume that the basic fault requirement of negligence continues to apply to all private figure plaintiff cases until the Supreme Court specifically holds to the contrary. The narrower reading of Dun & Bradstreet may have slightly more adherents among lower courts and legal commentators, but it is a close call.

LO6-9

Explain what a private figure plaintiff must prove, for constitutional reasons, in order to win a defamation case.

What about defamation cases brought by private figures, those corporations that are not public figures and those individual persons who are neither public figures nor public officials? In Gertz v. Robert Welch, Inc., 418 U.S. 323 (1974), the Supreme Court concluded that private figure plaintiffs should not be expected to prove actual malice in order to win defamation cases, despite defendants’ meaningful free speech and press interests. The Court noted that such plaintiffs have neither sought, nor do they command, the higher level of attention desired and achieved by public officials and public figures. Requiring private figure plaintiffs to prove actual malice would tip the balance too heavily in favor of defendants’ First Amendment interests and would do so at the expense of plaintiffs’ reputational interests. The Court sought to balance the respective interests more suitably by developing, in Gertz, a two-rule approach under which the first rule focused on liability and the second focused on damages. The first Gertz rule provided that in order to win a defamation case, the private figure plaintiff must prove some level of fault as set by state law, so long as that level of fault was at least negligence (in the sense discussed earlier). After Gertz, almost every state chose negligence as the applicable fault requirement. The second Gertz rule addressed recoverable damages. It provided that if a private figure plaintiff proved only negligence on the defendant’s part—the level of fault necessary to enable the plaintiff to win the case—the recoverable damages would be restricted to compensatory damages for proven reputational harm and other actual injury. Presumed damages and punitive damages would not be recoverable in such an instance. The second Gertz rule also spoke to the availability of presumed and punitive damages by providing that if the private figure plaintiff wanted to recover such damages (either instead of or in addition to damages for demonstrated harm), he, she, or it would need to prove actual malice by clear and convincing evidence.

Jury verdict in favor of Bertrand reversed; case dismissed.

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Part Two Crimes and Torts

The Obsidian Finance Group case, which follows shortly, illustrates the application of the two Gertz rules to a private figure plaintiff case. As the above discussion indicates, public concern determinations have become important in private figure plaintiff cases. (Note that the Supreme Court has not made the public concern–private concern distinction a requirement for public officials’ and public figures’ defamation cases—probably because the public concern character of statements about such prominent persons is essentially a “given.”) What sorts of statements, then, deal with matters of public concern? The Supreme Court provided little guidance on this issue in Dun & Bradstreet. Lower court decisions, however, have consistently established that statements dealing with crime address matters of public concern. The same is true of a broad range of statements dealing with public health, safety, or welfare, or with comparably important matters that capture society’s attention. For further discussion of what may constitute a public concern, see the Obsidian Finance Group case. The Media–Nonmedia Issue (or Nonissue?) A final set of

issues concerning defamation’s First Amendment–based fault requirements is whether they apply only when the defendant is a member of the media (i.e., the press), or in all defamation cases. In phrasing its holdings in certain defamation decisions, the Supreme Court has sometimes employed media-oriented language. That may have been done, however, because the cases involved media defendants. The

Court contributed to confusion on this point in one decision with an inaccurate footnote asserting that the Court had never decided whether the First Amendment–based fault requirements apply in nonmedia defendant cases. Yet the Court clearly had done so. The landmark New York Times case included media and nonmedia defendants. There, the Court held that the public official plaintiff needed to prove actual malice on the part of all of the defendants. Although the Court has not officially addressed the media–nonmedia issue in recent decisions, some justices over the years have unofficially rejected such a distinction by making comments along those lines in concurring and dissenting opinions. In view of those comments, the decision in New York Times, the equal billing the First Amendment gives to freedom of “speech” and freedom of the “press,” and the disapproval of a media–nonmedia distinction by most lower courts and an overwhelming majority of legal commentators, it seems extremely likely that if the Supreme Court now faced the issue squarely, it would hold that the First Amendment–based fault requirements apply to all defamation cases without regard for whether the defendant is a member of the media. Besides addressing the rules for private figure plaintiff cases and the role of the public concern element, the court in Obsidian Finance Group rejects the argument that the First Amendment aspects of defamation should apply only in cases against media defendants. That decision appears next. Figure  6.1’s summary of the relevant First Amendment rules follows.

Obsidian Finance Group, LLC v. Cox   740 F.3d 1284 (9th Cir. 2014) Kevin Padrick was a principal in Obsidian Finance Group, which provides advice to financially distressed businesses. Summit Accommodators Inc. retained Obsidian in connection with a contemplated bankruptcy. After Summit filed for reorganization, the bankruptcy court appointed Padrick as the Chapter 11 trustee. Because Summit had misappropriated funds from clients, Padrick’s main task was to marshal the firm’s assets for the benefit of those clients. After Padrick’s appointment, Crystal Cox published blog posts on several websites that she created. These blog posts accused Padrick and Obsidian of fraud, corruption, money laundering, and other illegal activities in connection with the Summit bankruptcy. Despite a cease-and-desist letter from Padrick and Obsidian, Cox continued posting allegations. Padrick and Obsidian then sued her for defamation. The federal district court held that all but one of Cox’s blog posts were constitutionally protected opinions because they employed figurative and hyperbolic language and could not be proven true or false. The court held, however, that a December 25 blog post on bankruptcycorruption.com made “fairly specific allegations [that] a reasonable reader could understand . . . to imply a provable fact assertion”—that is, that Padrick, in his capacity as bankruptcy trustee, failed to pay $174,000 in taxes owed by Summit. The district judge therefore allowed that single defamation claim to proceed to a jury trial. In a pretrial memorandum, dealing with proposed jury instructions, Cox argued that because the December 25 blog post involved a matter of public concern, Padrick and Obsidian had the burden of proving her negligence in order to recover for defamation and that they could not recover presumed damages absent proof that she acted with actual malice. Cox alternatively argued that Padrick and Obsidian were public figures and thus were required to prove that Cox made the statements against them with actual malice. Rejecting both of Cox’s arguments, the district court explained that Padrick and Obsidian were not required to prove either negligence or actual damages because Cox had failed to submit “evidence suggestive of her status as a journalist.” The court also ruled that neither Padrick nor Obsidian was a public figure.



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After the parties presented their evidence and made their closing arguments, the district judge instructed the jury that the plaintiffs “are entitled to receive reasonable compensation for harm to reputation, humiliation, or mental suffering even if [they did] not present evidence that proves actual damages . . . because the law presumes that the plaintiffs suffered these damages.” The jury returned a verdict in favor of Padrick and Obsidian, awarding Padrick $1.5 million and Obsidian $1 million in compensatory damages. After the district court denied her motion for a new trial, Cox appealed to the U.S. Court of Appeals for the Ninth Circuit. Obsidian and Padrick cross-appealed, contending that their defamation claims about the other blog posts should have gone to the jury.

Hurwitz, Circuit Judge Cox does not contest the district court’s finding that the ­December 25 blog post contained an assertion of fact; nor does she contest the jury’s conclusions that the post was false and defamatory. She challenges only the district court’s rulings that (a) liability could be imposed without a showing of fault or actual damages, and (b) Padrick and Obsidian were not public officials. The Supreme Court’s landmark opinion in New York Times Co. v. Sullivan, 376 U.S. 254 (1964), began the construction of a First Amendment framework concerning the level of fault required for defamation liability. New York Times held that when a public official seeks damages for defamation, the official must show “actual malice”—that the defendant published the defamatory statement “with knowledge that it was false or with reckless disregard of whether it was false or not.” Id. at 280. A decade later, Gertz v. Robert Welch, Inc., held that the First Amendment required only a “negligence standard for private defamation actions.” 418 U.S. 323, 350 (1974). This case involves the intersection between New York Times and Gertz, an area not yet fully explored by this Circuit, in the context of a medium of publication—the Internet—entirely unknown at the time of those decisions. Padrick and Obsidian first argue that the Gertz negligence requirement applies only to suits against the institutional press. [They] are correct in noting that Gertz involved an institutional media defendant and that the Court’s opinion specifically cited the need to shield “the press and broadcast media from the rigors of strict liability for defamation.” 418 U.S. at 348. We conclude, however, that the holding in Gertz sweeps more broadly. The Gertz court did not expressly limit its holding to the defamation of institutional media defendants. And, although the Supreme Court has never directly held that the Gertz rule applies beyond the institutional press, it has [applied the New York Times rules in defamation cases against non-media defendants]. [In addition, the Supreme Court has] repeatedly refused in non-defamation contexts to accord greater First Amendment protection to the institutional media than to other speakers. The Supreme Court recently emphasized the point in Citizens United v. Federal Election Commission: “We have consistently rejected the proposition that the institutional press has any constitutional privilege beyond that of other speakers.” 558 U.S. 310, 352 (2010). In construing the constitutionality of campaign finance statutes, the Court cited with approval the position of five Justices in Dun &

Bradstreet, Inc. v. Greenmoss Builders, Inc., that “in the context of defamation law, the rights of the institutional media are no greater and no less than those enjoyed by other individuals engaged in the same activities.” 472 U.S. 749, 784 (1985) (Brennan, J., dissenting); id. at 773 (White, J., concurring in the judgment). Dun & Bradstreet held that presumed and punitive damages are constitutionally permitted in defamation cases without a showing of actual malice when the defamatory statements at issue do not involve matters of public concern. See 472 U.S. at 763. Like the Supreme Court, the Ninth Circuit has not directly addressed whether First Amendment defamation rules apply equally to both the institutional press and individual speakers. But every other circuit to consider the issue has held that the First Amendment defamation rules in New York Times and its progeny apply equally to the institutional press and individual speakers. We agree with our sister circuits. The protections of the First Amendment do not turn on whether the defendant was a trained journalist, formally affiliated with traditional news entities, engaged in conflict-of-interest disclosure, went beyond just assembling others’ writings, or tried to get both sides of a story. As the Supreme Court has accurately warned, a First Amendment distinction between the institutional press and other speakers is unworkable: “With the advent of the Internet and the decline of print and broadcast media .  .  . the line between the media and others who wish to comment on political and social issues becomes far more blurred.” Citizens United, 558 U.S. at 352. In defamation cases, the public-figure status of a plaintiff and the public importance of the statement at issue—not the identity of the speaker—provide the First Amendment touchstones. We therefore hold that the Gertz negligence requirement for private defamation actions is not limited to cases with institutional media defendants. But this does not completely resolve the Gertz dispute. Padrick and Obsidian also argue that they were not required to prove Cox’s negligence because Gertz involved a matter of public concern and this case does not. The Supreme Court has “never considered whether the Gertz balance obtains when the defamatory statements involve no issue of public concern.” Dun & Bradstreet, 472 U.S. at 757 (plurality opinion). Dun & Bradstreet dealt only with the Gertz rule on presumed damages, not the Gertz negligence standard. See 472 U.S. at 754–55. But even assuming that Gertz is limited to statements involving matters of public concern, Cox’s blog post qualifies.

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Part Two Crimes and Torts

The December 25 post alleged that Padrick, a court-appointed trustee, committed tax fraud while administering the assets of a company in a Chapter 11 reorganization, and called for the “IRS and the Oregon Department of Revenue to look” into the matter. Public allegations that someone is involved in crime generally are speech on a matter of public concern. This court has held that even consumer complaints of non-criminal conduct by a business can constitute matters of public concern. Cox’s allegations in this case are similarly a matter of public concern. Padrick was appointed by a United States Bankruptcy Court as the Chapter 11 trustee of a company that had defrauded its investors through a Ponzi scheme. That company retained him and Obsidian to advise it shortly before it filed for bankruptcy. The allegations against Padrick and his company raised questions about whether they were failing to protect the defrauded investors because they were in league with their original clients. Unlike the speech at issue in Dun & Bradstreet that the Court found to be a matter only of private concern, Cox’s December 25 blog post was not “solely in the individual interest of the speaker and its specific business audience.” 472 U.S. at 762 (plurality opinion). The post was published to the public at large, not simply made “available to only five subscribers, who, under the terms of the subscription agreement, could not disseminate it further. . . . ” Id. Because Cox’s blog post addressed a matter of public concern, even assuming that Gertz is limited to such speech, the district court should have instructed the jury that it could not find Cox liable for defamation unless it found that she acted negligently. See Gertz, 418 U.S. at 350. The court also should have instructed the jury that it could not award presumed damages unless it found that Cox acted with actual malice. Id. at 349. Cox also argues that Padrick and Obsidian are “tantamount to public officials,” because Padrick was a court-appointed bankruptcy trustee. (She [unsuccessfully] argued in her pretrial memorandum that Padrick and Obsidian were public figures, but . . . raises only the public official argument on appeal.) Cox contends that the jury therefore should have been instructed that, under the New York Times standard, it could impose liability for defamation only if she acted with actual malice. We disagree. Although bankruptcy trustees are an integral part of the judicial process, neither Padrick nor Obsidian became a public official simply by virtue of Padrick’s appointment. Padrick was neither elected nor appointed to a government position, and he did not exercise “substantial . . . control over the conduct of governmental affairs.” Rosenblatt v. Baer, 383 U.S. 75, 85 (1966). A Chapter 11 trustee can be appointed by the bankruptcy court [but] an appointed trustee simply substitutes for, and largely exercises the powers of, a debtorin-possession. No one would contend that a debtor-in-possession has become a public official simply by virtue of seeking Chapter 11 protection, and we can reach no different conclusion as to the trustee who substitutes for the debtor in administering a Chapter 11 estate.

Padrick and Obsidian argue on cross-appeal that the district court erred in granting Cox summary judgment as to her other blog posts. Among other things, those posts accuse Padrick and Obsidian of engaging in “illegal activity,” including “corruption,” “fraud,” “deceit on the government,” “money laundering,” “defamation,” “harassment,” “tax crimes,” and “fraud against the government.” Cox also claimed that Obsidian paid off “media” and “politicians” and may have hired a hit man to kill her. In Milkovich v. Lorain Journal Co., the Supreme Court refused to create a blanket defamation exemption for “anything that might be labeled ‘opinion.’” 497 U.S. 1, 18 (1990). This court has held that “while ‘pure’ opinions are protected by the First  Amendment, a statement that ‘may . . . imply a false assertion of fact’ is actionable.” [citation omitted.] Partington v. Bugliosi, 56 F.3d 1147, 1153 (9th Cir. 1995) (quoting Milkovich, 497 U.S. at 19). We have developed a three-part test to determine whether a statement contains an assertion of objective fact. See Unelko Corp. v. Rooney, 912 F.2d 1049, 1053 (9th Cir. 1990). The test considers (1) whether the general tenor of the entire work negates the impression that the defendant was asserting an objective fact, (2) whether the defendant used figurative or hyperbolic language that negates that impression, and (3) whether the statement in question is susceptible of being proved true or false. As to the first factor, the general tenor of Cox’s blog posts negates the impression that she was asserting objective facts. The statements were posted on obsidianfinancesucks.com, a website name that leads “the reader of the statements [to be] predisposed to view them with a certain amount of skepticism and with an understanding that they will likely present one-sided viewpoints rather than assertions of provable facts” [(quoting the district court’s decision)]. The district judge correctly concluded that the “occasional and somewhat run-on[,] almost ‘stream of consciousness’-like sentences read more like a journal or diary entry revealing [Cox’s] feelings rather than assertions of fact.” As to the second factor, Cox’s consistent use of extreme language negates the impression that the blog posts assert objective facts. Cox regularly employed hyperbolic language in the posts, including terms such as “immoral,” “really bad,” “thugs,” and “­evil-doers.” Cox’s assertions that “Padrick hired a ‘hit man’ to kill her” or “that the entire bankruptcy court system is corrupt” similarly dispel any reasonable expectation that the statements assert facts. And, as to the third factor, the district court correctly found that, in the context of a non-professional website containing consistently hyperbolic language, Cox’s blog posts are “not sufficiently factual to be proved true or false.” We find no error in the court’s application of the Unelko test and reject the cross-appeal. District court judgment based on jury verdict in favor of plaintiffs reversed; case remanded for new trial on December 25 blog post; district court decision in favor of Cox on other blog posts affirmed.



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Figure 6.1 Constitutional Aspects of Defamation—Fault Requirements and Rules on Damages* Public Official Plaintiff or Public Figure Plaintiff

Private Figure Plaintiff Private Figure Plaintiff and Subject of Public Concern and Subject of Private Concern

What Plaintiff Must Prove to Win Case

Actual malice, by clear and  convincing evidence

Fault—at least negligence

Perhaps (probably?)  fault—at least negligence

Damages Recoverable If Plaintiff Wins Case

Damages for proven actual injury and/or presumed  damages, as well as punitive damages

Damages for proven actual  injury, if plaintiff proves only negligence. For presumed and punitive damages, plaintiff must prove actual malice, by clear and  convincing evidence.

Damages for proven actual  injury and/or presumed damages, as well as punitive damages

*These requirements and rules apply at least in defamation cases against a media defendant. Although the Supreme Court has left some uncertainty on this point, the requirements and rules set forth here probably apply in all defamation cases, regardless of the defendant’s media or nonmedia status.

Invasion of Privacy LO6-10 Distinguish among the four types of invasion of privacy.

In tort law, the term invasion of privacy refers to four distinct torts. Each involves a different sense of the term privacy. Intrusion on Solitude or Seclusion Any intentional intrusion on the solitude or seclusion of another constitutes an invasion of privacy if that intrusion would be highly offensive to a reasonable individual. The intrusion in question may be physical, such as an illegal search of a person’s home or body or the opening of his mail. It may also be a nonphysical intrusion such as tapping another’s telephone, examining her bank account, or subjecting her to harassing telephone calls. However, the tort applies only where there is a reasonable expectation of privacy. As a general rule, therefore, there is no liability for examining public records concerning a person, or for observing or photographing him in a public place. Public Disclosure of Private Facts Publicizing facts concerning someone’s private life can be an invasion of privacy if the publicity would be highly offensive to a reasonable person. The idea is that the public has no legitimate right to know certain aspects of a person’s private life. Thus, publicity concerning someone’s failure to pay his debts, humiliating illnesses he has suffered, or information about his sex life may constitute an invasion of privacy. Truth is not a defense to this type of invasion of privacy because the essence of the

tort is giving unjustified publicity to purely private matters. Here, in further contrast to defamation, publicity means a widespread communication of private details. For example, publication on the Internet would suffice. As does defamation, this form of invasion of privacy potentially conflicts with the First Amendment. Courts have attempted to resolve this conflict in two major ways. First, no liability ordinarily attaches to publicity concerning matters of public record or legitimate public interest. Second, public figures and public officials have no right of privacy concerning information that is reasonably related to their public lives. False Light Publicity Publicity that places a person in a false light in the public eye can be an invasion of privacy if that false light would be highly offensive to a reasonable person. What is required is unreasonable and highly objectionable publicity attributing to a person characteristics that she does not possess or beliefs that she does not hold. Examples include signing a person’s name to a public letter that violates her deeply held beliefs or attributing authorship of an inferior scholarly or artistic work to her. As in defamation cases, truth is a defense to liability. It is not necessary, however, that a person be defamed by the false light in which he is placed. For instance, signing a gun rights advocate’s name to a petition urging adoption of gun-control measures could create liability for false light publicity but probably not for defamation. In view of the overlap between false light publicity and defamation, and the obvious First Amendment issues at stake, defendants in false light cases enjoy constitutional protections matching those enjoyed by defamation defendants.

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Part Two Crimes and Torts

Ethics and Compliance in Action In Hernandez v. Hillsides, Inc., 211 P.3d 1063 (Cal. 2009), the Supreme Court of California considered an invasion of privacy case arising out of the defendants’ installation of a video surveillance system in an office shared by the plaintiffs. The defendants were the director of a residential facility for abused children and the two companies that operated the facility. The two plaintiffs were employees at the facility. The defendant director had the video surveillance system installed in the plaintiffs’ office without their knowledge because of reports from the defendants’ computer technician that someone—evidently neither of the plaintiffs—had been accessing pornographic websites at night from one of the computers in the plaintiffs’ office. The defendants activated the surveillance system only at night and after the plaintiffs’ regular work hours had ended for the day. The plaintiffs were not depicted in any of the video generated. Although no individual was identified as the person who accessed pornographic websites, such accessing appeared to cease within roughly a month of the surveillance system’s installation. The defendants therefore stopped using the system. After the plaintiffs learned of the system’s existence and operation, the director apologized for not having informed them and explained his rationale for using the system. The apology and explanation did not satisfy the plaintiffs, who sued on the theory that the facts constituted an unlawful intrusion on solitude. The trial court granted summary judgment in favor of the defendants, but the California Court of Appeal reversed, holding that the plaintiffs had a reasonable expectation of privacy in their office and that the defendants’ actions would have been highly offensive to a reasonable person. The Supreme Court of California, however, reversed and directed that summary judgment be entered in favor of the defendants. Although the Supreme Court recognized that the plaintiffs possessed a privacy interest in regard to their office, the court concluded that under the circumstances, the intrusion at issue

Commercial Appropriation of Name or Likeness LO6-11

Identify circumstances in which a celebrity’s right of publicity is implicated.

Liability for invasion of privacy can exist when, without that person’s consent, the defendant commercially uses someone’s name or likeness, normally to imply her endorsement of a product or service or a nonexistent connection with the defendant’s business. This form of invasion of privacy also draws on the personal property right connected with a person’s identity

would not have been highly offensive to reasonable persons. The surveillance was conducted for a limited period of time and only at night, and thus was suitably tailored to important rationales: finding out who was misusing the computers; and protecting minors at the facility against someone who might pose a danger to them. The fact that courts at different levels of the review process in Hernandez disagreed on the appropriate analysis indicates the sensitive interests at stake when privacy interests and countervailing considerations come into conflict in an employment setting. Now consider relevant ethical questions that go beyond the pure legal issues facing the courts in Hernandez and similar cases. Give some thought, for instance, to these questions:

• When employers seek to monitor employees’ actions through a video surveillance system, are there ethical obligations that constrain—or should constrain—employers? If so, what are those obligations, and how are they satisfied? Does it matter whether the employers have reason to suspect wrongdoing on the part of employees? Does it matter why the employers decide to use such a system? • In the situation that led to the plaintiffs’ lawsuit in Hernandez, did the defendants act ethically in not informing the plaintiffs about the video surveillance system? If the defendants had informed the plaintiffs of the plan to install the system but the plaintiffs objected, would it have been ethical for the defendants to proceed with the installation of the system anyway? • If an employer owns the computers in employees’ offices and the employer operates the network or system of which those machines are a part, is it ethical for the employer to engage in secret monitoring of employees’ use of the computers? Is it ethical for the employer to monitor employees’ e-mail? Be prepared to discuss the above questions and the reasons for the conclusions you draw.

and her exclusive right to control it. In recent decades, recognition of this property right has given rise to a separate legal doctrine known as the right of publicity, under which public figures, celebrities, and entertainers have a cause of action against defendants who, without consent, use the right holders’ names, likenesses, or identities for commercial purposes. Protected attributes of a celebrity’s identity may include such things as a distinctive singing voice. Use of a celebrity’s name or a “soundalike” of her in an advertisement for a product would be a classic example of a commercial use, as would use of an entertainer’s picture as a commercially sold poster. Not all uses are



Chapter Six Intentional Torts

commercial in nature, however, even if there is an underlying profit motive at stake. For example, though the cases are not entirely consistent on this point, a television show or movie that uses a celebrity’s name, likeness, or identity is likely to be classified as noncommercial and thus not a violation of the right of publicity. Some uses are close to the line and require courts to make difficult determinations regarding the use’s commercial or noncommercial nature. As the foregoing examples suggest, First Amendment interests may arise in right of publicity cases. Courts tend to hold that the intermediate level of First Amendment protection extended to commercial speech does not insulate a defendant against liability for having used the plaintiff’s name, likeness, or identity in the context of commercial speech. (Discussion of the distinction between commercial speech and noncommercial speech appears in Chapter 3.) If, on the other hand, the defendant’s speech was noncommercial, the First Amendment could come to the defendant’s rescue. Whether it does so

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depends upon the case’s particular facts and upon which one of various possible tests the court chooses to apply in balancing the plaintiff’s property interest against the defendant’s speech interest. In Jordan v. Jewel Food Stores, which follows shortly, the Seventh Circuit Court of Appeals must decide the appropriate speech classification for a grocery chain’s advertisement congratulating Michael Jordan on his induction into a basketball hall of fame. Is it commercial speech that potentially violates Jordan’s right of publicity, or, instead, is it noncommercial speech that the First Amendment may shield? (For discussion of whether college athletes should be entitled to the right of publicity, see Figure 6.2, which appears after the Jordan case.) States that recognize the right of publicity usually consider it inheritable—meaning that it may survive the death of the celebrity who held the right during his or her lifetime. There is little agreement among the states, however, on how long the right persists after the celebrity’s death.

Jordan v. Jewel Food Stores, Inc.   743 F.3d 509 (7th Cir. 2014) Jewel Food Stores, Inc. operates 175 Jewel-Osco supermarkets in and around Chicago. Basketball legend Michael Jordan, who spent most of his playing career in Chicago, is exceedingly well known and is widely regarded as one of the greatest players in history. On the occasion of Jordan’s September 2009 induction into the Naismith Memorial Basketball Hall of Fame, Time Inc., the publisher of Sports Illustrated magazine, produced a special commemorative issue devoted exclusively to Jordan’s remarkable career. The ­commemorative issue was sold in stores and at newsstands from late October 2009 until late January 2010. Approximately a month prior to the scheduled publication of the commemorative issue, a Time sales representative contacted Jewel to offer free advertising space in the issue in return for Jewel’s promise to stock and sell the magazines in its stores. Jewel agreed to the proposal and had its marketing department design a full-page color ad. The ad combined textual, photographic, and graphic elements and prominently included the Jewel-Osco logo as well as the supermarket chain’s marketing slogan, “Good things are just around the corner.” The logo and slogan were positioned in the middle of the page, above a photo of a pair of basketball shoes. Each shoe bore Jordan’s familiar jersey number, 23. The ad’s text read as follows: A Shoe In! After six NBA championships, scores of rewritten record books and numerous buzzer beaters, Michael Jordan’s elevation in the Basketball Hall of Fame was never in doubt! Jewel-Osco salutes #23 on his many accomplishments as we honor a fellow Chicagoan who was “just around the corner” for so many years. Time accepted Jewel’s ad and placed it on the inside back cover of the commemorative issue. Besides featuring Sports Illustrated editorial content and photographs from the magazine’s prior coverage of Jordan’s career, the commemorative issue featured congratulatory ads from various parties. Soon after the commemorative issue was released, Jordan sued Jewel for allegedly violating his right of publicity. (Jordan also invoked various other legal theories, but the right of publicity claim receives the bulk of the attention here.) Jewel later sought summary judgment, raising the First Amendment as a defense against liability and arguing that its ad was noncommercial speech entitled to full First Amendment protection. (For discussion of the First Amendment distinction between commercial speech and noncommercial speech, see Chapter 3.) Jordan also sought summary judgment, arguing that Jewel’s ad was a commercial use of his identity and therefore a potential violation of his right of publicity. The federal district court held that the ad was noncommercial speech and granted summary judgment in favor of Jewel. Jordan appealed to the U.S. Court of Appeals for the Seventh Circuit.

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Sykes, Circuit Judge Jewel maintains that its ad is noncommercial speech and thus has full First Amendment protection. Jordan insists that the ad is garden-variety commercial speech, which gets reduced constitutional protection and may give rise to liability for the private wrongs he alleges in this case. As the case comes to us, the commercial/noncommercial distinction is potentially dispositive. If the ad is properly classified as commercial speech, then it may be regulated, normal liability rules apply (statutory and common law), and the battle moves to the merits of Jordan’s claims. If, on the other hand, the ad is fully protected expression, then Jordan agrees with Jewel that the First Amendment provides a complete defense and his claims cannot proceed. The First Amendment prohibits the government from “abridging the freedom of speech.” U.S. Const. amend. I. Because “not all speech is of equal First Amendment importance,” [citation omitted], certain categories of speech receive a lesser degree of constitutional protection. Commercial speech was initially viewed as being outside the ambit of the First Amendment altogether. Current doctrine holds that commercial speech is constitutionally protected but governmental burdens on this category of speech are scrutinized more leniently than burdens on fully protected noncommercial speech. To determine whether speech falls on the commercial or noncommercial side of the constitutional line, the Court has provided this basic definition: Commercial speech is “speech that proposes a commercial transaction.” Board of Trustees v. Fox, 492 U.S. 469, 482 (1989). It is important to recognize, however, that [the basic definition] is just a starting point. Speech that does no more than propose a commercial transaction “fall[s] within the core notion of commercial speech,” Bolger v. Youngs Drug Products Corp., 463 U.S. 60, 66 (1983), but other communications also may “constitute commercial speech notwithstanding the fact that they contain discussions of important public issues.” Fox, 492 U.S. at 475 (quoting Bolger, 463 U.S. at 67–68). Indeed, the Supreme Court has “made clear that advertising which links a product to a current public debate is not thereby entitled to the constitutional protection afforded noncommercial speech.” Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626, 637 n.7 (1985) (quoting Bolger, 463 U.S. at 68). Although commercial-speech cases generally rely on the distinction between speech that proposes a commercial transaction and other varieties of speech, it is a mistake to assume that the boundaries of the commercial-speech category are marked exclusively by this “core” definition. To the contrary, there is a “commonsense distinction” between commercial speech and other varieties of speech, and we are to give effect to that distinction. [Citation omitted.] The Supreme Court’s decision in Bolger is instructive on this point. Bolger dealt with the question of how to classify speech

with both noncommercial and commercial elements. There, a prophylactics manufacturer published informational pamphlets providing general factual information about prophylactics but also containing information about the manufacturer’s products in particular. Bolger, 463 U.S. at 62. The manufacturer brought a pre-enforcement challenge to a federal statute that prohibited the unsolicited mailing of advertisements about contraceptives. The Supreme Court held that although the pamphlets did not expressly propose a commercial transaction, they were nonetheless properly classified as commercial speech based on the following attributes: the pamphlets were a form of advertising, they referred to specific commercial products, and they were distributed by the manufacturer for economic purposes. Id. at 66–67. We have read Bolger as suggesting certain guideposts for classifying speech that contains both commercial and noncommercial elements; relevant considerations include “whether: (1) the speech is an advertisement; (2) the speech refers to a specific product; and (3) the speaker has an economic motivation for the speech.” [Citation omitted.] This is just a general framework, however; no one factor is sufficient, and Bolger strongly implied that all are not necessary. Jewel argues that its ad doesn’t propose a commercial transaction and therefore flunks the leading test for commercial speech. As we have explained, the commercial-speech category is not limited to speech that directly or indirectly proposes a commercial transaction. Jewel nonetheless places substantial weight on this test, and the district judge did as well, . . . so we will start there. It is clear that the textual focus of Jewel’s ad is a congratulatory salute to Jordan on his induction into the Hall of Fame. If the literal import of the words were all that mattered, this celebratory tribute would be noncommercial. But evaluating the text requires consideration of its context, and this truism has special force when applying the commercial-speech doctrine. Modern commercial advertising is enormously varied in form and style. We know from common experience that commercial advertising occupies diverse media, draws on a limitless array of imaginative techniques, and is often supported by sophisticated marketing research. It is highly creative, sometimes abstract, and frequently relies on subtle cues. The notion that an advertisement counts as “commercial” only if it makes an appeal to purchase a particular product makes no sense today, and we doubt that it ever did. An advertisement is no less “commercial” because it promotes brand awareness or loyalty rather than explicitly proposing a transaction in a specific product or service. Applying the “core” definition of commercial speech too rigidly ignores this reality. Very often the commercial message is general and implicit rather than specific and explicit. Jewel’s ad served two functions: congratulating Jordan on his induction into the Hall of Fame and promoting Jewel’s



Chapter Six Intentional Torts

supermarkets. The first is explicit and readily apparent. The ad contains a congratulatory message remarking on Jordan’s recordbreaking career and celebrating his rightful place in the Basketball Hall of Fame. Jewel points to its longstanding corporate practice of commending local community groups on notable achievements, giving as examples two public-service ads celebrating the work of Chicago’s Hispanocare and South Side Community Services. The suggestion seems to be that the Jordan ad belongs in this “civic booster” category: A praiseworthy “fellow Chicagoan” was receiving an important honor, and Jewel took the opportunity to join in the applause. But considered in context, and without the rose-colored glasses, Jewel’s ad has an unmistakable commercial function: enhancing the Jewel-Osco brand in the minds of consumers. This commercial message is implicit but easily inferred, and is the dominant one. [A] point that should be obvious . . . seems lost on Jewel: There is a world of difference between an ad congratulating a local community group and an ad congratulating a famous athlete. Both ads will generate goodwill for the advertiser. But an ad congratulating a famous athlete can only be understood as a promotional device for the advertiser. Unlike a community group, the athlete needs no gratuitous promotion and his identity has commercial value. Jewel’s ad cannot be construed as a benevolent act of good corporate citizenship. As for the other elements of the ad, Jewel-Osco’s graphic logo and slogan appear just below the textual salute to Jordan. The bold red logo is prominently featured in the center of the ad and in a font size larger than any other on the page. Both the logo and the slogan are styled in their trademarked ways. Their style, size, and color set them off from the congratulatory text, drawing attention to Jewel-Osco’s sponsorship of the tribute. Apart from the basketball shoes, the Jewel-Osco brand-name is the center of visual attention on the page. And the congratulatory message specifically incorporates Jewel’s slogan: “as we honor a fellow Chicagoan who was ‘just around the corner’ for so many years.” The ad is plainly aimed at fostering goodwill for the Jewel brand among the targeted consumer group—“fellow Chicagoans” and fans of Michael Jordan—for the purpose of increasing patronage at JewelOsco stores. The district judge nonetheless concluded that the ad was not commercial speech based in part on his view that “readers would be at a loss to explain what they have been invited to buy,” a reference to the fact that the ad features only the tribute to Jordan, the Jewel-Osco logo and slogan, and a pair of basketball shoes. Granted, Jewel does not sell basketball shoes; it is a chain of grocery stores, and this ad contains not a single word about the specific products that Jewel-Osco sells, nor any product-specific art or photography. The Supreme Court has said that the failure to reference a specific product is a relevant consideration in the commercial-speech determination. See

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Bolger, 463 U.S. at 66–67. But it is far from dispositive, especially where “image” or brand advertising rather than product advertising is concerned. Image advertising is ubiquitous in all media. Jewel’s ad is an example of a neighborly form of general brand promotion by a large urban supermarket chain. What does it invite readers to buy? Whatever they need from a grocery store—a loaf of bread, a gallon of milk, perhaps the next edition of Sports Illustrated—from Jewel-Osco, where “good things are just around the corner.” The ad implicitly encourages readers to patronize their local JewelOsco store. That it doesn’t mention a specific product means only that this is a different genre of advertising. It promotes brand loyalty rather than a specific product, but that doesn’t mean it is noncommercial. The district judge was not inclined to put much stock in the ad’s use of Jewel-Osco’s slogan and graphic logo. Specifically, he considered the logo as little more than a convenient method of identifying the speaker and characterized the slogan as simply a means of ensuring “that the congratulatory message sounded like it was coming from Jewel.” Dismissing the logo and slogan as mere nametags overlooks their value as advertising tools. The slogan is attached to the Jewel-Osco graphic logo and is repeated in the congratulatory message itself, which describes Jordan as “a fellow Chicagoan who was ‘just around the corner’ for so many years.” This linkage only makes sense if the aim is to promote shopping at Jewel-Osco stores. Indeed, Jewel’s copywriter viewed the repetition of the slogan the same way we do; she thought it was “too selly” and “hitting too over the head.” In short, the ad’s commercial nature is readily apparent. It may be generic and implicit, but it is nonetheless clear. The ad is a form of image advertising aimed at promoting goodwill for the Jewel-Osco brand by exploiting public affection for Jordan at an auspicious moment in his career. Our conclusion is confirmed by application of the Bolger framework, which applies to speech that contains both commercial and noncommercial elements. Again, the Bolger inquiry asks whether the speech in question is in the form of an advertisement, refers to a specific product, and has an economic motive. Jewel’s ad certainly qualifies as an advertisement in form. Although the text is congratulatory, the page nonetheless promotes something to potential buyers: Jewel-Osco supermarkets. [T]he ad obviously isn’t part of the editorial coverage of Jordan’s career. It isn’t an article, a column, or a news photograph or illustration. It looks like, and is, an advertisement. We can make quick work of the second and third Bolger factors. As we have explained, although no specific product or service is offered, the ad promotes patronage at Jewel-Osco stores more generally. And there is no question that the ad serves an economic purpose: to burnish the Jewel-Osco brand

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name and enhance consumer goodwill. The record reflects that Jewel received Time’s offer of free advertising space enthusiastically; its marketing representatives said it was a “great offer” and it “would be good for us to have our logo in Sports Illustrated” because “having your logo in any location where people see it is going to help your company.” Indeed, Jewel gave Time valuable consideration—floor space in Jewel-Osco grocery stores—in exchange for the full-page ad in the magazine, suggesting that it expected valuable brand-enhancement benefit from it. We don’t doubt that Jewel’s tribute was in a certain sense public-spirited. We only recognize the obvious: that Jewel had something to gain by conspicuously joining the chorus of congratulations on the much-anticipated occasion of Jordan’s induction into the Basketball Hall of Fame. Jewel’s ad is commercial speech. A contrary holding would have sweeping and troublesome implications for athletes, actors, celebrities, and trademark holders seeking to protect the use of their identities or marks. Image advertising is commonplace in our society. [F]or illustrative purposes, think of the television spots by the corporate sponsors of the Olympics. Many of these ads consist entirely of images of the American athletes coupled with the advertiser’s logo or brand name and an expression of support for the U.S. Olympic team; nothing is explicitly offered for sale. Jewel’s ad in the commemorative issue belongs in this genre. It portrays Jewel-Osco in a

positive light without mentioning a specific product or service—in this case, by invoking a superstar athlete and a celebratory message with particular salience to Jewel’s customer base. To say that the ad is noncommercial because it lacks an outright sales pitch is to artificially distinguish between product advertising and image advertising. Classifying this kind of advertising as constitutionally immune noncommercial speech would permit advertisers to misappropriate the identity of athletes and other celebrities with impunity. Nothing we say here is meant to suggest that a company cannot use its graphic logo or slogan in an otherwise noncommercial way without thereby transforming the communication into commercial speech. Our holding is tied to the particular content and context of Jewel’s ad as it appeared in the commemorative issue of Sport Illustrated Presents. [Our holding] that Jewel’s ad in the commemorative issue qualifies as commercial speech . . . defeats Jewel’s constitutional defense, permitting Jordan’s case to go forward. The substance of Jordan’s case remains untested, however, [because] the district court’s First Amendment ruling halted further consideration of the merits. We [therefore] remand for further proceedings. District court’s grant of summary judgment in favor of Jewel reversed; case remanded for further proceedings on Jordan’s right of publicity claim and other claims.

Figure 6.2 College Athletes and the Right of Publicity? Although college athletes who become well known might seem to be among those who would qualify for the right of publicity, the traditional assumption has been that the amateur status requirement under which they must operate not only distinguishes them from professional athletes but makes them ineligible for the right of publicity. That traditional assumption has been challenged in recent years, as current and former college athletes have filed right of publicity lawsuits against video game producers and against the National Collegiate Athletics Association (NCAA), the governing body that sets rules under which many schools’ athletic programs operate. NCAA rules require that college athletes maintain amateur status and prohibit those athletes from garnering financial benefits of the sort that would come from exercising a right of publicity if one were to be recognized. For instance, NCAA rules bar a college athlete from receiving compensation associated with sales of jerseys bearing his familiar number, whereas a professional athlete could utilize his right of publicity to derive a financial benefit from such activity insofar as it was connected with his professional exploits (as opposed to his college career). Universities themselves, however, may earn significant sums from those jersey sales, from other memorabilia sales, and from licensing other parties to make uses that arguably draw upon players’ identities. Moreover, universities presumably have been free to do so without compensating their athletes despite the key role the athletes play in enhancing the value of such items and the value of the licensing right. Some universities have demonstrated sensitivity to such concerns by opting to have jersey and memorabilia sales draw upon the school or team generally, as opposed to invoking the identities of particular athletes. Clearly, however, not all universities have made such a change in their jersey and memorabilia sales practices. With current and former college athletes having instituted litigation in an effort to seek recognition of a full-fledged right of publicity (and with a settlement having taken place in one major case, as noted below), the relevant litigation and regulatory landscape has shown signs of shifting.



Chapter Six Intentional Torts

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Another part of that landscape was an important case in which former college athletes employed other legal grounds to challenge the NCAA rules that restrict athletes from receiving right-of-publicity-like compensation and other financial benefits. The plaintiffs in the O’Bannon case (so named because the lead plaintiff was former UCLA basketball star Ed O’Bannon) attacked the pertinent NCAA rules and universities’ agreement to abide by them as unreasonable restraints of trade in violation of a major antitrust statute, § 1 of the Sherman Act. (Antitrust law is the subject of Chapters 49 and 50.) A federal district court agreed with the plaintiffs’ argument that § 1 was violated. The district court held that as a remedy, NCAA member schools should be permitted to compensate scholarship athletes up to the full cost of attendance. (At that time, NCAA rules on full scholarships left a gap between what the scholarship covered and the full cost of attendance, and barred member schools from financially covering that gap for the athletes.) In addition, the district court concluded that an appropriate remedy was to permit universities to set up accounts for athletes in amounts up to $5,000 in recognition of the use of their identities, with the monies to be paid to the athletes once their college playing eligibility was exhausted. In the judgment of the court, that remedy for the antitrust violation recognized the athletes’ interests in their identities without unduly compromising the NCAA’s (and universities’) interests in promoting amateurism and furthering related educational concerns. On appeal, however, the U.S. Court of Appeals for the Ninth Circuit only partially agreed with the district court’s decision. The Ninth Circuit held that there was indeed an antitrust violation, but that the district court’s remedy of permitting payments up to $5,000 was inappropriate. O’Bannon v. National Collegiate Athletic Association, 802 F.3d 1049 (9th Cir. 2015). Instead, the Ninth Circuit reasoned that the appropriate remedy was to permit NCAA member institutions to pay scholarship athletes amounts equal to the full cost of attendance—something that the NCAA had very recently changed its rules to allow member schools to do. The Ninth Circuit’s decision in O’Bannon was thus a mixed bag for college athletes. Whether the decision leads to other changes in the status quo for college athletes will certainly bear watching. The previously mentioned right of publicity actions against a video game maker have borne some fruit for former college athletes. Two federal courts of appeal have held that the First Amendment did not furnish a defense to Electronic Arts, whose college football video game arguably invoked the college identities of former players (though not their names). The alleged uses of the players’ identities occurred without their consent but with the permission of a licensing organization that is affiliated with the NCAA and represents many universities. The two cases are Hart v. Electronic Arts, Inc., 717 F.3d 141 (3d Cir. 2013), and Keller v. NCAA, 724 F.3d 1268 (9th Cir. 2013). Although the Supreme Court has held in another context that video games have significant expressive content and therefore may merit substantial First Amendment protection (see the discussion of Brown v. Entertainment Merchants Association in ­Chapter 3), the courts in Hart and Keller focused on what was, and was not, present in the video game at issue. Both courts stressed that the First Amendment should not protect Electronic Arts because the defendants’ video game appeared merely to use the payers’ identities without being transformative in the sense of adding significant new creative or expressive content. The rejection of the First Amendment defense cleared the way for the plaintiffs’ cases to proceed—prompting Electronic Arts to enter into a financial settlement with the plaintiffs and to announce that it would cease making a college football game of the sort it had produced. The NCAA also reached a financial settlement with the former college players regarding the NCAA’s ­alleged role in granting the video game maker permission to use aspects of the players’ identities.

Misuse of Legal Proceedings Three

intentional torts protect people against the harm that can result from wrongfully instituted legal proceedings. Malicious prosecution affords a remedy for the wrongful institution of criminal proceedings. Recovery for malicious prosecution requires proof that (1) the defendant caused the criminal proceedings to be initiated against the plaintiff without probable cause to believe that an offense had been committed, (2) the defendant did so for an improper purpose, and (3) the criminal proceedings eventually were terminated in the plaintiff’s favor. Wrongful use of civil proceedings is designed to protect people from wrongfully instituted civil suits. Its elements are very similar to those for malicious prosecution.

Abuse of process imposes liability on those who initiate legal proceedings, whether criminal or civil, for a primary purpose other than the one for which the proceedings were designed. Abuse of process cases tend to involve situations in which the legal proceedings compel the other person to take some action unrelated to the subject of the suit. For example, Rogers wishes to buy Herbert’s property, but Herbert refuses to sell. To pressure him into selling, Rogers files a private nuisance suit against Herbert, contending that Herbert’s activities on his land interfere with Rogers’s use and enjoyment of his adjoining property. Rogers may be liable to Herbert for abuse of process even if Rogers otherwise had reason to file the case.

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The Global Business Environment Does the right of publicity apply in a case brought in a court in the United States if the activities about which the plaintiff complains occurred outside the United States and in a nation that does not recognize the right of publicity as a part of its law? In Love v. Associated Newspapers, Ltd., 611 F.3d 601 (2010), the U.S. Court of Appeals for the Ninth Circuit provided a “no” answer. With some original members of the famous musical group known as The Beach Boys having died and others having gone their separate ways, the group no longer exists in its original form. As part of a settlement of earlier litigation, Mike Love, a founding member of the group, acquired the right to use The Beach Boys name in live performances. Love regularly tours with a varying lineup of musicians and uses The Beach Boys name in those appearances. Love sued former Beach Boy Brian Wilson and various other defendants—including British firms— in federal district court in California on the basis of the facts set forth here. Wilson, also a founding member of The Beach Boys, wrote or co-wrote most of the group’s hits before leaving the group many years ago. In 2004, Wilson released a solo album titled Smile. He and a backup band embarked on a tour to promote the album. As part of the promotional efforts for Wilson’s Smilethemed tour, the British newspaper Mail on Sunday distributed a CD with approximately 2.6 million copies of an edition of the newspaper. The CD, titled Good Vibrations, consisted of Wilson’s solo version of Beach Boys songs and other solo work by him. The editions of Mail on Sunday, complete with the CD, were distributed in the United Kingdom. Roughly 425 copies of the paper were distributed in the United States (including 18 in California), but without the CD. The front page of the Mail on Sunday edition prominently advertised the Good Vibrations CD and included an image of the CD’s cover, which featured a photo of Wilson and three smaller photos of The Beach Boys. Love appeared in the photos of the group.

Deceit (Fraud) Deceit

(or fraud) is the formal name for the tort claim that is available to victims of knowing misrepresentations. Liability for fraud usually requires proof of a false statement of material fact that was knowingly or recklessly made by the defendant with the intent to deceive the plaintiff, along with actual, justifiable, and detrimental reliance on the part of the plaintiff. Because most fraud actions arise in a contractual setting, and because a tort action is only one of the remedies available to a victim of fraud, a more complete discussion of this topic is deferred until Chapter 13.

Because Love appeared in the pictures on the CD’s cover, the right of publicity (as recognized under statute and common law in California) was among the various legal theories Love relied on in his lawsuit. Love later reached a settlement with Wilson. The federal district court dismissed various defendants from the case, some because they had nothing to do with the promotion of Wilson’s tour and others for lack of in personam jurisdiction. (For discussion of in personam jurisdiction, see Chapter 2.) The British company that published Mail on Sunday remained as a defendant concerning the right of publicity claim. The district court dismissed Love’s right of publicity claim after holding that English law, which does not recognize the right of publicity, controlled the case. (The court also dismissed Love’s various other legal claims.) Love appealed to the U.S. Court of Appeals for the Ninth Circuit, but fared no better there. The Ninth Circuit concluded that although California recognizes the right of publicity, the state “has no interest in applying its law to the conduct in question.” The court stressed that the remaining defendant in the right of publicity component of the case was a British firm, that the allegedly wrongful behavior Love complained about “occurred almost exclusively” in the United Kingdom, and that “[a]t most, de minimis conduct occurred in California when a handful of copies of [Mail on Sunday] were delivered without the CD and a handful of copies of Good Vibrations were sent to Wilson’s attorney in California.” In addition, the Ninth Circuit emphasized that “England’s interests would be . . . greatly impaired by a failure to apply English law.” Firmly rejecting Love’s attempt to invoke the right of publicity, the court stated: Even if California has an interest in protecting the right of an entertainer with economic ties to the state to exploit his image overseas, that interest is not nearly as significant as England’s interest in (not) regulating the distribution of millions of copies of a newspaper and millions of compact discs by a British paper primarily in the United Kingdom.

Interference with Property Rights LO6-12

Explain the difference between trespass to land and private nuisance.

Trespass to Land Trespass

to land may be defined as any unauthorized or unprivileged intentional intrusion upon another’s real property. Such intrusions include (1) physically entering the plaintiff’s land, (2) causing another to do so (e.g., by chasing someone



Chapter Six Intentional Torts

onto the land), (3) remaining on the land after one’s right to remain has ceased (e.g., staying past the term of a lease), (4) failing to remove from the land anything one has a duty to remove, (5) causing an object or other thing to enter the land (although some overlap with nuisance exists here), and (6) invading the airspace above the land or the subsurface beneath it (if property law and federal, state, and local regulations give the plaintiff rights to the airspace or subsurface and do not allow the defendant to intrude). The intent required for trespass liability is simply the intent to be on the land or to cause it to be invaded. A person, therefore, may be liable for trespass even though the trespass resulted from his mistaken belief that his entry was legally justified. Where the trespass was specifically intended, no actual harm to the land is required for liability, but actual harm is required for reckless or negligent trespasses.

Private Nuisance In

general, a private nuisance involves some interference with the plaintiff’s use and enjoyment of her land. Unlike trespass to land, nuisance usually does not involve any physical invasion of the

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plaintiff’s property. Trespass normally requires an invasion of tangible matter, whereas nuisance involves other interferences. Examples of such other interferences include odors, noise, smoke, light, and vibration. For nuisance liability to exist, however, the interference must be substantial and unreasonable. The defendant, moreover, must intend the interference. Nuisance law distinguishes between private nuisances and public nuisances. In a private nuisance case, the plaintiff landowner has sustained a particular harm of the sort described above—one that pertains to his, her, or its own property and is not a harm common to the public generally. If the only harm a plaintiff landowner can demonstrate is the same one that the public in general has sustained as a result of the defendant’s supposed nuisance, the plaintiff cannot prove what is necessary to win a private nuisance case. Any nuisance present in such an instance would likely be a public nuisance. As a general rule, the government is the appropriate party to seek abatement (i.e., elimination) of a public nuisance. The Toyo Tire case, which follows, illustrates private nuisance and trespass principles and explores issues concerning recoverable damages.

Toyo Tire North America Manufacturing, Inc. v. Davis    787 S.E.2d (Ga. 2016)

Lynn and Duron Davis owned and resided in a house located on four acres adjacent to a highway in Bartow County, Georgia. As of 1995, the year the Davises began residing in the house, the general area was zoned for low-density residential or agricultural use. In 2004, however, the property located across the highway from the Davises’ property was rezoned for heavy industrial use. That same year, Toyo Tire North America Manufacturing, Inc. began building a manufacturing and distribution facility on approximately 260 acres across the road from the Davises’ home. During the roughly five-year period after operations began at the Toyo Tire facility in January 2006, the facility underwent three expansions. In these expansions, the number of employees working at the facility went from 400 in 2006 to 570 in 2008 to 1,000 in mid-2011, and the number of tires produced per day went from 3,000 in 2006 to 4,500 in 2008 to 13,500 in mid-2011. In March 2014, with the litigation described below being under way, the facility was undergoing a fourth expansion. That expansion was expected to increase the number of employees to 1,450 and the number of tires per day to approximately 19,200. With employees working 12-hour shifts, the Toyo Tire facility operated around the clock every day. In late 2007, the Davises sent a letter to Toyo Tire through their counsel, alluding to possible trespass and nuisance claims and requesting that Toyo Tire purchase their home (as it had done with the two properties next door to the Davises’ property). Toyo Tire ­declined. In early 2013, the Davises sued Toyo Tire in a Georgia court. They alleged that the noise, lights, odors, black dust, and increased traffic from the facility constituted a nuisance. They also alleged that the black dust emitted by the facility constituted a trespass. During the discovery phase of the case, Toyo Tire took the Davises’ depositions. In those depositions, the Davises explained how Toyo Tire’s operations—including the loud noises, bright lights, odors, and black dust emissions from the facility; its equipment; and frequent truck deliveries, as well as the increased traffic from both trucks and employees—interfered with their use and enjoyment of the property and with their daily lives. They testified, for example, that their sleep was interrupted by the light and noise from the facility. They also testified that they wore masks when they went outside and that they could no longer use their large yard for family gatherings because of the odors emitted from the facility, the danger from the increased traffic, and the black dust that settled in their yard.

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Bruce Penn, a real estate appraisal expert hired by the Davises, was also deposed. He testified that the value of the Davises’ property would be $280,000 if not for the presence and effects of the Toyo Tire plant. Penn also testified about his depreciation analysis, which led him to conclude that the nuisance of the Toyo Tire facility had decreased the value of the Davises’ property by about 35 to 40%, with the black dust as a trespass decreasing the value by an additional 10 to 15%. After the completion of discovery, Toyo Tire moved for summary judgment, arguing that the Davises failed to prove that the specific interferences they alleged had caused their property value to decrease and that, under Georgia law, the Davises could not recover both for diminution of property value and for discomfort and annoyance caused by a nuisance. Toyo Tire did not argue that Penn’s expert testimony was inadmissible. The trial court denied Toyo Tire’s summary judgment motion, concluding that material issues of fact existed. Toyo Tire appealed, but the Georgia Court of Appeals affirmed the denial of the summary judgment motion. Toyo Tire appealed further to the Supreme Court of Georgia, which agreed to decide the case.

Nahmias, Justice First, we consider Toyo Tire’s argument that the Davises presented insufficient evidence, at the summary judgment stage of the case, to show that the decrease in their property value was proximately caused by the alleged nuisance and trespass. Second, we consider Toyo Tire’s argument that even if the Davises can establish causation, they cannot recover damages both for their discomfort and annoyance and for the diminution in their property value, because that would constitute an impermissible double recovery. Toyo Tire [bases its above-noted first argument on the notion that] the Davises’ appraisal expert, Bruce Penn, did not consider the specific interferences alleged by the Davises but rather looked at depreciation caused by industries in general. In his deposition, Penn explained that he had over 30 years of experience as a real estate appraiser, had done several hundred appraisals in the Bartow County area, and was certified in the top tier of licensing for appraising in Georgia. He testified that in his expert opinion, the Toyo Tire facility and its black dust emissions caused the Davises’ property value to decrease by 50%—35 to 40% due to the nuisance and 10 to 15% due to the black dust trespass. Penn arrived at this conclusion primarily by conducting a “paired sales” analysis, in which he compared the sales prices of three pairs of houses. One house in each pair was very close to an industrial facility in the vicinity of Bartow County, and the other was far away but still in the same general market area; the houses in each pair were otherwise similar. The three industrial facilities used were the Dobbins Air Reserve base, the Shaw carpet plant, and the Budweiser beer plant. He based the additional decrease in value resulting from the black dust trespass on research he previously conducted to determine the decrease in the value of homes affected by concrete dust from a concrete recycling plant in west Atlanta. He also relied generally on other work he had done during his career examining the effects of industrial sites on residential property values. The dissent in the Court of Appeals focused on several aspects of Penn’s methodology that [might] call into genuine question its validity and reliability, including Penn’s admission that he did not

gather any evidence about the specific invasions involved here or conduct any analysis of whether the other industrial sites in his paired sales analysis involved similar situations. It is appropriate to question why an expert of this type did not actually visit the industrial facilities and residential properties that he was comparing to better determine whether the interferences caused by an Air Force base, a carpet factory, and a beer-­brewing facility are really similar in type and degree to the interferences allegedly caused by a tire manufacturing and distribution facility. The flaw in the dissent’s analysis, however, is that these potential deficiencies in Penn’s methodology relate to whether his testimony should be admissible as expert opinion (and if so, what weight the factfinder should give his testimony), not to whether his opinions provide the evidence necessary on a motion for summary judgment to show causation. At this point in the case, only the latter question is properly presented for decision. Toyo Tire has not challenged the admissibility of Penn’s expert testimony in the trial court, and that court therefore has not considered whether Penn’s methodology [is sufficiently sound to warrant permitting him to testify as an expert]. An appellate court should not conduct the analysis of Penn’s methodology in the first instance. “Whether the opinions of the experts are admissible .  .  . is something that must be determined in the first instance by the [trial] court. .  .  .” [Citation omitted.] Consequently, we will consider only whether the record as we now find it— including the opinions of the expert—is enough to get the Davises past summary judgment. Toyo Tire maintains that even if Penn’s testimony is admissible, the Davises have failed to show causation. We disagree. Although Penn acknowledged in his deposition that he had not visited the Davises’ property or considered separately each specific claim of interference the Davises have made, he also testified that he was made generally aware of the characteristics of the Toyo Tire facility, including its “round-the-clock shifts” and the “middle of the night traffic,” and interferences resulting from those characteristics, such as increased traffic, lights, noise, and emissions. He explained his belief that these are common byproducts of industry. Viewed in its full context, Penn’s



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conclusion was not that Toyo Tire’s mere presence near the Davises’ property was a nuisance, but that the facility’s industrial operations (which he would expect to include things such as odors, light, noise, and traffic) caused the value of the Davises’ adjacent property to diminish. The testimony from the Davises amply described the alleged nuisance and the specific interferences coming from it, so this is not a case where there is no evidence that the alleged nuisance has interfered with the plaintiffs’ property. The Davises also testified about the black dust coming across the road from the tire factory onto their property, and Penn factored that alleged trespass into his diminution of value calculations. In sum, although it might not convince a jury at trial, the combined testimony of Penn and the Davises suffices to defeat Toyo Tire’s challenge to causation on motion for summary judgment. Accordingly, the Court of Appeals did not err in affirming the trial court’s denial of Toyo Tire’s summary judgment motion on this issue. We turn now to the second question presented—whether allowing the Davises to seek to recover both for their discomfort and annoyance caused by the alleged nuisance and for the diminution in their property value would permit a double recovery. Georgia courts have made it clear in nuisance and trespass cases . . . that a plaintiff cannot recover twice for the same injury. [In this case, however,] the alleged discomfort and annoyance experienced by the Davises and the alleged diminution in their property’s fair market value are two separate injuries that cannot be fixed by one recovery. Recovery for their discomfort and annoyance is designed to compensate them for what they have already experienced as residents of the property due to the Toyo Tire factory. [C]ompensation for past discomfort and annoyance will not eliminate the discomfort and annoyance that will be experienced by future residents of the Davises’ property. That future discomfort and annoyance is reflected in the diminished fair market value of the property. This ongoing diminution

in property value is therefore a second injury, which should be separately compensated (assuming it is proved at trial). The distinction between these injuries may be more easily grasped where non-owner residents of the property suffer the discomfort and annoyance caused by a nuisance, and non-resident owners suffer the diminution in the value of their property. Both groups have been injured, and both can seek recovery under a theory of nuisance; when, as here, the residents and owners are the same, they can recover for both kinds of injuries. The distinction between the two kinds of damages is also clear in the timing of the harms each is meant to address. The discomfort and annoyance damages would compensate the Davises for the interference with the use and enjoyment of their property that they have allegedly endured while living on the property. See Restatement (Second) of Torts § 929 (1)(c) (1979) (explaining that damages for harm to land resulting from a past invasion include “discomfort and annoyance to [the plaintiff] as an occupant”). The prospective damages available to the Davises as owners, on the other hand, are measured not through speculation about how much discomfort and annoyance they (or other occupants) may suffer in the future, but rather by how much the market value of their property has diminished based on the expectation of such continued discomfort and annoyance. See Restatement (Second) of Torts § 930(3) (explaining that the prospective damages for continuing invasions include “either the decrease in the value of the land caused by the prospect of the continuance of the invasion . . . or the reasonable cost to the plaintiff of avoiding future invasions”). For these reasons, the Davises can potentially recover for their past discomfort and annoyance as well as the diminution in their property value.

Conversion Conversion is the defendant’s intentional

In each case, the necessary intent is merely the intent to exercise dominion or control over the property. It is therefore possible for the defendant to be liable if she buys or sells stolen property in good faith. However, conversion is limited to serious interferences with the plaintiff’s property rights. If there is a serious interference and conversion, the defendant is liable for the full value of the property. What happens when the interference is nonserious? Although it has largely been superseded by conversion and its elements are hazy, a tort called trespass to personal property may come into play here. Suppose that Richards goes to Metzger Motors and asks to test-drive a new Corvette. If Richards either wrecks the car, causing major damage,

exercise of dominion or control over the plaintiff’s personal property without the plaintiff’s consent. Usually, the personal  property in question is the plaintiff’s goods. This can happen through the defendant’s (1) acquisition of the plaintiff’s property (e.g., theft, fraud, and even the purchase of stolen property), (2) removal of the plaintiff’s property (e.g., ­taking that property to the dump or moving the plaintiff’s car), (3) transfer of the plaintiff’s property (e.g., selling stolen goods or misdelivering property), (4) withholding possession of the plaintiff’s property (e.g., refusing to return a car one was to repair), (5) destruction or alteration of the plaintiff’s property, or (6) using the plaintiff’s property (e.g., driving a car left by its owner for storage purposes only).

Judgment of Court of Appeals affirmed; Toyo Tire’s motion for summary judgment correctly denied.

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or drives it across the United States, he is probably liable for conversion and obligated to pay Metzger the reasonable value of the car. On the other hand, if Richards is merely involved in a fender-bender, or keeps the car for eight hours, he is probably liable only for trespass. Therefore, he is obligated to pay only damages to compensate Metzger for the loss in value of the car or for its loss of use of the car. A very different attempted application of trespass principles was unsuccessful in the Intel case, which is discussed in the nearby Cyberlaw in Action box.

Other Examples of Intentional Tort Liability Chapter 8 discusses three additional intentional torts that protect various economic interests and often involve unfair competition: injurious falsehood (a type of business “defamation”), intentional interference with contractual relations, and interference with prospective advantage. Chapter 51 examines an intentional tortlike recovery for wrongful discharge called the public policy exception to employment at will.

CYBERLAW IN ACTION If a person uses a corporation’s e-mail system to distribute unsolicited e-mails to large numbers of the corporation’s employees and does so without the consent of the corporation, has the distributor committed the tort of trespass to personal property? That was the issue addressed by the Supreme Court of California in a 2003 decision. After being fired from his job at Intel, Kourosh Hamidi obtained the company’s e-mail address list without breaching Intel’s computer security system; instead, an anonymous source sent the list to Hamidi on a computer disk. Over a period of approximately two years, Hamidi sent six e-mails to each of at least 8,000, and perhaps as many as 35,000, Intel employees. Hamidi’s e-mails discussed his grievances against Intel and criticized the company’s employment practices. A number of Intel employees complained to their employer about having received Hamidi’s e-mails. Hamidi offered, however, to remove from his distribution list the addresses of Intel employees who requested that their addresses be removed. When employees so requested, Hamidi followed through on his removal offer. After Intel’s attempts to block Hamidi’s e-mails proved largely unsuccessful and Hamidi ignored Intel’s demands that he cease sending messages to the firm’s employees, Intel sued Hamidi. Intel alleged that it owned the e-mail system, that the system was intended primarily for business use by Intel employees, that the address list was confidential, and that Hamidi had continued his mass e-mailings despite demands from Intel that he stop. Contending that Hamidi’s actions amounted to trespass to chattels (i.e., trespass to personal property), Intel asked the court for an injunction barring Hamidi from sending further e-mails to Intel employees at their Intel addresses. A California trial court later granted summary judgment in favor of Intel and issued the requested injunction. Hamidi appealed to the California Court of Appeal, which affirmed the lower court’s decision. The appellate court concluded that injunctive relief was appropriate in view of the disruption to Intel’s business that resulted from Hamidi’s intentional interference with the company’s e-mail system. This interference, the court

reasoned, brought the case within the ownership and possessionrelated interests protected by the legal theory of trespass to personal property. Again Hamidi appealed, this time to the Supreme Court of California. In Intel Corp. v. Hamidi, 71 P.3d 296 (Cal. 2003), the Supreme Court reversed the lower courts’ decisions. The court observed that Hamidi’s e-mails neither physically damaged nor functionally disrupted Intel’s computers and did not prevent Intel from using its computers. These key facts caused the court to regard trespass to personal property as an ill-fitting theory. The court held that the trespass theory does not encompass, and should not be extended to encompass, an electronic communication that neither damages the recipient computer system nor impairs its functioning. Such an electronic communication does not constitute an actionable trespass to personal property, i.e., the computer system, because it does not interfere with the possessor’s use or possession of, or any other legally protected interest in, the personal property itself.

Although Intel argued that it had suffered harm in the form of lost productivity resulting from the fact that employees read and reacted to Hamidi’s messages, the Supreme Court noted that any such harm did not help Intel establish the necessary elements of a trespass claim. Such supposed harm was “not an injury to the company’s interest in its computers—which worked as intended and were unharmed by the communications—any more than the personal distress caused by reading an unpleasant letter would be an injury to the recipient’s mailbox. . . .” Intel’s real concern, the court concluded, pertained to the content of Hamidi’s messages. The court was unwilling to allow the trespass to personal property theory, whether in traditional or modified form, to be employed as a means of squelching speech that Intel found objectionable. Although the court only briefly touched on the potential First Amendment implications of a contrary holding, the decision appeared to have been influenced by the free speech arguments of organizations that had filed amicus curiae (friend-of-the-court) briefs in the case.



Chapter Six Intentional Torts

In rejecting Intel’s attempt to employ the trespass to personal property theory to the facts at hand, the Supreme Court emphasized that its holding would not prohibit Internet service providers (ISPs) from invoking trespass principles as a basis for legal relief against senders of “unsolicited commercial bulk e-mail, also known as ‘spam.’” Citing cases in which spammers had been held liable to ISPs, the court noted that in those

Problems and Problem Cases 1. Betty England worked at a Dairy Queen restaurant owned by S&M Foods in Tallulah, Louisiana. One day while she was at work, her manager, Larry Garley, became upset when several incorrectly prepared hamburgers were returned by a customer. Garley expressed his dissatisfaction by throwing a hamburger that hit England on the leg. Assume that while Garley was not trying to hit England with the hamburger, he was aware that she was substantially certain to be hit as a result of his action. Also, assume that England was not harmed by the hamburger. England sued Garley for battery. Did Garley have the necessary intent for battery liability? Does England’s not suffering harm defeat her battery claim? 2. On January 9, 2009, Lyshell Wilson filed suit against Jocelyn Howard in a Mississippi court. Wilson’s complaint stated as follows: On December 22, 2007, Plaintiff Lyshell Wilson . . . entered Citi Trends located [in] Jackson, Mississippi, for the purpose of shopping for clothing. While shopping on the premises of Citi Trends, Lyshell Wilson was brutally injured when an employee of Citi Trends, Jocelyn Howard, maliciously, recklessly, negligently, and violently attacked Lyshell Wilson with a pair of scissors.

Howard filed a motion to dismiss, contending that Wilson had failed to file her complaint within the oneyear statute of limitations set forth by a Mississippi statute, which provides that “all actions for assault, assault and battery . . . shall be commenced within one (1) year next after the cause of such action accrued, and not after.” (Different statutes of limitation apply to different types of claims. When a lawsuit raising a given claim has not been filed with an appropriate court prior to the expiration of the period specified in the relevant statute of limitations, the claim can no longer be pursued and is subject to dismissal.) ­Wilson responded to Howard’s motion by denying that she

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cases, the trespass to personal property theory was applicable because “the extraordinary quantity of [spam] impaired the [relevant] computer system’s functioning.” The supposed injury in Intel v. Hamidi, by contrast, took the form of “the disruption or distraction caused to recipients by the contents of the e-mail messages, an injury . . . not directly affecting the possession or value of personal property.”

was filing a battery claim. Instead, Wilson insisted that the claim set forth in her complaint was a negligence claim. The Mississippi statute of limitations pertaining to negligence claims set forth a longer limitations period than the period specified by the statute ­applicable to assault and battery claims, and would not have expired by the time Wilson initiated her lawsuit. The trial court denied Howard’s motion to dismiss. On appeal, Howard made two arguments. First, she argued that the claim made in Wilson’s complaint was for battery–­meaning that the complaint was not filed within the applicable one-year statute of limitations. Second, Howard argued that Wilson’s attempt to characterize the incident as an act of negligence was simply an attempt to circumvent the relevant statute of limitations. Was Howard correct? How did the appellate court rule? 3. Rex Moats sought election to the Nebraska Legislature in 2008. During the run-up to the election, the Nebraska Republican Party paid for and distributed publications in opposition to Moats’s candidacy. Moats filed a defamation lawsuit against the Republican Party on the basis of 10 statements in the publications. He listed the following statements in his complaint:  Publication No. 1: “Trial attorney Rex Moats is a registered Democratic [sic] and the Democrat [sic] Party is supporting him!”  Publication No. 2: “Moats received a $50,000 trust fund from the directors of National Warranty.”  Publication No. 3: “Would you put a shady insurance company based in the Cayman Islands ahead of Nebraska’s consumers? You wouldn’t. But trial attorney Rex Moats would. . . .” The same publication further stated: “How did Rex Moats mislead creditors and the public? Rex Moats claimed in an affidavit that National Warranty was doing financially well.”  Publication No. 4 (a mock letter purportedly sent by Moats from the Cayman Islands to Nebraskans): “Greetings from the Cayman Islands. From insurance

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Part Two Crimes and Torts

company trial lawyer extraordinaire Rex Moats.” The “letter” also stated, in relevant part: I have a fantastic job working for a shady insurance company that is incorporated right here in the Cayman Islands. The tax benefits sure are great out here! Unfortunately my company, National Warranty, has gone bankrupt and is unable to pay off numerous claims for thousands of Nebraskans. Also, it looks like I have made misleading statements in an affidavit. Evidently, I claimed that my company is doing “just fine,” but then declared bankruptcy two weeks later.

 Publication No. 5: “Rex Moats and National Warranty went down as a result of the same irresponsibility we see on Wall Street.”  Publication No. 6: “Rex Moats cannot be trusted with your money.” This publication further stated that Moats was a “trial attorney” and that “National Warranty’s directors set aside $50,000 for Rex Moats.”  Publication No. 7: This publication asserted that Moats was sued but the publication failed, according to the complaint, to disclose that the litigation against him was dismissed without a trial.  Publication No. 8: “Rex Moats received a $50,000 golden parachute even though 150 Nebraskans lost their jobs.” This publication also stated: “Rex Moats misled creditors and the public about the solvency of National Warranty. Even worse, right before the company folded, Moats received $50,000 from the directors of National Warranty.”  Publication No. 9: “[A]ccording to his own letter to the editor of a local newspaper, Rex Moats supports using your tax dollars to fund abortions.”  Publication No. 10 (listed as No. 11 in Moats’s complaint): “Rex Moats was legal counsel for a now bankrupt insurance company that cost Nebraskans their jobs but rewarded Rex with a $50,000 trust,” and “Rex Moats supports using tax dollars to fund abortions.”  In his complaint, Moats claimed that all of the above statements were false and defamatory and that the Republican Party made the statements with actual malice. The Republican Party filed a motion to dismiss, contending that Moats’s complaint failed to state a claim on which relief could be granted. The trial court granted the motion, and Moats appealed. Was the trial court correct in granting the motion to dismiss? 4. Nicky Pope filed a false imprisonment lawsuit against the Rostraver Shop ’n Save store (Shop ’n Save) and its manager, Howard Russell, on the basis of the incident described below. Pope and Russell each

provided deposition testimony during the discovery phase of the case. The incident, which took place in a Pennsylvania city, began when Pope entered the Shop ’n Save store, stopped at the bakery counter, and purchased a cup of coffee and a piece of cake to eat while in the store. She then browsed through the store. After being notified that Pope was walking back and forth without much in her shopping cart, Russell began watching her. Russell observed that she was wearing a long-sleeved, unbuttoned flannel shirt over a T-shirt. He testified in his deposition that he saw Pope’s hand going “underneath and back into the . . . flannel shirt,” followed by a “movement made down, possibly into the pants.” Thereafter, her “arm came back out.” Russell further observed what appeared to be a “protrusion from the left area of [Pope’s] back, at about the belt area.” Finally, Russell testified that “because of Pope’s shirt as well as her movement and the way she was positioned with her cart,” he could not see whether Pope had actually concealed any item. After Pope proceeded to the checkout stand and paid for the items, Russell stopped her in the store’s vestibule area and asked to see her receipt. Russell verified that Pope’s bakery receipt and store receipt matched her purchased items. He then asked Pope to lift up her outer shirt so that he could see whether she had concealed any items. Pope refused. As Pope acknowledged in her deposition, Russell did not touch her and did not create any physical barrier to prevent her from exiting the store. During their in-store exchange, however, Pope became upset at being accused of shoplifting. Pope told Russell that she believed she was being stopped because she was Black and that she intended to sue. Russell informed Pope that he was calling the police and that she should not leave the premises.  According to her deposition testimony, Pope believed that because the police had been called, she was not free to leave. During the 5 to 10 minutes it took for a police officer to arrive, Pope neither asked to leave the store premises nor made any attempt to leave. She also stated in her deposition that she decided to wait for the police. Upon his arrival at the Shop ’n Save, the police officer observed Russell waiting for him outside the store and Pope waiting alone in the vestibule area. Russell informed the officer of what he had observed. Pope exited the store and approached the officer, who questioned her but did not arrest her. Pope, who was never charged with shoplifting, testified in her deposition that since the incident, she had suffered from panic attacks and lack of sleep.



Chapter Six Intentional Torts

 Pennsylvania has a statute providing that if a merchant or the merchant’s employee has probable cause to believe that a customer was engaged in shoplifting, the merchant or employee may detain the customer in order to investigate. The statute further provides that if the detention is conducted for a reasonable time and in a reasonable manner, the detaining merchant or employee is protected against false imprisonment liability even if the customer did not shoplift. After the completion of the discovery phase in Pope’s case, Pope moved for summary judgment in her favor and the defendants moved for summary judgment in their favor. How did the court rule? Why did the court rule that way? 5. “The Mating Habits of the Suburban High School Teenager” served as the headline for a Boston magazine article that addressed sexuality and promiscuity among teenagers in the Boston area. An accompanying subheading, which appeared in lettering smaller than that used for the headline, read this way: “They hook up online. They hook up in real life. With prom season looming, meet your kids—they might know more about sex than you do.” According to the article, sexual experimentation had become increasingly common among high school students in recent years, with today’s teenagers being both “sexually advanced” and “sexually daring.” The author wrote that it had become common for “single boys and girls with nothing to do [to] go in a group to a friend’s house . . . drink or smoke pot, then pair off and engage in no-strings hookups.” Concerning the supposed prevalence of sexual promiscuity, the author quoted a teenager as saying that “everybody’s having casual sex and pretty much everybody’s doing it with multiple partners.” Throughout the article, the author included excerpts from her interviews with Boston-area students about their sexual experiences and views on sexuality.  A large photograph accompanied the beginning portion of the article. The photograph, which took up a full page plus part of a facing page, showed five formally attired students standing near an exit door at a high school prom. Three students were smoking cigarettes, and a fourth was drinking from a plastic cup. The fifth student, Stacey Stanton, was looking in the direction of the camera with an apparently friendly expression. Her face and a portion of her body were readily visible. She wore a formal dress and was neither smoking nor drinking. Beneath the headlines and the article’s opening text, and on the same page as the large photograph, there appeared the following caption and disclaimer: “The photos on these pages are from an award-winning five-year project on teen sexuality by photojournalist Dan

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Habib. The individuals pictured are unrelated to the people or events described in this story. The names of the teenagers interviewed for the story have been changed.” Of the type sizes used on the page, the one used for the caption and disclaimer was the smallest. Other pictures that did not depict Stanton accompanied later portions of the article.  Stanton, who was not named in the article, neither consented to the use of the large photograph nor participated in Habib’s “project on teen sexuality.” She sued Metro Corporation, the publisher of Boston magazine. According to her complaint, the juxtaposition of the large photograph and the article created the false impression that she was a person engaged in the activities described in the article. Therefore, Stanton contended that she had been the victim of defamation. Moreover, Stanton contended that the publication of the photograph amounted to an invasion of her privacy. The federal district court, however, ruled that Stanton had stated neither a valid defamation claim nor a valid invasion of privacy claim. Therefore, the court dismissed Stanton’s complaint. Stanton appealed. Did the district court rule correctly? 6. Irma White, a churchgoing woman in her late forties, was employed at a Monsanto refinery. While working in the canning department, she and three other employees were told to transfer a corrosive and hazardous chemical from a larger container into smaller containers. After they asked for rubber gloves and goggles, a supervisor sent for the equipment. In the meantime, White began cleaning up the work area and one of the other employees went to another area to do some work. The other two employees sat around waiting for the safety equipment, contrary to a work rule requiring employees to busy themselves in such situations.  After learning that the group was idle, Gary McDermott, the canning department foreman, went to the work station. Once there, he launched into a profane one-minute tirade directed at White and the other two workers present, calling them “motherf—s,” accusing them of sitting on their “f—g asses,” and threatening to “show them to the gate.” At this, White became upset and began to experience pain in her chest, pounding in her head, and difficulty in breathing. Her family physician met her at the hospital, where he admitted her, fearing that she was having a heart attack. She was later diagnosed as having had an acute anxiety reaction.  White later sued Monsanto for intentional infliction of emotional distress. Was her distress sufficiently severe for liability? Was McDermott’s behavior sufficiently outrageous for liability?

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Part Two Crimes and Torts

7. Dr. David Kipper filed a defamation lawsuit in a New York trial court against NYP Holdings Co. (NYP), the owner and publisher of the New York Post. Kipper based his case on an article in the December 7, 2003, edition of the Post. The article was an 8-paragraph “rewrite” of a 98-paragraph article taken from the wire service of the Los Angeles Times (LAT). The LAT article described rock musician Ozzy Osbourne’s allegations that his former physician, Kipper, had overprescribed various medications to him during the time that Osbourne starred in a television reality series. In addition, the LAT article accurately stated that the California Medical Board had “moved to revoke” Kipper’s license because of his alleged gross negligence in the treatment of other patients. However, the Post article, which appeared under the inaccurate headline “Ozzy’s Rx Doc’s License Pulled,” contained an error. Despite clearly indicating that it was based upon LAT reports, the Post rewrite incorrectly stated that “the state medical board revoked Kipper’s license.” NYP later conceded that this statement was false and defamatory, and published a “Correction” in response to a retraction demand from Kipper’s attorney.  The circumstances surrounding the erroneous statement in the December 7 article were not entirely clear. During the evening of December 6, a Post editor assigned the task of rewriting the wire service story to a reporter, Lyle Hasani Gittens. Gittens testified at a deposition that he did not recall writing—and did not think he wrote—that Kipper’s license was revoked. Gittens speculated that the error might have occurred during the editing process. After Gittens prepared the rewrite, he transmitted it to an electronic “basket” where it was reviewed by an editor. Gittens was aware that editors sometimes made stylistic changes to the text of articles. He denied having any knowledge that Post editors deliberately changed the facts of stories. The editor responsible for editing Gittens’s rewrite testified at his deposition that he would “never deliberately” falsify information pertaining to a doctor’s licensure, but that he could not offer any specific ­details pertaining to his review of the rewrite. Following the editor’s review, the article then went to the copy desk, where, among other things, the story’s headline was written.  The sole source material for Gittens’s rewrite was the LAT wire service story. Gittens testified that the Post sometimes reprints stories disseminated on reputable wire services (such as that of the LAT) verbatim, and that additional research regarding the factual accuracy of such stories is not generally undertaken. Regarding

the LAT wire service dispatch relevant to Kipper’s case, the editor testified that “this is not the kind of story that [the Post] would have expected a reporter to do additional research [on].” Upon completion of the discovery phase in Kipper’s defamation lawsuit against NYP, the defendant moved for summary judgment. Assume that Kipper is a public figure. What First Amendment–­based fault requirement must be proved in order for Kipper to win the case? In light of the facts, which party should win the case? How would the analysis change if Kipper were a private figure? 8. The late Evel Knievel, a motorcycle daredevil, acquired considerable fame as a result of his widely publicized and dangerous stunts during a career that began in the mid-1960s. Knievel’s exploits have been featured in several books and movies and in a Smithsonian Museum exhibit. Prior to his death in 2007, Knievel served as an advertising spokesman for various well-known corporations. He also devoted considerable time to the promotion of antidrug and motorcycle safety programs. In 2001, ESPN held its Action Sports and Music Awards ceremony. Celebrities from the field of “extreme” sports attended, as did famous rap and heavy-metal musicians. Knievel, sometimes known as the “father of extreme sports,” attended along with his wife, Krystal. In one of the many photographs ESPN arranged to have taken at the ceremony, Knievel was pictured with his right arm around his wife and his left arm around an unidentified woman. Knievel was wearing rosetinted sunglasses and a motorcycle jacket. The photograph of the Knievels and the unidentified woman was one of 17 photographs that ESPN published on the Green Carpet Gallery section of its EXPN.com website. That site featured information and photographs concerning motorcycle racing and various other “extreme” sports. The Green Carpet Gallery section was devoted to pictures of celebrity attendees of the Action Sports and Music Awards ceremony. A viewer who clicked on the Green Carpet Gallery icon was first directed to a photograph of two men grasping hands, with an accompanying caption stating that “Colin McKay and Cary Hart share the love.” By clicking on the “next” icon, the viewer could scroll through the remaining photographs and corresponding captions. A photograph of a woman in a black dress had this caption: “Tara Dakides lookin’ sexy, even though we all know she is hardcore.” Another photograph showed a sunglasses-wearing man, with a caption stating that “Ben Hinkley rocks the shades so the ladies can’t see him scoping.” The photograph of the Knievels was the



Chapter Six Intentional Torts

tenth in the sequence and could not be viewed without first viewing the photographs that preceded it. Its caption read this way: “Evel Knievel proves that you’re never too old to be a pimp.”  Evel and Krystal Knievel sued ESPN for defamation, contending that the caption, as used in connection with the photograph, falsely charged them with “immoral and improper behavior” and otherwise harmed their reputations. In particular, they alleged that after the publication of the photograph and caption, several of the corporations for which Evel had done product endorsements no longer wanted him associated with their products. ESPN moved to dismiss the Knievels’ complaint for failure to state a claim on which relief could be granted. According to the defendant, defamation could not have occurred because reasonable persons would not have interpreted the caption as an allegation that Evel was a criminal “pimp” or that Krystal was a prostitute. The federal district court granted the motion to dismiss. The Knievels appealed. Did the district court rule correctly? 9. Victoria Dauzat and Phyllis Jeansonne were shopping at a Dollar General store. Security cameras were in operation at the store that day. A Dollar General employee, Amanda Poarch, commenced observation of security camera footage in the store’s office at 11:56 A.M. Eight minutes later, Poarch called the police to report an alleged “theft in progress” at the store. Poarch stated in this call that she was presently watching Dauzat and Jeansonne steal several items from the store. Police officers arrived at the store at 12:09 P.M. Acting on an identification provided by Poarch, the officers directed Dauzat and Jeansonne to leave the checkout line. The officers then provided the Miranda warnings to Dauzat and Jeansonne. Other shoppers in the Dollar General store at the time included members of the same church Dauzat attended. Following the removal of Dauzat and Jeansonne from the checkout line, questioning of them took place in an office at the back of the store for more than an hour. The two maintained their innocence. Moreover, the video from the security cameras did not reveal evidence of apparent shoplifting.  Dauzat and Jeansonne, who ultimately were not criminally prosecuted, sued Poarch and Dollar General for false imprisonment and defamation. They based their false imprisonment claim on the detention that occurred following Poarch’s identification of them to the police officers. They based their defamation

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claim on the theory that false accusations of shoplifting would have been heard by other shoppers at the store and by other members of the tight-knit community on their in-home police scanner radios. The defendants argued that applicable state law included a shopkeepers’ statute of the sort discussed in the text and that the statute should protect them against false imprisonment liability. The defendants also contended that a conditional privilege should apply to Poarch’s report to the police and that they therefore should not be held liable for defamation. The trial court ruled in favor of the plaintiffs on both claims. The defendants appealed. How did the appellate court rule on the false imprisonment claim? How did the appellate court rule on the defamation claim? 10. In December 2000, a group of 18 plaintiffs sued James Pillen and various other defendants, seeking injunctive relief and damages on the theory that the defendants’ hog confinement operation constituted a private nuisance. The plaintiffs alleged that the hog confinement operation, which was conducted at four facilities in two Nebraska counties, had been a nuisance since 1997. In addition, the plaintiffs alleged that they had been deprived of the normal use and enjoyment of their property, and that the defendants had been notified of the plaintiffs’ concerns but had failed to take corrective action. At a 2002 bench trial in a state district court, Pillen testified about the relevant facilities, each of which was classified as a “5,000 sow unit.” The first of the four facilities was put into operation in 1996. The most recent facility was added in 1999. Pillen testified that he knew in May 1997 of a complaint from Nebraska’s Department of Environmental Quality (DEQ) concerning “the odor from [an] incinerator” at one of the facilities. Pillen believed that the DEQ complaint resulted from a complaint made to the DEQ by one of the plaintiffs. In addition, Pillen testified that he had discussed an odor problem with some of the plaintiffs prior to the end of September 1997.  All 18 plaintiffs testified concerning how the hog confinement operation had affected their lives and the use and enjoyment of their property. The testimony generally concerned the impact of odors. The plaintiffs described the odors from the defendants’ facilities as “unbearable,” as “overwhelmingly a suffocating stench,” as a “musty hog [excrement] smell,” as a “sewage odor,” as a “gas[-like] smell,” and as an odor that “chokes you.” Various plaintiffs said the smell was so bad that they had to keep their houses closed up at all times. The odor problem prevented

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Part Two Crimes and Torts

them from spending time in their yards or gardens, from hanging laundry on outdoor clotheslines, and from participating in outside activities with children and grandchildren. One plaintiff testified that she was a “prisoner” in her own home. According to Pillen’s testimony, the defendants had tried various procedures to diminish the odors emanating from the facilities and waste lagoons located there. These measures included the use of food additives, waste additives, and lagoon treatments. Pillen further testified that he did not think the hog confinement operation had changed the plaintiff’s quality of life or would ever disrupt their daily activities to such an extent that the operation should be changed.  The trial court ruled in favor of the plaintiffs and held that the defendants’ four-facility operation constituted a nuisance. The court ordered the defendants to explore the utility of processes to mitigate the odors and to implement such processes. In addition, the court ordered that the defendants must, within 12 months, “abate the nuisance or cease operating” their hog confinement facilities. Although the court found that the plaintiffs had suffered at least “some damage” as a result of the nuisance, the court noted that “none of the plaintiffs [was] able to quantify any request for damages” and that the plaintiffs “had not adduced any evidence sufficient for the court to award them specific damages.” As a result, the court awarded no monetary recovery to any of the plaintiffs. On appeal to the Nebraska Court of Appeals, the defendants challenged the trial court’s conclusion that the hog confinement operation constituted a nuisance. The plaintiffs challenged the trial court’s failure to award damages. How did the court of appeals rule on the parties’ respective arguments? 11. At the time of the events described below, California’s statute dealing with a deceased celebrity’s right of publicity read as follows: “Any person who uses a deceased personality’s name, voice, signature, photograph, and likeness, in any manner, on or in products, merchandise, or goods, or for purposes of advertising or selling, or soliciting purchases of products, merchandise, goods, or services, without prior consent from [the legal owner of the deceased personality’s right of publicity] shall be liable” to the right of publicity owner. The statute also set forth exemptions from the consent requirement for uses in news, public affairs, or sports broadcasts; in plays, books, magazines, newspapers, musical compositions, or film, television, or radio programs; or in

other works of political or news-related value. There was also an exemption for “single and original works of fine art.”  Comedy III Production Inc. owns the rights of publicity of the deceased celebrities who, through their comedy act and films, had become familiar to the public as “The Three Stooges.” Relying on the statute quoted above, Comedy III brought a right of publicity action against artist Gary Saderup and the corporation of which he was a principal. Without Comedy III’s consent, the defendants (referred to here collectively as “Saderup”) had produced and profited from the sale of lithographs and T-shirts bearing a depiction of The Three Stooges. The depiction had been reproduced from Saderup’s charcoal drawing, which featured an accurate and easily recognizable image of the Stooges. The trial court awarded damages to Comedy III after concluding that Saderup had violated the right of publicity statute and that neither the exemptions set forth in statute nor the First Amendment furnished a defense. When the California Court of Appeals affirmed, Saderup appealed to the Supreme Court of California. Were the lower courts correct in ruling in favor of Comedy III? 12. Ann Bogie attended a comedy performance by Joan Rivers. During the performance, Rivers told a joke about the legendary Helen Keller, who was deaf and blind. This joke offended an audience member who had a deaf son. The audience member heckled Rivers, and the two had a brief but sharp exchange that was captured on film. Immediately after the show, Rivers exited to a backstage area closed to the general public. Bogie gained entry to this backstage area and asked Rivers to sign a copy of her book. Bogie engaged Rivers in a brief conversation during which Bogie expressed frustration with the heckler and sympathy for Rivers. Rivers responded with an expression of sympathy for the heckler. The conversation went as follows: Bogie: Thank you. You are so . . . I never laughed so hard in my life. Rivers: Oh, you’re a good laugher and that makes such a difference. Bogie: Oh, I know. And that rotten guy. . . . Rivers: Oh, I’m sorry for him. Bogie: I was ready to get up and say . . . tell him to leave. Rivers: He has a, he has a deaf son. Bogie: I know.



Chapter Six Intentional Torts

Rivers: That’s tough. Bogie: But he’s gotta realize that this is comedy. Rivers: Comedy. Bogie: Right.  Unbeknownst to Bogie, her conversation with Rivers was captured on film. The film showed that at least three other persons were present during this exchange (a uniformed security guard and two other men who appeared to work for Rivers). They were all within a few feet of both Bogie and Rivers.  The film of the exchange between Rivers and the heckler and the film of Bogie’s interaction with Rivers were included in a nationally distributed documentary titled Joan Rivers: A Piece of Work. Bogie’s conversation with Rivers accounted for 16 seconds in the 82-minute documentary. Bogie sued Rivers and other defendants, contending that the filming of her conversation with Rivers and the inclusion of the interaction in the documentary constituted invasion of privacy. In her complaint, Bogie alleged (among other things) that she was portrayed in the documentary as having approved of condescending and disparaging remarks by Rivers toward the heckler. A federal district court granted the defendants’ motion to dismiss Bogie’s complaint for failure to state a claim on which relief could be granted. Was the district court correct in so ruling? (In deciding on your answer, consider each of the types of invasion of privacy discussed in the chapter.) 13. Mark Chanko was brought into the emergency room of New York and Presbyterian Hospital (the Hospital). He had been hit by a vehicle but was alert and responding to questions. Dr. Sebastian Schubl was the Hospital’s chief surgical resident and was responsible for Chanko’s treatment. While Chanko was being treated, employees of ABC News, a division of American Broadcasting Companies Inc. (ABC), were in the Hospital. With the Hospital’s knowledge and permission, the ABC employees were filming a documentary series (NY Med) about medical trauma and the professionals who attend to

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the patients suffering from such trauma. No one informed Chanko, his wife (who was at the Hospital), or members of his family (who were also there) that a camera crew was present and filming. Nor was their consent obtained for filming or for the crew’s presence. Less than an hour after Chanko arrived at the Hospital, Dr. Schubl declared him dead. That declaration was filmed by ABC. Chanko’s prior treatment was apparently filmed as well. Dr. Schubl then informed the family of Chanko’s death. That moment was also recorded without their knowledge.  Sixteen months later, Chanko’s widow, Anita Chanko, watched an episode of NY Med on her television at home. She recognized the scene, heard her late husband’s voice as he asked about her, saw him ­pictured on a stretcher, heard him moaning, and watched the video depiction of him as he died. In addition, she saw, and relived, the scene in which Dr.  Schubl informed the family of his death. She then told the other family members, who also watched the episode. This was the first time she and the family members became aware that decedent’s medical treatment and death had been recorded. Anita Chanko and other family members later filed a lawsuit against ABC, the Hospital, and Dr. Schubl. They brought various claims, including one for intentional infliction of emotional distress (IIED). The defendants moved to dismiss the IIED claim. How did the court rule? 14. Mann was the attorney for the Town of Rye, a New York community. He filed a defamation lawsuit against a newspaper that served the Rye area and against the writer of that newspaper’s Town Crier column. Mann based his case on statements that appeared in the column. The writer of the column referred to Mann as a “political hatchet man” and as “one of the biggest powers behind the throne in local government.” The writer also asserted that “Mann pulls the strings” and raised the question whether Mann was “leading the Town of Rye to destruction.” What arguments should the defendants make in an effort to avoid defamation liability? Should Mann win his case?

CHAPTER 7

Negligence and Strict Liability

T

NT Well Service Inc. hired Melvin Clyde as a rig operator. Clyde’s duties called for him to travel to various well sites within approximately 100 miles of Gillette, Wyoming. TNT provided Clyde with a companyowned pickup, which he used for work-related purposes and for travel to and from his home. Although TNT had a general policy of drug-testing prospective employees, TNT did not drug-test Clyde before hiring him and furnishing him with the pickup. Neither did TNT look into whether Clyde had any history of impaired driving or illegal drug use. Had TNT done such checking, it would have discovered that during roughly the preceding eight years, Clyde had been convicted twice for driving under the influence of alcohol and once for possession of a controlled substance. Late one afternoon approximately a year after he began working for TNT, Clyde was driving the TNT pickup when it crossed the highway’s center line and collided head-on with a tractor-trailer driven by Rodney Shafer (the tractor-trailer’s owner). Clyde died in the accident. A post-accident blood test revealed the presence of controlled substances in his blood. Shafer sustained serious injuries in the collision, and his tractor-trailer was damaged beyond repair. Shafer and his wife sued TNT in a Wyoming court. In seeking to have TNT held liable, the Shafers were unable to rely on a frequently involved legal basis for imposing liability on employers. Under the doctrine of respondeat superior, an employer is liable for its employee’s tort if the tort was committed within the scope of employment. Respondeat superior would not apply in this case, however, for either of two reasons: First, evidence offered by TNT indicated that Clyde had been fired from his job earlier in the afternoon of the accident (meaning that he would not have been TNT’s employee at the time of the accident); second, even if Clyde was still TNT’s employee at the time of the accident, he was outside the scope of employment because he was driving in an area that was outside TNT’s business territory. (In this chapter, you will read other cases in which the respondeat superior theory is applicable.) However, respondeat superior’s inapplicability would not necessarily bar the Shafers from succeeding in their case against TNT. Whereas respondeat superior provides a basis for an employer to be held liable for an employee’s tort, an employer may sometimes be held liable for the employer’s own tort. Look back over the facts set forth above and consider these questions as you study Chapter 7: • Are there things that TNT failed to do, but probably should have done? If so, what? Why those things? • Are there things that TNT did, but probably should not have done? If so, what? Why those things? • How do the things you have identified relate to the above-described accident and to the Shafers’ attempt to have TNT held legally liable? • On what legal basis would the Shafers be relying in their lawsuit against TNT?

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LO

Part Two Crimes and Torts

LEARNING OBJECTIVES After studying this chapter, you should be able to: 7-1 7-2 7-3 7-4 7-5

7-6

Identify the elements necessary for a valid negligence claim to exist (duty, breach of duty, and causation of injury). Explain what the reasonable care standard contemplates. Explain the role of foreseeability in determining whether a defendant owed the plaintiff a duty of reasonable care. Explain what goes into a determination of whether a defendant breached the duty of reasonable care. Explain the differences among the respective duties of care owed by owners or possessors of property to invitees, licensees, and trespassers. Explain what the doctrine of negligence per se does and when it applies.

THE INDUSTRIAL REVOLUTION THAT changed the face of 19th-century America created serious strains on tort law. Railroads, factories, machinery, and new technologies meant increased injuries to persons and harm to their property. These injuries did not fit within the intentional torts framework because most were unintended. In response, courts created the law of negligence. Negligence law initially was not kind to injured plaintiffs. One reason was the fear that if infant industries were held responsible for all the harms they caused, the country’s industrial development would be seriously restricted. As a viable industrial economy emerged in the 20th century, this concern began to fade. Also fading over the same period was the 19thcentury belief that there should be no tort liability without genuine fault on the defendant’s part. More and more, the injuries addressed by tort law have come to be seen as the inevitable consequences of life in a high-speed, technologically advanced society. Although 21st-century negligence rules have not eliminated the fault feature, they sometimes seem consistent with a goal of imposing tort liability on the party better positioned to bear the financial costs of these consequences. That party often is the defendant. However, it is important to remember that even though negligence law may seem to have become more pro-plaintiff in recent decades, statistics indicate that defendants win negligence cases at least as often as plaintiffs do. Because most tort cases that do not involve intentional torts are governed by the law of negligence, the bulk of

7-7 Identify the types of injuries or harms for which a plaintiff may recover compensatory damages in a negligence case. 7-8 Explain the difference between actual cause and proximate cause. 7-9 Explain what an intervening cause is and what effect it produces. 7-10 Explain the difference between traditional contributory negligence and the comparative negligence doctrine now followed by almost all states. 7-11 Explain the difference in operation between pure comparative negligence and mixed comparative negligence. 7-12 Identify circumstances in which strict liability principles, rather than those of negligence, control a case.

this chapter will deal with negligence principles. In a narrow range of cases, however, courts dispense with the fault requirement of negligence and impose strict liability on defendants. Strict liability’s more limited application will be addressed during the latter part of this chapter. The chapter will conclude with discussion of recent decades’ tort reform movement, whose primary aims are to reduce plaintiffs’ ability to prevail in tort cases and limit the amounts of damages they may receive when they win such cases.

Negligence LO7-1

Identify the elements necessary for a valid negligence claim to exist (duty, breach of duty, and causation of injury).

The previous chapter characterized negligence as conduct that falls below the level reasonably necessary to protect others against significant risks of harm. The elements of a negligence claim are that (1) the defendant owed a duty of care to the plaintiff, (2) the defendant committed a breach of this duty, and (3) this breach was the actual and proximate cause of injury experienced by the plaintiff. In order to win a negligence case, the plaintiff must prove each of these elements, which will be examined in the following pages. Later in the chapter, defenses to negligence liability will be considered.



Chapter Seven Negligence and Strict Liability

Duty and Breach of Duty Duty of Reasonable Care LO7-2 Explain what the reasonable care standard contemplates.

Negligence law rests on the premise that members of society normally should behave in ways that avoid the creation of unreasonable risks of harm to others. As a general rule, therefore, negligence law contemplates that each person must act as a reasonable person of ordinary prudence would have acted under the same or similar circumstances. This standard for assessing conduct is often called either the “reasonable person” test or the “reasonable care” standard. In most cases, the duty to exercise reasonable care serves as the relevant duty for purposes of a negligence claim’s first element. The second element—breach of duty—requires the plaintiff to establish that the defendant failed to act as a reasonable person would have acted. Negligence law’s focus on reasonableness of behavior leads to a broad range of applications in everyday personal life (e.g., a person’s negligent driving of a car) and in business and professional contexts (e.g., an employer’s negligent hiring of a certain employee or an accountant’s, attorney’s, or physician’s negligent performance of professional obligations). Recent years have witnessed attempts to extend negligence principles to contexts not previously explored in litigation. For instance, numerous former National Football League (NFL) players sued the NFL for alleged failures to disclose the full extent of the long-term health risks posed by concussions (particularly of the repeated variety) and for alleged failures to develop appropriate protocols that would guard against players being put back on the field too

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soon after a head injury. Negligence was among the legal theories being invoked by the plaintiffs. The players and the NFL eventually agreed to a settlement in which the NFL would, among other things, set up a very large fund against which the ex-players could make claims. Was the Duty Owed? LO7-3

Explain the role of foreseeability in determining whether a defendant owed the plaintiff a duty of reasonable care.

Of course, there could not have been a breach of duty if the defendant did not owe the plaintiff a duty in the first place. It therefore becomes important, before we look further at how the reasonable person test is applied, to consider the ways in which courts determine whether the defendant owed the plaintiff a duty of reasonable care. Courts typically hold that the defendant owed the plaintiff a duty of reasonable care if the plaintiff was among those who would foreseeably be at risk of harm stemming from the defendant’s activities or conduct, or if a special relationship logically calling for such a duty existed between the parties. Most courts today broadly define the group of foreseeable “victims” of a defendant’s activities or conduct. As a result, a duty of reasonable care is held to run from the defendant to the plaintiff in a high percentage of negligence cases—meaning that the outcome of the case will hinge on whether the defendant breached the duty or on whether the requisite causation link between the defendant’s breach and the plaintiff’s injury is established. In Magri v. Jazz Casino Co., which follows, the court considers whether the defendant casino owed and breached a duty of reasonable care to the plaintiff customer whose foot was injured while he was playing blackjack.

Magri v. Jazz Casino Co., LLC   275 So. 3d 352 (La. Ct. App. 2019) On January 18, 2012, Mr. Magri went to Harrah’s Casino [owned by Defendant Jazz Casino Company, LLC] to celebrate his ­birthday. Mr. Magri was seated on a high stool at the blackjack table, with an empty stool situated to Mr. Magri’s immediate left. Because Mr. Magri recently had undergone a left knee replacement, he rested his left leg and ankle on the bottom of the empty stool and faced the dealer. While Mr. Magri was playing blackjack, the pit boss called for an employee to empty a trash can in the area. When the employee, Nakeisha McCormick, attempted to empty the trash can, she moved the stool upon which Mr. Magri’s left foot was resting. Mr. Magri claims that she yanked the stool, twisting his left foot and ankle. After the incident, Harrah’s employees applied ice and wrapping to Mr. Magri’s left foot. On January 15, 2013, Mr. Magri filed suit against Harrah’s and others alleging various theories of negligence, including failure to exercise reasonable care, failure to warn of an unsafe condition, and failure to properly train employees. After a two-day bench trial, on October 17, 2018, the trial court rendered a judgment in favor of Mr. Magri and against Harrah’s in the amount of $601,689.31, after reducing the amount of the original judgment by 30%, based on Mr. Magri’s comparative fault. Harrah’s timely appealed.

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Part Two Crimes and Torts

Sandra Cabrina Jenkins, Judge Defendant Jazz Casino Company, LLC, the owner of Harrah’s New Orleans Casino (“Harrah’s”), appeals the trial court’s ­October 17, 2018 judgment awarding $601,689.31 in damages to plaintiff Irvin Magri, Jr., following a two-day bench trial. The suit arises from personal injuries sustained by Mr. Magri when a Harrah’s employee abruptly moved a stool on which Mr. Magri was resting his foot while sitting at a blackjack table. Harrah’s challenges the trial court’s findings on three of the five legal elements of negligence. For the reasons that follow, we find that Harrah’s owed a duty of reasonable care to Mr. Magri, Harrah’s breached that duty, and the particular harm sustained by Mr. Magri fell within the scope of Harrah’s duty to exercise reasonable care. We also find that the trial court was not clearly wrong in apportioning 70% of fault to Harrah’s, and 30% to Mr. Magri. Accordingly, we affirm the trial court’s judgment. Harrah’s raises four assignments of error: (1) Harrah’s owed no duty to protect or warn Mr. Magri because the risk that the empty stool could be moved was open and obvious to everyone who encountered it; (2) The trial court erred in finding that Harrah’s breached its legal duty because a reasonably prudent person observing an empty stool would not have inspected underneath the stool before moving it; (3) The trial court erred in finding legal causation because the risk that a patron sitting on one stool would put his foot on an adjacent stool, and that his foot would be injured when the stool was moved, is not within the scope of a Harrah’s duty to exercise reasonable care; and (4) The trial court erred in allocating only 30% of the fault to Mr. Magri since he placed his foot on an empty stool knowing that the stool could be moved at any time. Mr. Magri testified that he had been to Harrah’s four to ten times before the incident, and during these prior visits he saw “more people than he could count” sitting with their feet on adjacent stools. At the time of the accident, he was sitting at a blackjack table to the left of the dealer, with his left foot on the bottom rung of the empty stool next to him. Mr. Magri described his left foot as “intertwined” in the stool, with his foot inserted over the rung and then underneath it. He stated that he was facing the dealer with the majority of his body facing forward, while his left leg was on the rung of the adjacent stool. According to Mr. Magri, because he had a left knee replacement surgery on ­August 2, 2011, he was stretching his left leg out on the rung of the adjacent stool to relieve stiffness. Mr. Magri testified that while he was playing blackjack, the pit boss called for environmental services to empty a trash can. Mr. Magri said that when a female employee arrived, she and the pit boss got involved in a heated argument that lasted thirty seconds or less. Mr. Magri said that after the argument, the employee “yanked” the stool two or three times, and after each time she yanked the stool, he yelled for her to stop. He said that when the employee pulled the empty stool out, his foot and ankle were tangled in it. Mr. Magri stated that after the third pull, the employee

stopped yanking the stool. He stated that he felt a sharp pain in his surgically repaired left knee and ankle. Mr. Magri testified that before the accident, he did not ask any casino personnel if he could put his foot on the adjacent stool. He said that he was aware as a matter of “common sense” that another casino patron or employee could move the empty stool at any time, and he acknowledged that he did not need a sign to tell him that. He stated that he saw Ms. McCormick put her hands on the stool, but did not warn her that his foot was entwined in the stool. After the accident, Mr. Magri completed a Guest Accident Report stating that the Harrah’s employee “pulled the chair next to me (behind me) completely out with (unfortunately) my left foot attached causing  me to almost fall.” Mr. Magri also completed a handwritten form on February 8, 2012, stating that the Harrah’s employee “basically yanked the high stool away from me with my left ankle and leg entangled in same.” Ms. McCormick testified that she has worked as a cleaning specialist at Harrah’s for ten years. She said that on the night of the accident, she was assigned to work in the Smuggler’s restroom, which is near the blackjack table. According to Ms. ­McCormick, she received a call on the radio stating that a trash can in Pit 3 needed to be emptied, but the employee who normally emptied the trash can did not respond, so Ms. McCormick volunteered to pick up the trash. Ms. McCormick testified that she was not upset about picking up the trash, as it was part of her job. She denied that she had an argument with the pit boss that night. Ms. ­McCormick stated that because the blackjack tables are located next to one another, she had to go between two tables to empty the trash can. She described the space between the blackjack ­tables as “narrow.” She said that as she approached Pit 3 to empty the trash can, an empty stool at the blackjack table blocked her path. When she saw Mr. Magri, he was seated to the right of the empty stool, and was facing the dealer. She said that in order to get past the empty stool, she pushed it toward the blackjack table one time. She stated that she did not see Mr. Magri’s feet and did not realize that his left foot was on the footrest of the empty stool before she pushed. She stated that she had no reason to believe that Mr. Magri’s foot would be on the empty stool. According to Ms. McCormick, when she pushed the stool, Mr. Magri screamed “my foot, my leg.” She stated that she did not move the stool again after Mr. Magri yelled. She said that she asked Mr. Magri if he was okay, and he responded that he was fine. Ms. ­McCormick stated that she retrieved the trash can, emptied it, and then departed. Duty/Risk Analysis The duty/risk analysis is the standard negligence analysis employed in determining whether to impose liability under [­Louisiana statute and case law]. Under the duty/risk analysis, the plaintiff must prove five elements: (1) the defendant had a duty to conform his conduct to a specific standard (the duty element); (2) the ­defendant’s



Chapter Seven Negligence and Strict Liability

conduct failed to conform to the appropriate standard (the breach element); (3) the defendant’s ­substandard conduct was a cause-in-fact of the plaintiff ’s injuries (the cause-in-fact element); (4) the defendant’s substandard conduct was a legal cause of the plaintiff ’s injuries (the scope of liability or scope of protection element); and (5) actual damages (the damages ­element). “A negative answer to any of the inquiries of the duty-risk ­analysis results in a determination of no liability.” [­Citation omitted] Harrah’s challenges only the first, second, and fourth elements of the duty/risk analysis. Legal Duty “The threshold issue in any negligence action is whether the defendant owed the plaintiff a duty.” [Citations omitted for all quoted legal principles] Whether a duty is owed is a question of law for the court to decide, subject to de novo review. “There is an almost universal duty on the part of the defendant in a negligence action to use reasonable care to avoid injury to another.” “In general, the duty owed by a business owner to its customers is that of reasonable care.” “This duty extends to keeping the premises safe from unreasonable risks of harm or warning persons of known dangers.” “[T]he basic standard is that the defendant must exercise the degree of care that we might expect from an ordinarily prudent person under the same or similar circumstance.” A reasonably prudent person will avoid creating an unreasonable risk of harm. Harrah’s relies on the “open and obvious” doctrine in support of its contention that it owed no legal duty to Mr. Magri. “[A] defendant generally does not have a duty to protect against that which is obvious and apparent.” [Citations omitted] “In order for an alleged hazard to be considered obvious and apparent [the supreme] court has consistently stated the hazard should be one  that is open and obvious to everyone who may potentially encounter it.”  Ms. McCormick testified that she did not see Mr. Magri’s feet and did not realize that his left foot was on the footrest before she pushed the stool. She also testified that she had no reason to believe that Mr. Magri’s foot would be on the empty stool. Mr. Magri testified that he did not inform anyone at the blackjack table that he was resting his foot on the adjacent high stool. Under the circumstances, we find that the risk that a Harrah’s employee would move a chair with a patron’s foot entangled in it was not an open and obvious risk of harm, given the showing in the record that Ms. McCormick was the only person who knew Ms. McCormick was going to move the stool. As the “open and obvious” doctrine does not apply, we conclude that Harrah’s, at a minimum, owed a legal duty to Mr. Magri to keep the casino safe from unreasonable risks of harm. Breach of Duty The second element, breach of duty, is a question of fact, or a mixed question of law and fact, and the reviewing court must

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a­ ccord great deference to the facts found and the inferences drawn by the fact-finder. [Citation omitted] Factual findings regarding breach of duty are subject to the manifest error standard of review. [Citation omitted] This Court has described the breach of duty standard as follows: [T]o find that the defendant’s conduct is substandard, you must find that an ordinarily prudent person under all of the surrounding circumstances would reasonably have foreseen that as a result of its conduct, some such injury as the plaintiff suffered would occur, and that defendant failed to do what an ordinarily prudent person would have done. You may find it helpful to ask yourself, “How would an ordinary prudent person have acted or what precautions would they have taken if faced with similar conditions or circumstances?” [Citation omitted] Mr. Magri testified that it was common to see people resting their feet on an adjacent stool. Ms. McCormick testified that she did not look to see whether there was any impediment to moving the stool in the narrow space between the tables. A reasonably prudent person—particularly an employee working on the floor of a busy casino—moving a chair in a cramped space would have examined the stool prior to moving it to ensure that a customer would not be harmed. The trial court apparently found Mr. Magri’s testimony that Ms. McCormick “yanked” on the stool several times, even after he screamed, to be credible. We find that the trial court was not clearly wrong in finding that Harrah’s breached its duty to protect Mr. Magri from unreasonable harm. Legal Cause The fourth element of the duty/risk analysis is “legal cause” or “scope of protection.” “[This] inquiry assumes that a legal duty exists and questions whether the injury suffered by the plaintiff is one of the risks encompassed by the rule of law that imposed the duty.”  [Citations omitted] “The extent of protection owed to a particular plaintiff is determined on a case-by-case basis to avoid making a defendant an insurer of all persons against all harms.” This Court has described the “legal cause” or “scope of duty” inquiry as follows: In determining the limitation to be placed on liability for a defendant’s substandard conduct, the proper inquiry is often how easily the risk of injury to the plaintiff can be associated with the duty sought to be enforced. [Citations omitted] Thus, a risk may be found not within the scope of a duty where the circumstances of that injury to the plaintiff could not reasonably be foreseen or anticipated, because there was no ease of association between the risk of injury and the legal duty. [Citations omitted] Under the circumstances presented here, it was foreseeable that a patron sitting at a blackjack table would have comfortably

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Part Two Crimes and Torts

rested his foot and leg on an adjacent empty stool. We find an ease of association between the risk that a seated patron’s foot would be injured when an adjacent stool is “yanked” three or four times, and Harrah’s legal duty to protect Mr. Magri from unreasonable harm. Assessment of Fault Harrah’s contends that the trial court should have allocated more than 30% fault to Mr. Magri. A trial court’s findings regarding percentages of fault are factual, and will not be disturbed on appeal unless clearly wrong. [Citations omitted] An appellate court’s determination of whether the trial court was clearly wrong in its allocation of fault is guided by the factors set forth in Watson v. State Farm Fire and Cas. Ins. Co., 469 So. 2d 967 (La. 1985). In Watson, the Supreme Court said that “­various factors may influence the degree of fault assigned, including: (1) whether the conduct resulted from inadvertence or involved an awareness of the danger; (2) how great a risk was created by the conduct; (3) the significance of what was sought by the conduct; (4) the capacities of the actor, whether superior or inferior; and (5) any extenuating circumstances which might require the actor to proceed in haste, without proper thought.” Watson, 469 So. 2d at 974. These same factors guide the appellate court’s ­determination as to the highest or lowest percentage of fault that could reasonably be assessed.

Was the Duty Breached?

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Explain the role of foreseeability in determining whether a defendant owed the plaintiff a duty of reasonable care.

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Explain what goes into a determination of whether a defendant breached the duty of reasonable care.

Assuming that the defendant owed the plaintiff a duty of reasonable care, whether the defendant satisfied or instead breached that duty depends upon the application of the reasonable person test. This test is objective in two senses. First, it compares the defendant’s actions with those that a hypothetical person with ordinary prudence and sensibilities would have taken (or not taken) under the circumstances. Second, the test focuses on the defendant’s behavior rather than on the defendant’s subjective mental state. The reasonable person test has another noteworthy characteristic: flexibility. In contemplating that courts consider all of the relevant facts and circumstances, the test allows courts to tailor their decisions to the facts of the particular case being decided.

The trial court found that the evidence showed that Harrah’s negligence arose from Ms. McCormick’s inadvertence. Ms. ­McCormick created a substantial risk of harm when she knowingly moved the chair without warning Mr. Magri or examining the area. The risk could have been avoided by Ms. McCormick by examining the stool beforehand to determine if anyone could be injured as a result of moving the stool. The trial court also found that Mr. Magri’s negligence arose from his own inadvertence, and that he had some comparative fault for placing his left foot on the adjacent empty chair. The trial court found that Mr. Magri should have expected that someone would attempt to move or utilize the adjacent empty chair. The trial court also considered that Mr. Magri did not ask permission to prop his foot on the chair, and did not inform anyone at the blackjack table that he was resting his foot on the high stool. We find that a reasonable interpretation of the facts supports the trial court’s finding that Harrah’s, through Ms. McCormick, bears 70% of the fault. Accordingly, the trial court’s assessment of 30% fault to Mr. Magri and 70% fault to Harrah’s was not manifestly erroneous, and should be upheld. Based on the foregoing we affirm the trial court’s October 17, 2018 judgment, in favor of Mr. Magri and against Harrah’s, in the amount of $601,689.31. AFFIRMED.

When applying this objective yet flexible standard to specific cases, courts consider and balance various factors. The most important such factor is the reasonable foreseeability of harm. This factor does double duty, helping to determine not only whether the defendant owed the plaintiff a duty (as noted above) but also what the defendant’s duty of reasonable care entailed in the case at hand. Suppose that Donald falls asleep at the wheel and causes a car accident in which another motorist, Peter, is injured. Falling asleep at the wheel involves a foreseeable risk of harm to others, so a reasonable person would remain awake while driving. Because Donald’s conduct fell short of this behavioral standard, he has breached a duty to Peter. However, this probably would not be true if Donald’s loss of awareness resulted from a sudden, severe, and unforeseeable blackout. On the other hand, there probably would be a breach of duty if Donald was driving and had a blackout to which a doctor had warned him he was subject. Negligence law does not require that we protect others against all foreseeable risks of harm. Instead, the risk created by the defendant’s conduct need only be an unreasonable one. In determining the reasonableness of the risk,



Chapter Seven Negligence and Strict Liability

courts consider other factors besides the foreseeability of harm. One such factor is the seriousness or magnitude of the foreseeable harm. As the seriousness of the harm increases, so does the need to take action to avoid it. Another factor is the social utility of the defendant’s conduct. The more valuable that conduct, the less likely that it will be regarded as a breach of duty. A further consideration is the ease or difficulty of avoiding the risk. Negligence law normally does not require that defendants make superhuman efforts to avoid harm to others. To a limited extent, negligence law also considers the personal characteristics of the defendant. For example, children are generally required to act as would a reasonable person of similar age, intelligence, and experience. A person who is physically disabled must act

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as would a reasonable person with the same disability. Mental deficiencies, however, ordinarily do not relieve a person from the duty to conform to the usual reasonable person standard. The same is true of voluntary and negligent intoxication. Finally, negligence law is sensitive to the context in which the defendant acted. For example, someone confronted with an emergency requiring rapid decisions and action need not employ the same level of caution and deliberation as someone in circumstances allowing for calm reflection and deliberate action. The Currie case, which follows, focuses mainly on the duty and breach of duty elements of a negligence claim. It also furnishes an introduction to concepts dealt with more fully later in the chapter.

Currie v. Chevron U.S.A., Inc.   266 F. App'x 857 (11th Cir. 2008) Acting in her own right and as personal representative of the estate of her deceased daughter (Nodiana Antoine), Tracye Currie sued Chevron U.S.A., Inc. and Chevron Stations Inc. (collectively, “Chevron”) on the theory that Chevron negligently caused Antoine’s death. The facts giving rise to the case are summarized here. For approximately two years, Antoine and Anjail Muhammad had had a close personal relationship. The relationship between the two women was a stormy one, with Muhammad sometimes threatening to inflict physical harm on Antoine. One morning in 2003, Muhammad and Antoine were in Muhammad’s car, which Muhammad had parked in a restaurant parking lot in Marietta, Georgia. According to a statement Muhammad later made to the police, Muhammad and Antoine became involved in an argument, during which Antoine said that she wanted to end their relationship. Muhammad also said in her statement that Antoine left the car and started walking toward a Chevron gas station across the street to call her family. Muhammad followed her, and the women continued arguing as they walked across the street. Pamela Robinson, a customer at the Chevron station, testified at the trial in Currie’s case that when she pulled into the station, she saw Muhammad and Antoine approach the station. Muhammad was pulling on Antoine’s neck or the collar of her clothing and essentially dragging Antoine. Robinson also stated that Muhammad appeared to tighten her grip when Antoine tried to pull away. Robinson, who watched the two women move in the direction of gas pump number one, went inside the station when she realized that the pump she was seeking to use had to be activated by a Chevron cashier before it would work. Jyotika Shukla was the cashier at the station on that day. Robinson testified that she entered the station and “told [Shukla] immediately that there was something going on with the two young ladies out here and that she needed to contact the police immediately.” Robinson explained that she then pointed out the two women to Shukla. Shukla testified at the trial that she did not know there was anything wrong outside until Robinson came into the station and told her, though an earlier statement by Shukla to the police indicated that Shukla saw the women before Robinson came into the station. Regardless of when she first saw the women, Shukla said that she did see the two women “verbally fighting” and that one woman was holding the other by her shirt. Shukla did not call the police because, according to her testimony, she thought the two women were or would be leaving the Chevron property. Evidence adduced at the trial indicated that when customers at the Chevron station sought to use a gas pump, they had to lift a lever on the pump. A beeping sound inside the station would then inform the cashier that a customer had lifted the lever. In order for the customer to receive gas through the pump, the cashier would then have to hit the “authorize pump” button. After the pump was authorized, the beeping sound would stop. The evidence established that Shukla authorized gas pump number one by pushing the appropriate button inside the station. This authorization of the pump enabled Muhammad to use it, even though Muhammad did not have a car on the premises. Shukla testified at trial that she authorized pump number one before Robinson came into the station and before she (Shukla) saw the women fighting, but Shukla’s deposition testimony and an earlier statement given to the police indicated that she could not remember whether she knew about or had seen the fighting before she authorized the pump.

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Part Two Crimes and Torts

Robinson’s testimony suggested that Shukla authorized a pump after Robinson told Shukla about the two women fighting. Based on her prior experience of working at a gas station, Robinson recognized that a beeping sound informed the cashier that a gas pump needed to be activated. Robinson testified that she heard a beeping sound when she entered the Chevron station. She also testified that the beeping sound stopped “right after” she told Shukla to call the police. Robinson also stated that she did not ask Shukla to authorize her gas pump until after she talked to Shukla about the two women fighting outside and showed Shukla where they were standing—by gas pump number one. Moreover, there were no other customers waiting for other pumps to be authorized. Shukla’s testimony was inconsistent about whether she looked at gas pump number one before authorizing it. She first testified that she did not remember whether she had looked at pump number one before authorizing it, but later she said “[m]aybe yes.” In her statement to the police, Muhammad said that Shukla looked at pump number one before authorizing it. Muhammad stated that “[e]verybody was really helpful like the lady . . . in the store. . . . [S]he just turned the pump on.” When a police detective asked, “Even though ya’ll didn’t have a car?” Muhammad responded, “Didn’t even have a car right next to it, she just turned it on, she looked at us and just turned the pump on.” After Shukla authorized pump number one, Muhammad sprayed 65 cents worth of gasoline on Antoine. Robinson testified that she exited the station to return to her car to pump gas and immediately saw the two women “in the same position with [Muhammad] holding [Antoine].” Before Robinson got to her car, Muhammad asked Robinson whether she had a cigarette lighter. Robinson said she did not. She then watched the two women as they left the Chevron station, with Muhammad still pulling Antoine by her shirt. According to Muhammad’s statement to the police, she and Antoine left the Chevron station and went back to Muhammad’s car. Muhammad then found a cigarette lighter in the car and used the lighter to set Antoine on fire. Antoine ran through the parking lot while on fire and tried to roll over in a grassy area in an effort to put out the flames. A passerby called 911, and Antoine was taken to the hospital. Several weeks later, Antoine died as a result of the burns she had suffered. Muhammad, who confessed to police that she set Antoine on fire, was later indicted on criminal charges of murder, aggravated battery, aggravated assault, and arson. In Currie’s wrongful death lawsuit against Chevron, Currie alleged that Shukla negligently authorized the gas pump used by Muhammad and that Antoine died as a result. Under the respondeat superior principle discussed in Chapter 36 of this text, Chevron would be liable for any negligence on the part of its employee, Shukla, if that negligence occurred within the scope of Shukla’s employment. A federal district court jury returned a $3,500,000 verdict in Currie’s favor. The court issued a judgment against Chevron for $2,625,000, an amount that reflected a 25 percent reduction from $3,500,000 because of the jury’s finding that Antoine’s own negligence accounted for 25 percent of the reason why she was killed. (Later in this chapter, you will learn about the comparative negligence principle applied by the court in reducing the amount of damages awarded.) Chevron unsuccessfully moved for judgment as a matter of law or, in the alternative, a new trial. Chevron then appealed to the U.S. Court of Appeals for the Eleventh Circuit.

Per Curiam In this diversity case controlled by Georgia law, . . . Currie contended at trial that Chevron’s Shukla negligently activated the gas pump for Muhammad only after: (1) Shukla saw Muhammad pulling Antoine around the Chevron station’s property by her shirt and thought that something was wrong; (2) Shukla saw that Muhammad and Antoine did not have a vehicle; and (3) customer Pamela Robinson warned Shukla that there was a problem with the two women outside, asked Shukla to call the police, and showed Shukla where the two women were standing by gas pump number one. Currie claimed that, given this evidence, Shukla should have foreseen that Antoine would suffer some injury as a result of Shukla’s activating the gas pump for Muhammad. On appeal, Chevron argues that . . . Muhammad’s actions were not a reasonably foreseeable consequence of Shukla’s negligence; [that] Antoine failed to exercise ordinary care to avoid the consequences of Shukla’s negligence; [and that] Antoine’s negligence was equal to or greater than Shukla’s negligence. A cause of action for negligence in Georgia must contain the following elements: (1) a legal duty to conform to a standard of

conduct for the protection of others against unreasonable risks of harm; (2) a breach of this standard; (3) a legally attributable causal connection between the conduct and the resulting injury; and (4) some loss or damage resulting from the breach of the legal duty. In order to establish a breach of the applicable standard of conduct, there must be evidence that the alleged negligent act (or omission) created a foreseeable, unreasonable risk of harm. As to foreseeability of injury, Georgia courts have stated that “in order for a party to be held liable for negligence, it is not necessary that he should have been able to anticipate the particular consequences which ensued. It is sufficient if, in ordinary prudence, he might have foreseen that some injury would result from his act or omission, and that consequences of a generally injurious nature might result.” [Citations omitted.] In Georgia, questions of negligence, proximate cause, and foreseeability are generally for the jury. [After reviewing the record in this case, we] conclude that reasonable minds could differ as to whether Shukla was aware at the moment she authorized gas pump number one that her action would create a foreseeable risk of injury to Antoine. There was evidence from which the jury



Chapter Seven Negligence and Strict Liability

could have inferred that Shukla was aware that Muhammad and Antoine were involved in a serious fight on the Chevron station’s property. In her statement to police on the day of the incident, Shukla said that she saw the two women walking on the station’s property, that Muhammad had “grabbed” and “pulled” Antoine by the front of her shirt, and that Shukla “thought something was wrong.” Shukla also testified at trial that she saw the women fighting on the Chevron station’s property. Robinson’s testimony confirmed Shukla’s observation that the fight was serious. Robinson testified that [Muhammad tightened her grip on Antoine] when Antoine try to pull away from her. Robinson [also testified] that Muhammad then pulled Antoine “down to the ground like an animal.” There also was evidence from which the jury could have found that Shukla was aware that Muhammad and Antoine were involved in a serious fight at the Chevron station before she activated gas pump number one for Muhammad. [In addition,] there was evidence from which the jury could have concluded that Shukla looked at Muhammad before authorizing gas pump number one. Muhammad told police on the day of the incident that “. . . she looked at us and just turned the pump on. . . .” Based on Muhammad’s statement and Shukla’s own testimony, the jury could have found that Shukla looked at gas pump number one before she authorized it, saw Muhammad (whom Shukla had seen fighting with Antoine on the station’s property and had recognized did not have a car), and nevertheless authorized gas pump number one for Muhammad. [Considering] the totality of this evidence . . . , the jury could have found that the beeping sound that Robinson heard inside the Chevron station was Muhammad seeking authorization of gas pump number one and that Shukla looked at Muhammad and authorized gas pump number one for her (thus stopping the beeping sound) after Shukla’s conversation with Robinson. The jury also could have found that Shukla was aware at the time she authorized gas pump number one for Muhammad that: (1) Muhammad had been pulling Antoine around the Chevron station’s property by her shirt as they were fighting; (2) the fight was sufficiently serious that Shukla herself thought something was wrong and that Robinson came into the station to warn Shukla that something was going on with the two women outside and to ask her to call the police; (3) Muhammad and Antoine were fighting by gas pump number one; and (4) Muhammad and Antoine did not have a car on the station’s property. Thus, we conclude that there was, at the very least, a substantial conflict in the evidence such that reasonable and fair-minded jurors might reach different conclusions as to whether Shukla was aware before she authorized gas pump number one that her negligent action would create a foreseeable risk of injury to Antoine. Chevron presented expert testimony from Rosemary ­Erickson, Ph.D., a forensic sociologist, that it was not reasonably foreseeable

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to Shukla that Muhammad would douse Antoine with gas and set her on fire. Dr. Erickson based her opinion on a review of the depositions, the police records, the low crime rate in the area surrounding the Chevron station, the lack of previous violent crimes at this specific Chevron station, and the rarity of the particular crime that occurred here. In addition to Dr. Erickson’s testimony, Shukla testified that she had never [witnessed] a crime or fire at the Chevron station before that day and never had to call the police. [The] former Chevron station manager testified that there had not been any criminal activity at the Chevron station in his eight to ten years working there before this incident. However, in cross-examining Dr. Erickson, plaintiff’s counsel asked, “You would agree with me . . . would you not, that if something is going on at a gas station and a clerk sees one person holding another at a gas pump and there’s no car and no container, that it’s foreseeable that the gas may be used inappropriately and harm can result. . . .” Dr. Erickson replied, “If all those factors were in evidence.” Thus, even from Chevron’s own witness, there was in effect testimony to support Currie’s claim that Shukla should not have authorized the gas pump after Shukla saw Muhammad and Antoine fighting (or was told by Robinson they were fighting) and where Muhammad and Antoine had no car or gas container. [In addition, both the former station manager] and Robinson [, who had worked at a gas station,] testified that they would not activate a gas pump if they saw people at the gas pump without a car or gas can. In arguing that this incident was not foreseeable, Chevron cites Georgia premises liability cases providing that property owners have a duty to exercise ordinary care to protect invitees from foreseeable third-party criminal attacks where there are prior similar criminal acts occurring on the premises that put the property owner on notice of the dangerous condition. Chevron argues that the criminal attack by Muhammad on Antoine was not foreseeable because this particular Chevron station was in a low crime area and had not been the site of any criminal activity in previous years, much less violent crime. First, while Currie raised a premises liability theory at trial, her primary theory of liability was that given the particularly serious events unfolding before Shukla and given Robinson’s warning, Shukla then committed her own affirmative negligent act in activating gas pump number one for Muhammad, not that Chevron breached its duty to Antoine to keep its premises safe generally. Second, the lack of prior criminal activity at this Chevron station does not wholly foreclose the foreseeability issue. Even in cases grounded solely on a premises liability theory, Georgia courts have stated that “a showing of prior similar incidents on a proprietor’s premises is not always required to establish that a danger was reasonably foreseeable. An absolute requirement of this nature would create the equivalent of a one free bite rule for premises liability, even if the proprietor

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Part Two Crimes and Torts

otherwise knew that the danger existed.” [Citation omitted.] This Court applied this same reasoning in a premises liability case to conclude that there was a jury question of whether hostilities throughout the evening of which bowling alley employees were, or should have been, aware were sufficient to make it reasonably foreseeable to them that a fight would erupt, even though there had been no similar prior altercations on the premises. [Citation omitted.] Similarly, in this case, there was a sufficient conflict in the evidence for reasonable minds to differ as to whether the particular serious and exigent events unfolding right before Shukla at the Chevron station that morning, together along with Robinson’s warning, should have put her on notice that activating the gas pump for Muhammad would

pose an unreasonable risk of harm to Antoine, even though there was no history of prior similar incidents at this specific Chevron station. Therefore, we cannot say that the district court erred in denying Chevron’s motion for judgment as a matter of law or a new trial. [Note: In a later portion of the opinion not included here, the Eleventh Circuit concluded that the district judge had correctly instructed the jury on issues related to Antoine’s own failure to use reasonable care, that the jury’s assignment of a 25 percent degree of responsibility to Antoine was supported by the evidence, and that the court had therefore properly reduced the award of damages by 25 percent.]

Judgment in favor of Currie affirmed.

Ethics and Compliance in Action Suppose that during regular work hours, an employee of XYZ Co. commits a sexual assault or other violent attack upon a member of the public. The employee, of course, is liable for the intentional tort of battery (about which you learned in Chapter 6), as well as a criminal offense. Although the doctrine of respondeat superior makes employers liable for their employees’ torts when those torts are committed within the scope of employment, XYZ is quite unlikely to face respondeat superior liability for its employee’s flagrantly wrongful act because a sexual assault or violent attack, even if committed during regular work hours, presumably would be outside the scope of employment. However, as the principles explained in this chapter suggest, XYZ could be liable for its own tort if XYZ was negligent in hiring, supervising, or retaining the employee who committed the attack. A determination of whether XYZ was negligent would depend upon all of the relevant facts and circumstances. Regardless of whether XYZ would or would not face legal liability, the scenario described above suggests related

Special Duties In some situations, courts have ­fashioned particular negligence duties to supplement the general reasonable person standard. When performing their professional duties, for example, professionals such as doctors, lawyers, and accountants generally must exercise the ­knowledge, skill, and care ordinarily possessed and employed by members of the profession.1 Also, common carriers and (sometimes) innkeepers are held to an extremely high duty of care approaching strict liability Chapter 46 discusses professional liability in greater detail.

1

ethical questions that may confront employers. Consider the following:

• Does an employer have an ethical obligation to take corrective or preventive action when the employer knows, or has reason to know, that the employee poses a danger to others? • Does it matter whether the employer has irrefutable evidence that the employee poses a danger, or whether the employer has only a reasonable suspicion to that effect? • If the employer has an ethical obligation to take corrective or preventive action, to whom does that obligation run and what should that obligation entail? • Does the employer owe any ethical duty to the employee in such situations? You may find it helpful to consider these questions through the frames of reference provided by the ethical theories discussed in Chapter 4 (e.g., utilitarianism, rights, virtue, shareholder, and justice theories). Then compare and contrast the results of the respective analyses.

when they are sued for damaging or losing their customers’ property. Many courts say that they also must exercise great caution to protect their passengers and lodgers against personal injury—especially against the foreseeable wrongful acts of third persons. This is true even though the law has long refused to recognize any general duty to aid and protect others from third-party wrongdoing unless the defendant’s actions foreseeably increased the risk of such wrongdoing. Some recent decisions have imposed a duty on landlords to protect their tenants against the foreseeable criminal acts of others.



Chapter Seven Negligence and Strict Liability

Explain the differences among the respective duties LO7-5 of care owed by owners or possessors of property to invitees, licensees, and trespassers.

Duties to Persons on Property Another important set of special duties runs from possessors of real estate (land and buildings) to those who enter that property. Negligence cases that address these duties are often called premises liability cases. Traditionally, the duty owed by the possessor has depended on the classification into which the entering party fits. The three classifications are: 1. Invitees. Invitees are of two general types, the first of which is the “business visitor” who is invited to enter the property for a purpose connected with the possessor’s business. Examples include customers, patrons, and delivery persons. The second type of invitees consists of “public invitees” who are invited to enter property that is held open to the public. Examples include persons using government or municipal facilities such as parks, swimming pools, and public offices; attendees of free public lectures and church services; and people responding to advertisements that something will be given away. The entry, however, must be for the purpose for which the property is held open. A possessor of property must exercise reasonable care for the safety of his invitees. In particular, he must take appropriate steps to protect an invitee against dangerous on-premises conditions that he knows about, or reasonably should discover, and that the invitee is unlikely to discover. 2. Licensees. A licensee enters the property for her own purposes, not for a purpose connected with the possessor’s business. She does, however, enter with the possessor’s consent. In some states, social guests are licensees, though today they are more commonly classified as invitees. Other examples of

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licensees are door-to-door salespeople, solicitors of money for charity, and sometimes persons taking a shortcut across the property. As these examples suggest, consent to enter the property is often implied. The possessor usually is obligated only to warn licensees of dangerous on-premises conditions that they are unlikely to discover. 3. Trespassers. A trespasser enters the land without its possessor’s consent and without any other privilege. Traditionally, a possessor of land owed trespassers no duty to exercise reasonable care for their safety; instead, there was only a duty not to willfully and wantonly injure trespassers once their presence was known. Recent years have seen some tendency to erode these traditional distinctions. Most notably, many courts no longer distinguish between licensees and invitees. These courts hold that the possessor owes a duty of reasonable care to persons regardless of whether they are licensees or invitees. Some courts have created additional duties that possessors owe to trespassers. For example, a higher level of care is often required as to trespassers who are known to regularly enter the land, and as to children known to be likely to trespass. Traditionally, premises liability cases have focused on whether reasonable care was exercised to guard against or remedy potentially dangerous physical conditions such as slippery substances on the floor or poorly lighted staircases—­the sorts of conditions that could cause an invitee to fall or experience a similar mishap resulting in physical injuries. (Hence, those premises liability cases are often referred to as “slip-and-fall” cases.) In recent years, courts have considered whether the duty of reasonable care should encompass measures to protect invitees against onthe-premises criminal acts of third parties. Lord v. D & J Enterprises, Inc., which follows, is such a case.

Lord v. D & J Enterprises, Inc.   757 S.E.2d 695 (S.C. 2014) D & J Enterprises, Inc. operates businesses involving check cashing, payday lending, and motor vehicle title lending. One of its businesses is Cash on the Spot, which is located in Rock Hill, South Carolina. For the protection of employees, Cash on the Spot is outfitted with iron bars on the windows of its building and bulletproof glass on its tellers’ windows. On February 14, 2008, Ida Lord went to Cash on the Spot to retrieve money that had been wired to her. As Lord approached a teller’s window, a man seated at a nearby table stood up, reached under his clothing, pulled out a pistol, and shot Lord in the head and back. The man then demanded money as he slid his weapon through the opening in the teller’s window. The store manager, who was stationed behind the bulletproof window and had access to a silent alarm, called 911. The man fled the premises but was soon arrested. He was later identified as Phillip Watts Jr. After Watts was apprehended, he confessed to committing seven armed robberies in Rock Hill and elsewhere in York County (where Rock Hill is located). Those robberies, which began in October 2007 and primarily targeted small businesses, were the subject of significant media coverage. Two of the publicized robberies occurred within three weeks prior to the Cash on the Spot incident. In those robberies, Watts shot two store clerks and a bystander. Before the February 14, 2008, incident in which Lord was shot, D & J’s president,

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Part Two Crimes and Torts

Darrell Starnes (who oversaw the corporation’s day-to-day operations), warned his employees to be vigilant because “there is a madman on the loose.” Watts ultimately pleaded guilty but mentally ill to criminal charges in connection with the Cash on the Spot incident and the other armed robberies. Lord filed a negligence lawsuit against D & J in a South Carolina court in an effort to obtain damages for what she described as the “catastrophic brain injuries” she suffered in the shooting. She alleged that D & J breached its duty to use reasonable care to protect her while she was at Cash on the Spot. D & J later moved for summary judgment, arguing that it had no duty to protect Lord from the injuries directly caused by Watts. It was not foreseeable that Watts would shoot Lord, D & J contended, because Watts appeared to be a regular customer, because the incident lasted less than six seconds, and because there had not been prior instances of attempted armed robberies or acts of violence at Cash on the Spot. In opposing D & J’s motion, Lord offered the deposition testimony of D & J officers and employees, an affidavit from a private security expert who opined that D & J should have had a security guard stationed at Cash on the Spot, and evidence of media coverage of the earlier robberies committed by Watts. Concluding that D & J did not owe a duty to Lord, the trial court granted summary judgment in favor of D & J. After Lord appealed to the South Carolina Court of Appeals, the Supreme Court of South Carolina certified the case for resolution by that court rather than the Court of Appeals.

Beatty, Justice In this premises liability case involving a third-party criminal act, Lord . . . asserts the court erred in granting summary judgment to D & J because she presented . . . evidence showing a genuine issue of material fact as to each element of her negligence claim. Specifically, Lord asserts that: (1) D & J owed a duty to her as she was a business invitee on the premises of Cash on the Spot; (2) the risk of harm to her was foreseeable because D  &  J’s president admitted he knew before the shooting that “there was a madman on the loose” and reviewed procedures with D & J employees regarding a response to a potential armed robbery; (3) D & J failed to post a security guard at the entrance of Cash on the Spot despite the foreseen risk of a shooting; (4) the affidavit of private security expert Robert Clark established that the shooting of Lord “most probably would not have occurred if D & J had posted a security guard”; and (5) there is evidence that the shooting caused Lord to suffer profound neurological complications. Bass v. Gopal, Inc., 716 S.E.2d 910 (S.C. 2011) (Gopal II) . . . is used to determine a business owner’s duty to protect a patron based on the foreseeability of violent acts by third parties. Gopal II was a premises liability action that arose out of the shooting of Gerald Bass while he was a guest at the Super 8 Motel in Orangeburg, South Carolina. Gopal, Inc., a Super 8 franchisee, owned and operated the motel. [The shooter was someone who was at the motel for the apparent purpose of committing a robbery.] Bass filed a complaint alleging negligence [on the part of] Gopal, Inc. and Super 8. The defendants filed motions for summary judgment, which were granted by the circuit court. The South Carolina Court of Appeals affirmed. [Bass appealed to the Supreme Court of South Carolina.] In [ruling on Bass’s appeal in] Gopal II, we considered whether the Court of Appeals erred in upholding the circuit court’s finding that Gopal, Inc., . . . did not have a duty to

protect Bass from the criminal act of a third party. [We] noted that the threshold question in any negligence action is whether the defendant owed a duty to the plaintiff. [We stated that although] “an innkeeper is not the insurer of [the] safety of its guests,” an innkeeper “is under a duty to its guests to take reasonable action to protect them against unreasonable risk of physical harm.” The court [further] explained in Gopal II that “a business owner has a duty to take a reasonable action to protect its invitees against the foreseeable risk of physical harm.”* In assessing the foreseeability issue, the Gopal II court [adopted] a balancing test, which . . . acknowledges that duty is a flexible concept, and seeks to balance the degree of foreseeability of harm against the burden of the duty imposed. The court explained that “the more foreseeable a crime, the more onerous is a business owner’s burden of providing security.” Accordingly, “[u]nder this test, the presence or absence of prior criminal incidents is a significant factor in determining the amount of security required of a business owner, but their absence does not foreclose the duty to provide some level of security if other factors support a heightened risk.” The court found that “the balancing approach appropriately weighs both the economic concerns of businesses and the safety concerns of their patrons.” By adopting this test, the court hoped to “encourage a reasonable response to the crime phenomenon without making unreasonable demands.” Applying the balancing approach to the facts of Bass’s case, the court found the Court of Appeals correctly affirmed the grant of summary judgment in favor of Gopal, Inc. In reaching this decision, the court determined that Bass presented “at least some evidence the aggravated assault was foreseeable” because Bass produced a CRIMECAST report that showed . . . the risk of rape, *

Gerald BASS, Appellant, v. GOPAL, INC. and Super 8 Motels, Inc., ­Respondents. No. 4576.



Chapter Seven Negligence and Strict Liability

robbery, and aggravated assaults at the Super 8 as compared to the national average risk, the state average risk, and the county average risk.  The court, however, found Bass did not provide any evidence that Gopal Inc.’s preventative measures were unreasonable given the risk of criminal activity on the property. Although Bass presented the deposition testimony of an expert who “concluded the addition of a closed circuit camera or some type of additional security personnel would have been reasonable in light of his perceived risk,” the court found Bass “failed to provide any evidence that [Gopal, Inc.] should have expended more resources to curtail the risk of criminal activity that might have been probable.” Instead, the court found determinative the expert’s statement that “if . . . this is [the] first time [a criminal incident occurred], there wasn’t enough data for [Gopal, Inc.] to say he really needed to spend a bunch of money on surveillance cameras, a bunch of money on a full-time security guard or part-time, or train his employees to do a guard tour.” [Gopal II provides controlling insights on] how to determine (1) if a crime is foreseeable, and (2) the economically feasible security measures that are required to prevent the foreseeable harm. Applying the Gopal II balancing test [to the case at hand], we hold the circuit court erred in granting summary judgment to D & J. Viewing the evidence in the light most favorable to Lord, we find she presented [enough] evidence to withstand the motion for summary judgment as to her negligence claim against D & J. To prevail on a negligence claim, a plaintiff must establish duty, breach, causation, and damages. The key determination in the instant case is whether D & J breached its duty to take reasonable action to protect Lord, its business invitee, against the foreseeable risk of physical harm. Regarding the foreseeability prong of Gopal II, Lord presented the deposition testimony of Starnes (D & J’s president) and Marsha Boyd, the manager of Cash on the Spot the day of the shooting. Starnes and Boyd testified they were aware of the prior robberies in York County because the local newspapers had covered the incidents. Prior to the shooting, Starnes discussed the robberies with his employees and warned them to “be on their toes to look out for suspicious people” because there was a “madman on the loose.” Based on the foregoing, we find, as did the circuit court, that Lord produced at least some evidence that the shooting was foreseeable. [T]he question [then] becomes whether D & J’s preventative security measures were unreasonable given this risk. Lord primarily asserts that D & J should have posted a security guard at the entrance of Cash on the Spot. Although this court in Gopal II acknowledged the significant cost associated with hiring security guards absent evidence of prior crimes on the premises, we stated that a plaintiff may produce evidence of this prong

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through the testimony of an expert. Here, unlike the plaintiff in Gopal II, Lord presented expert testimony precisely on this point. Robert Clark, Lord’s expert in private security, reviewed the media coverage of the prior armed robberies, reviewed the deposition testimonies of Starnes and Boyd, and conducted a field investigation of the security measures used at Cash on the Spot. Based on his investigation, Clark opined that D & J “had a duty, in the exercise of reasonable care, to post a security guard at the entrance” of Cash on the Spot in order to “provide reasonable protection for its employees and customers against the threat of a serial armed robber who had shot two store clerks and a bystander in two previous armed robberies of businesses that fit the profile of D & J’s business.” He further stated, “The armed robbery attempt during which Ida Lord was shot most probably would not have occurred if D & J had posted a security guard at the entrance of its check cashing location.” As we noted in Gopal II, “whether a business proprietor’s security measures were reasonable in light of a risk will, at many times, be identified by an expert.” Here, Lord presented such expert testimony. Under the specific facts presented in this case, we find the expert testimony was sufficient to create a question of fact for the jury. [W]e conclude it is premature to deprive Lord of the opportunity to present her case to a jury. At this stage, it is not the role of the circuit court or this court to determine whether Lord will prevail on her negligence claim, but whether she presented [sufficient] evidence to withstand D & J’s motion for summary judgment. We emphasize that our decision should not be construed as requiring all merchants to hire costly security guards. Instead, we merely find that it is for a jury to decide whether D & J employed reasonable security measures to fulfill its duty to protect Lord from the foreseeable risk of a shooting. Clearly, D & J recognized that it was susceptible to an armed robbery at Cash on the Spot, as it had installed security cameras and placed bars on the office windows. It also sought to protect its employees by placing them behind bulletproof glass, equipping them with panic buttons, and providing them with immediate access to a silent alarm. The circumstances of this case, however, presented a heightened risk of danger beyond the ordinary operation of Cash on the Spot. As evidenced by Starnes’s deposition testimony, there was a foreseeable risk of a shooting at Cash on the Spot given the rash of armed robberies that culminated in the shootings of store clerks and customers at nearby businesses. Under these unique facts, we cannot find that D & J was entitled to judgment as a matter of law on Lord’s cause of action for negligence. Circuit court’s grant of summary judgment to D & J reversed; case remanded for trial regarding Lord’s negligence claim.

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Part Two Crimes and Torts

LO7-6 Explain what the doctrine of negligence per se does and

when it applies.

Negligence Per Se Courts sometimes use statutes, ordinances, and administrative regulations to determine how a reasonable person would behave. Under the doctrine of negligence per se, the defendant’s violation of such laws may create a breach of duty and may allow the plaintiff to win the case if the plaintiff (1) was within the class of

persons intended to be protected by the statute or other law and (2) suffered harm of a sort that the statute or other law was intended to protect against. In the Winger case, which follows, the plaintiffs’ decedent fell to her death from an apartment balcony whose guardrail was shorter than the height mandated by a supposedly applicable municipal housing code provision. The court considers whether the negligence per se principle can be applied when the supposed violation was of a local ordinance rather than a state or federal law.

Winger v. CM Holdings, L.L.C.   881 N.W.2d 433 (Iowa 2016) At 1:30 A.M. on July 23, 2011, 21-year-old Shannon Potts came to her friends’ second-floor apartment at the Grand Stratford Apartments in Des Moines, Iowa. She arrived in a slightly intoxicated state and continued drinking until about 4:00 A.M., when her friends hid the alcohol. A conversation took place between Shannon and a friend while the two were on the apartment’s balcony. When the conversation ended, the friend returned inside the apartment. A scream and a crash were then heard. Discovering that Shannon had fallen over the balcony’s railing, the group of friends came to her aid and found her unresponsive. Shannon’s injuries proved to be fatal. Toxicology tests indicated that she was intoxicated at the time of her fall and that she had marijuana and Xanax in her bloodstream. Until roughly five months before Shannon’s fatal fall, Mark Critelli solely owned the Grand Stratford Apartments (Apartments), which were located in buildings constructed in 1968. The Apartments were built to comply with the 1968 Des Moines housing code, which required balcony guardrails to be at least 30 inches in height. The original iron railings at the Apartments were 32 inches tall. They were still in place when Shannon fell to her death 43 years later. Amendments to the Des Moines housing code in 1979 and 2005 required that guardrails be at least 42 inches in height. However, these later versions of the housing code included a grandfather provision permitting previously installed guardrails that complied with the earlier version of the code to remain in use if they were in sound structural condition. In 2009, Critelli attached a 48-inch-high white plastic lattice to the guardrails at the Apartments. He used zip ties to attach the lattice, which served as a privacy screen to shield each balcony from view. In February 2011, a Des Moines housing inspector visited the Apartments and found 106 violations, including the guardrail height. The inspector reasoned that Critelli’s attachment of the lattice modified the guardrails and that this modification both eliminated the protection of the above-noted grandfather provision and triggered a duty to comply with the code provision requiring 42-inch-high guardrails. Later in February 2011, CM Holdings, L.L.C. acquired controlling ownership interest in the Apartments. (Critelli retained a partial ownership interest.) CM undertook significant renovations and other actions to correct most of the problems identified in the list of 106 violations. During a July 5, 2011, visit to the property, the city housing inspector noted only six remaining violations, one of which was the guardrail-height violation. He imposed a penalty of $1,090 for that violation. CM, which had ordered new 42-inch guardrails but did not yet have them, did not appeal the finding that it had violated the guardrail-height requirement. Instead, CM requested that the Des Moines Housing Appeal Board (HAB) grant it a three-month extension to comply with the 42-inch height requirement and that the $1,090 penalty be suspended. In a decision issued on July 20, 2011, the HAB upheld the finding of a violation but granted CM’s request for an extension of time to comply and a suspension of the penalty. Shannon Potts fell to her death three days later. Acting in their personal capacities and as executors of Shannon’s estate, Shannon’s parents sued CM. They alleged that the 32-inch guardrails violated the housing code, that the code violation constituted negligence per se, and that a 42-inch-high guardrail would have prevented Shannon from falling. (During the eventual jury trial, the plaintiffs’ expert witness offered such an opinion about the likely effect of a 42-inch guardrail.) The trial court ruled on a pretrial basis that the newer code provision (the one requiring 42-inch guardrails) applied as a matter of law. The court also rejected CM’s arguments that the property was grandfathered out of the current code, that the 1968 code applied as a matter of law, and that, in any event, the HAB’s extension of time to install higher railings excused tort liability. The court instructed the jury that CM’s violation of the housing



Chapter Seven Negligence and Strict Liability

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code constituted negligence per se. The court also limited the jury to deciding causation, comparative fault on Shannon’s part, and damages. The jury found CM 65 percent at fault and Shannon 35 percent at fault, and awarded damages of $1,750,000 ($1,137,500 after the necessary reduction for comparative fault). In a post-trial ruling, however, the trial court concluded that the doctrine of negligence per se did not apply after all and that a new trial was therefore warranted. Both sides appealed to the Iowa Court of Appeals, which affirmed the lower court’s post-trial ruling and earlier rulings on other key issues. Both sides again appealed, this time to the Supreme Court of Iowa. The ­following edited version of that court’s opinion notes various issues on which the court ruled but focuses on one key question: whether the negligence per se doctrine can apply when the defendant violated a municipal housing code provision (as opposed to a state statute).

Waterman, Justice The central fighting issue on appeal is whether CM was negligent as a matter of law by failing to replace the 32-inch-high balcony guardrails with 42-inch-high guardrails. We must resolve several related questions. First, CM argues—and the court of appeals ultimately concluded—that only breach of a specific statewide statute or rule can constitute negligence per se, while the breach of a local ordinance cannot. [Analysis of this key issue appears below.] Second, CM argues that its property was grandfathered out of the 42-inch-high guardrail requirement[, whereas] the plaintiffs argue that CM is bound by the HAB’s determination that [the] 32-inch-high balcony guardrails with the attached lattice violated the code. We . . . hold that the HAB finding is not determinative in this tort action. Third, CM contends that the HAB’s extension of time to install 42-inch-high railings excused its tort liability in the interim. We affirm the [trial] court’s ruling rejecting that legal excuse. Finally, we conclude neither side was entitled to a directed verdict on the grandfather issue under the existing record. That issue must be litigated  on remand. [Further discussion of the three issues noted in this paragraph is omitted.] [Because the plaintiffs are seeking to rely on the negligence per se doctrine, we must resolve this threshold question:] Can a violation of a city ordinance constitute negligence per se? The court of appeals construed Griglione v. Martin, 525 N.W.2d 810 (Iowa 1994), [as holding] that only the breach of a statewide standard can constitute negligence per se and affirmed the order granting a new trial on that basis. The court of appeals understandably relied on this language from Griglione: “We believe rules of conduct that establish absolute standards of care, the violation of which is negligence per se, must be ordained by a state legislative body or an administrative agency regulating on a statewide basis under authority of the legislature.” The plaintiffs argued that [the quoted] language is dicta, but the court of appeals concluded that the language is controlling. We note that [the quoted] language was unnecessary to the decision and is not supported by the cited authorities. We resolve the issue by overruling Griglione.

Our court has long recognized that the violation of a municipal safety ordinance can be negligence per se.  See Hedges v. Conder, 166 N.W.2d 844 (Iowa 1969) (holding that party could be negligent per se for failing to follow city ordinance requiring use of crosswalks); Kisling v. Thierman, 243 N.W. 552 (Iowa 1932) (adopting general rule that violation of rules of the road in statutes or ordinances constitutes negligence per se); Tobey v. Burlington, Cedar Rapids & Northern Railway, 62 N.W. 761 (Iowa 1895) (holding that violation of speech limit ordinance was negligence per se). However, the [trial] court and court of appeals questioned the viability of this line of cases based on what we [more] recently said in Griglione, a case that did not involve a municipal ordinance or code with the force of law. The fighting issue in Griglione was whether the violation of a local police department’s internal operating procedures constituted negligence per se. [In that case,] Paula Blythe had received threatening phone calls from Rodney Griglione. She called the Mt. Pleasant Police Department. The responding officer, while interviewing Blythe inside her trailer, heard someone yelling profanities outside. The officer stepped outside in the dark and looked around with his flashlight. He saw Griglione climbing over a fence with a large knife in his right hand. Griglione ran toward the officer, who drew his pistol and fired three times, fatally wounding Griglione. Griglione’s widow sued the officer, arguing that he was negligent per se [because he violated] his police department’s operating procedures by using deadly force, by failing to call for backup before shooting, and by failing to identify himself as a police officer before shooting. The preamble to the operating procedures stated that the document provided “guidelines that are suggested” for handling situations and that they were not meant “to assist in assessing . . . possible liability after the fact.” We concluded in Griglione that violations of the police department’s internal operating procedures were not negligence per se for two reasons. First, we held that the operating procedures “do not involve the delineation of that type of precise standard required to invoke the negligence per se doctrine.” Second, we stated that

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Part Two Crimes and Torts

only the violation of a rule applying “statewide” could constitute negligence per se. That statement was broader than necessary to decide the narrow issue of whether an officer’s violation of his department’s internal procedures is negligence per se. We could have answered “no” without addressing local ordinances that have the force of law. In  Wiersgalla v. Garrett, 486 N.W.2d 290 (Iowa  1992), we reiterated the governing standard as follows: [I]f a statute or regulation . . . provides a rule of conduct specifically designed for the safety and protection of a certain class of persons, and a person within that class receives injuries as a proximate result of a violation of the statute or regulation, the injuries “would be actionable, as . . . negligence per se.” To be actionable as such, however, the harm for which the action is brought must be of the kind which the statute was intended to prevent; and the person injured, in order to recover, must be within the class which [the statute] was intended to protect. Id. at 292 (internal citations omitted). We hold this standard applies equally to municipal ordinances. The ordinance at issue here requires 42-inch-high guardrails on second-floor or higher balconies. The obvious purpose for requiring a 42-inch-high guardrail on balconies above ground level is to protect persons from getting killed or injured falling off the balcony. Shannon clearly was within the scope of persons intended to be protected from injury by the municipal ordinance.  The requirement is sufficiently specific to prescribe a standard of care, the violation of which constitutes negligence per se.  See  O’Neil v. Windshire Copeland Assocs., L.P., 197 F. Supp. 2d 507 (E.D. Va. 2002)  (ruling that apartment owner was negligent per se for having balcony guardrail lower than required by city building code);  Heath v. La Mariana Apartments, 180 P.3d 664 (N.M. 2008) (violation of guardrail spacing requirement in ordinance would be negligence per se if not for grandfather provision excusing landlord from obligation to upgrade railings to current code). [Compare the cases just cited with] Brichacek v. Hiskey, 401 N.W.2d 44 (Iowa 1987) (holding the Des Moines municipal code provision

Causation of Injury Proof

that the defendant breached a duty does not guarantee that the plaintiff will win a negligence case. The plaintiff must also prove that the defendant’s breach caused her to experience injury. We shall look briefly at the injury component of this causation of injury requirement before examining the necessary causation link in greater depth.

requiring a “working lock” lacked the requisite specificity for negligence per se), and Struve v. Payvandi, 740 N.W.2d  436 (Iowa Ct. App. 2007) (holding statutory requirement to maintain heating appliances in a safe and working order was not specific enough to support negligence per se theory). CM’s argument that only a violation of a statewide law can be negligence per se conflicts with Iowa’s public policy encouraging local control over residential housing for public health and safety. The legislature has specifically allowed local housing ordinances [that are] more stringent than statewide standards.  See  Iowa Code § 562A.15(1)(a)  (requiring the landlord to follow greater duties imposed by local building or housing codes that materially affect health and safety).  Our legislative enactments thus tolerate local variations in housing codes. Although building codes may differ on either side of a city’s boundary, buildings are in fixed locations. Building owners will not have to deal with inconsistent local codes at a single location. We see no good reason to limit application of the negligence per se doctrine to laws of statewide application. The negligence per se doctrine [can be applied regarding violations of] local ordinances. [Therefore, the trial court erred in its post-trial ruling that negligence per se was inapplicable, and the court of appeals erred in affirming that ruling. However, because the trial judge’s instructions to the jury contemplated that the later code provision requiring 42-inch-high guardrails applied as a matter of law, the jury verdict in favor of the plaintiffs could not simply be reinstated. The record produced at trial was insufficient to allow a determination as a matter of law on the question whether the later code provision applied, or whether the 1968 code provision instead applied because of grandfathering. Hence, a remand for a new trial was necessary.] Court of Appeals decision vacated; trial court’s post-trial ruling on negligence per se issue reversed; other trial court orders affirmed in part and reversed in part; case remanded for new trial.

Types of Injury and Damages LO7-7

Identify the types of injuries or harms for which a plaintiff may recover compensatory damages in a negligence case.

Personal injury—also called “physical” or “bodily” injury— is harm to the plaintiff’s body. It is the type of injury present



Chapter Seven Negligence and Strict Liability

in many negligence cases. Plaintiffs who experienced personal injury and have proven all elements of a negligence claim are entitled to recover compensatory damages. These damages may include not only amounts for losses such as medical expenses or lost wages but also sums for pain and suffering. Although the nature of the harm may make it difficult to assign a dollar value to pain and suffering, we ask judges and juries to determine the dollar value anyway. The rationale is that the plaintiff’s pain and suffering is a distinct harm resulting from the defendant’s failure to use reasonable care, and that merely totaling up the amounts of the plaintiff’s medical bills and lost wages would not compensate the plaintiff for the full effects of the defendant’s wrongful behavior. Property damage—harm to the plaintiff’s real estate or a personal property item such as a car—is another recognized type of injury for which compensatory damages are recoverable in negligence litigation. In other negligence cases, many of which arise in business or professional contexts, no personal injury or property damage is involved. Instead, the plaintiff’s injury may take the form of economic loss such as out-of-pocket expenses, lost profits, or similar financial harms that resulted from the defendant’s breach of duty but have no connection to personal injury or property damages. Compensatory damages are available for losses of this nature in appropriate cases. Whatever the type of injury experienced by the plaintiff, the usual rule is that only compensatory damages are

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recoverable in a negligence case. As noted in Chapter 6, punitive damages tend to be reserved for cases involving flagrant wrongdoing. Negligence amounts to wrongdoing, but not of the more reprehensible sort typically necessary to trigger an assessment of punitive damages. What if the plaintiff’s claimed injury is emotional in nature? As you learned in Chapter 6, the law has long been reluctant to afford recovery for purely emotional harms. Until fairly recently, most courts would not allow a plaintiff to recover damages for emotional harms allegedly resulting from a defendant’s negligence unless the plaintiff proved that she experienced a physical injury or at least some impact on or contact with her person. Growing numbers of courts have abandoned the physical injury and impact rules and allow recovery for foreseeable emotional harms that stand alone, but clearly not all have done so. Among courts that still require either physical injury or impact as a general rule when emotional distress damages are sought, many have recognized exceptions to that general rule in particular instances where emotional harm seems especially likely to occur and especially likely to be severe. In Philibert v. Kluser, which follows, the court decides on the appropriate legal treatment of “bystander” emotional distress cases—those in which a person died as a result of the defendant’s negligence and a member of the decedent’s family witnessed the fatal injuries as they were being inflicted.

Philibert v. Kluser   385 P.3d 1038 (Ore. 2016) Three brothers—ages 12, 8, and 7, respectively—were crossing a street together in an Oregon city. While the brothers were in the crosswalk with the stoplight’s walk signal in their favor, Dennis Kluser drove his pickup truck through the crosswalk. The truck ran over the 7-yearold boy and narrowly missed the other two. The brother who was struck died at the scene. The other two boys witnessed their brother’s death. Acting in her capacity as guardian ad litem for the surviving brothers, Stacy Philibert brought a negligence lawsuit against Kluser. (Because Philibert brought the case for the benefit of the 12- and 8-year-old brothers, they will often be referred to as “the plaintiffs” in this statement of facts and in the edited version of the court’s opinion.) The complaint alleged that as a result of witnessing their brother’s death, the boys experienced severe emotional distress, depression, post-traumatic stress disorder, aggression, and severe anxiety. The defendant moved to dismiss the complaint for failure to state a claim upon which relief could be granted. He argued that because the plaintiffs were by­standers who had experienced neither a physical injury nor a physical impact in the accident, they could not recover for their emotional distress. The trial court granted the dismissal motion. The plaintiffs appealed to the Oregon Court of Appeals, which affirmed the trial court’s ruling. The plaintiffs then appealed to the Supreme Court of Oregon.  Balmer, Chief Justice This case requires us to consider the circumstances, if any, under which damages may be recovered by a bystander who suffers serious emotional distress as a result of observing the negligent

physical injury of another person. Plaintiffs witnessed the death of a family member who was run over by a truck, but were not themselves physically injured.  They sought recovery for their emotional distress. The trial court dismissed the action and the

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Court of Appeals affirmed, both relying on the “impact rule.” The impact rule allows a plaintiff to seek damages for negligently caused emotional distress only if the plaintiff can show some physical impact to himself or herself [. We must decide whether the rule applies here or whether, under the circumstances present here, the ] plaintiffs should be able to pursue their claims notwithstanding the fact that they did not suffer physical injury [or a physical impact]. [In their decisions, the trial court and the Court of Appeals relied on Saechao v. Matsakoun, 717 P.2d 165 (Ore. Ct. App. 1986).] In Saechao, the Court of Appeals confronted a situation factually similar to the present case. A driver negligently drove a car onto a sidewalk, killing one child, striking a sibling, and leaving two additional siblings untouched.  The three surviving children sued to recover for the emotional distress caused by witnessing their brother’s death. The court recognized the case as presenting a question of first impression[:] “[whether, and if so, when] a person who witnesses the negligently caused injury or death of a member of the immediate family may recover damages for serious emotional distress resulting from witnessing the accident.” A divided court adopted the impact rule, requiring that there be “a direct accompanying [physical] injury to the person who suffers the emotional distress as a prerequisite to its compensability.” As a result, the child who was physically injured was permitted to seek emotional distress damages caused by witnessing his brother’s death, but the claims by the two siblings who were not physically injured were dismissed. The Court of Appeals has continued to follow the impact rule in subsequent cases, as it did here. We directly address the bystander recovery issue [in this court] for the first time. In  Norwest v. Presbyterian Intercommunity Hospital, 652 P.2d 318 (Ore. 1982), we mapped the landscape of cases addressing claims for emotional distress damages. Oregon allows plaintiffs to recover damages for emotional distress when they are physically injured, and when the defendant acted intentionally. At issue here is a third basis recognized in Norwest for recovery of damages for emotional distress: when a defendant negligently causes foreseeable, serious emotional distress and also infringes some other legally protected interest. The plaintiff’s claim in that circumstance partially resembles [other] negligence claims in that it rests on the concept of foreseeability. Norwest made clear, however, that the injury’s foreseeability, standing alone, is insufficient to establish the defendant’s liability: there must also be another legal source of liability for the plaintiff to recover emotional distress damages. Those two concepts identified in Norwest—­foreseeability and the source of a legally protected interest—guide our analysis in this case. Perhaps the simplest legally protected interest is that to be free from physical harm at the hands of another. Labeling freedom

from physical harm as a legally protected interest for purposes of recovering emotional distress damages under the third category outlined in Norwest is simply a different way of stating the general rule that emotional distress damages are available to a plaintiff who is physically injured. In contrast to physical harms, emotional harms occur frequently. Any number of people may suffer  emotional distress as the foreseeable result of a single negligent act. The Restatement  (Third) of Torts provides an example: “[A] negligent airline that causes the death of a beloved celebrity can foresee genuine emotional harm to the celebrity’s fans, but no court would permit recovery for emotional harm under these circumstances.”  Restatement (Third)  § 48, comment g. For that reason, foreseeability, standing alone, is not a useful limit on the scope of liability for emotional injuries. Without some limiting principle in addition to foreseeability, permitting recovery for emotional injuries would create indeterminate and potentially unlimited liability. Nevertheless, even where a plaintiff has not been physically harmed, recovery for foreseeable emotional damages is available when the defendant’s conduct “infringed some legally protected interest apart from causing the claimed distress.” Norwest, supra. In the context of emotional distress, a legally protected interest is “an independent basis of liability separate from the general duty to avoid foreseeable risk of harm.” [Citation omitted.] The right to recovery for such injuries does not “arise from infringement of every kind of legally protected interest, but from only those that are of sufficient importance as a matter of public policy to merit protection from emotional impact.” [Citation omitted.] See, e.g., Hovis v. City of Burns, 415 P.2d 29 (Ore 1966)  (allowing claim for emotional damages on the basis of infringement of right of a surviving spouse to have the remains of a deceased spouse undisturbed). In contrast, this court has denied recovery to plaintiffs for emotional injuries resulting from a defendant’s negligence when there is no independent legal source of liability. See, e.g., Hammond v. Central Lane Communications Center, 816 P.2d 593 (Ore. 1991) (denying recovery to wife who claimed emotional injury caused by watching husband die from heart attack while 911 system negligently delayed response because she had not “point[ed] to some legally protected interest of hers that defendants violated”). We now turn to the bystander’s claim for negligently inflicted emotional distress. Plaintiffs assert a common law right of a bystander to avoid observing the physical injury of a close family member as [an important enough legal interest] to support their claims. This court has not had occasion to previously consider such a bystander claim. Our prior cases, however, have allowed claims for negligently inflicted emotional distress to proceed when the court has determined that an asserted common law



Chapter Seven Negligence and Strict Liability

interest is sufficiently important to support the imposition of liability. The negligent handling of a spouse’s remains in Hovis [is an example]. In our view, the interest in avoiding being a witness to the negligently caused traumatic injury or death of a close family member is similarly important. Witnessing sudden physical injury or death is a palpable and distinct harm, different in kind even from the emotional distress that comes with the inevitable loss of our loved ones. Plaintiffs here watched as their younger brother was crushed by a pickup truck—a violation of their interest in not witnessing such a shocking and tragic event. And the resulting impact on them might be described as the emotional equivalent of a physical injury. We have no difficulty concluding that plaintiffs have alleged the violation of a legally protected common law interest to be free from the kind of emotional distress injury caused by defendant’s negligence here. Our remaining task is to frame the contours of that interest and identify the elements that will allow a bystander to recover for the negligent infliction of emotional distress, while also providing a limiting principle that will avoid potentially unlimited claims or damages. To do so, we consider three tests  that courts commonly have used in similar cases: the impact test, the zone of danger test, and the Restatement (Third) approach. The Impact Test The impact rule allows a plaintiff to recover for emotional distress when he or she also has suffered a physical injury [or at least a physical impact]. The Court of Appeals in Saechao applied that general rule to bystander cases. Proponents of the impact rule claim that its merit lies in the bright line test for liability that it creates [and in the] “guarantee that the mental disturbance is genuine.” [Citation omitted.] The impact rule is problematic, however, because  it sets a bar to recovery in bystander cases that can be both too high and too low. The bar is often too high because there is no principled reason to deny recovery for negligently caused emotional injury simply because the physical contact was with a third person rather than the plaintiff. The facts of this case illustrate that point. Plaintiffs witnessed the traumatic death of their brother, but under the impact rule were denied recovery because the truck did not touch them. Yet, their distress at witnessing the death of their brother is likely unrelated to the coincidental fact that the truck did not hit them also. To deny recovery because . . . the plaintiffs [were not] physically injured—when even a minor physical impact is sufficient under that test—seems arbitrary and fails to protect plaintiffs’ interest in avoiding witnessing the negligently caused death of their brother. At the same time, the impact rule sets the bar too low in other circumstances,

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because a minor injury unrelated to the emotional distress satisfies the impact requirement and permits the claim to proceed.  The impact rule bars plaintiffs who have suffered genuine serious emotional distress from recovering and fails to treat like cases alike. We therefore reject the impact rule as the test for a bystander’s recovery of emotional distress resulting from injury to another. The Zone of Danger Test Plaintiffs suggest that we permit their recovery under the zone of danger test, which is used by some courts to allow recovery to a plaintiff who experiences “serious emotional distress due to witnessing a fatal injury to a third person only if the plaintiff was personally within the zone of danger of physical impact from the defendant’s negligence.” [Citation omitted.] Although the zone of danger test found some favor, California notably abandoned [it] in Dillon v. Legg, 441 P.2d 912 (Cal. 1968). In that case, a child’s sister, standing close by, and her mother, standing down the block, observed a negligent driver kill the child. The court rejected the zone of danger rule and allowed both witnesses to proceed with their claims for emotional distress. The court explained that rejecting the zone of danger test logically follows rejecting the impact test. Neither test actually relates to the likelihood or severity of the emotional distress that can result from seeing a close family member suffer serious injury. In practice, the zone of danger test results in unfairly denying  recovery to plaintiffs who are located outside the zone of physical danger, but witness the physical injury to the third person just the same as if they had been in that zone, as the facts of Dillon demonstrate. We are persuaded by the reasoning of the California Supreme Court in Dillon and decline to adopt the zone of danger test. The Restatement (Third) Rule A number of authorities have attempted to articulate a test for bystander recovery that avoids the somewhat arbitrary aspects of the impact and zone of danger tests, while limiting the potential for indeterminate and excessive liability for emotional distress claims. Probably the most thoughtful recent formulation is found in the Restatement (Third) of Torts § 48, which builds on  Dillon  and similar cases. Under that approach, a defendant “who negligently causes sudden serious bodily injury to a third person is subject to liability for serious emotional harm caused thereby to a person who (a) perceives the event contemporaneously, and (b) is a close family member of the person suffering the bodily injury.”  Restatement  (Third) § 48. In our view, that test hews closely to the interest that should be legally protected, while also recognizing necessary limits on potential liability and providing at least some guidance to courts

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Part Two Crimes and Torts

and juries. Moreover, the Restatement (Third) test is generally consistent with this court’s cases dealing with other aspects of claims for negligently caused serious emotional distress. We turn to a closer examination of the rule articulated in the Restatement (Third). The first element is that the bystander must witness a sudden, serious physical injury to a third person negligently caused by the defendant. Hammond presented a situation in which that element was not present. There, the plaintiff awoke to find her husband lying on the floor, apparently the victim of heart attack. The plaintiff sought to recover for her severe emotional distress, alleging that if the defendant 911 service had arrived in the “couple of minutes” that the 911 operator predicted, rather than after the 45 minutes that actually elapsed, she would not have suffered emotional distress. This court did not allow recovery. Although the defendant may have contributed to the death by failing to respond quickly enough, the defendant did not cause the actual physical injury—the heart attack. Second, the plaintiff must have suffered serious emotional distress. It is a truism that emotional distress is an unavoidable and essential part of life. For that reason, our cases allow compensation for only serious emotional distress. A bystander who experiences emotional harm that does not rise to the level of  serious emotional distress, therefore, cannot  recover for that harm. Third, in order to recover, the plaintiff must have perceived the events that caused injury to the third person as they occurred. This contemporaneous perception is at the core of the bystander’s action for damages. Observation of the scene of an accident after it has happened, or perceiving a recently injured person, does not meet this requirement. This bright line rule is justified in part by the fact that the distressing life experience of learning about the death or injury of a loved one is unavoidable. In comparison, the visceral experience of witnessing the sudden death or injury of a loved one by a negligent driver, as here, is not a certain part of life and therefore presents a stronger basis for allowing recovery against the tortfeasor. The final element of the claim is that the physically injured person be a close family member of the plaintiff. Witnessing the

injury of a stranger or acquaintance, while likely distressing, is not sufficient to recover. The fraternal relationship of plaintiffs here to the person killed meets that requirement, but other cases may present closer questions as to the meaning of “close family member.”  See  Restatement (Third) § 48 (“[A] grandparent who lives in the household may have a different status from a cousin who does not.”). We recognize that the bystander recovery rule outlined in the  Restatement (Third)  may give rise to the possibility of false or inflated claims and that aspects of the rule may seem arbitrary. For as long as courts have awarded damages for emotional injuries, there have been concerns about plaintiffs bringing false claims. Juries are charged with discerning truth from self-serving fiction when plaintiffs testify about their own injuries and are as competent to do this in claims for emotional injuries as they are in other cases. The Restatement (Third) rule [includes] elements that, on the basis of human experience, are objective indicators of possibly serious emotional injury. When the elements of the test are met, a plaintiff’s claims of subjective emotional distress are more likely to be genuine. The  Restatement  (Third) rule may have the effect of permitting some claims that would be rejected under other tests, and vice-versa. In this area of the law in particular, some arbitrariness cannot be avoided. But although the rule may be arbitrary in some circumstances, it “serve[s] a function and [is] neither random nor irrational.” Restatement (Third) § 48, comment g. The undesirable arbitrary aspect of rules must be balanced against the need to provide ex ante understanding of liability and assistance in the orderly administration of justice. We return to the facts of this case. Plaintiffs are two brothers who watched their brother die as a result of being hit by defendant’s negligently driven pickup truck. They allege emotional injuries, including depression and severe emotional distress. Examined in the light of the  Restatement  (Third) test set forth above, plaintiffs here state a negligence claim for recovery of emotional distress damage. 

The Causation Link Even if the defendant has breached a duty and the plaintiff has suffered actual injury, there is no liability for negligence without the necessary causation link between breach and injury. The causation question involves three issues: (1) Was the breach an actual cause of the injury? (2) Was the breach a proximate cause

of the injury? and (3) What was the effect of any intervening cause arising after the breach and helping to cause the injury? Both actual and proximate causes are necessary for a negligence recovery. Special rules dealing with intervening causes sometimes apply, depending on the facts of the case.

Court of Appeals decision reversed; case remanded to trial court for further proceedings.



Chapter Seven Negligence and Strict Liability

Actual Cause LO7-8

Explain the difference between actual cause and proximate cause.

Suppose that Dullard drove his car at an excessive speed on a crowded street and was therefore unable to stop the car in time to avoid striking and injuring Pence, who had lawfully entered the crosswalk. Dullard’s conduct, being inconsistent with the behavior of a reasonable driver, was a breach of duty that served as the actual cause of Pence’s injuries. To determine the existence of actual cause, courts often employ a “but-for” test. This test provides that the defendant’s conduct is the actual cause of the plaintiff’s injury when the plaintiff would not have been hurt but for (i.e., if not for) the defendant’s breach of duty. In the example employed above, Pence clearly would not have been injured if not for Dullard’s dutybreaching conduct. In some cases, however, a person’s negligent conduct may combine with another person’s negligent conduct to cause a plaintiff’s injury. Suppose that fires negligently started by Dustin and Dibble combine to burn down Potter’s house. If each fire would have destroyed Potter’s house on its own, the but-for test could absolve both Dustin and Dibble. In such cases, courts apply a different test by asking whether each defendant’s conduct was a substantial factor in bringing about the plaintiff’s injury. Under this test, both Dustin and Dibble are likely to be liable for Potter’s loss. Proximate Cause LO7-8

Explain the difference between actual cause and proximate cause.

The plaintiff who proves actual cause has not yet established the causation link necessary to enable her to win the case. She must also establish the existence of proximate cause—a task that sometimes, though clearly not always, is more difficult than proving actual cause. Questions of proximate cause assume the existence of actual cause. Proximate cause concerns arise because it may sometimes seem unfair to hold a defendant liable for all the injuries actually caused by his breach—no matter how remote, bizarre, or unforeseeable they are. Thus, courts typically say that a negligent defendant is liable only for the proximate results of his breach. Proximate cause, then, concerns the required degree of proximity or closeness between the defendant’s breach and the injury it actually caused.

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Courts have not reached complete agreement on the appropriate test for resolving the proximate cause question. In reality, the question is one of social policy. When deciding which test to adopt, courts must recognize that negligent defendants may be exposed to catastrophic liability by a lenient test for proximate cause, but that a restrictive test prevents some innocent victims from recovering damages for their losses. Courts have responded in various ways to this difficult question. A significant number of courts have adopted a test under which a defendant who has breached a duty of care is liable only for the “natural and probable consequences” of his actions. In many negligence cases, the injuries actually caused by the defendant’s breach would easily qualify as natural and probable consequences because they are the sorts of harms that are both likely and logical effects of such a breach. The Dullard–Pence scenario discussed earlier would be an example. It is to be expected that a pedestrian struck by a car would sustain personal injury. In other negligence cases, however, either the fact that the plaintiff was injured or the nature of his harms may seem unusual or in some sense remote from the defendant’s breach, despite the existence of an actual causation link. The presence or absence of proximate cause becomes a more seriously contested issue in a case of that nature. A great deal will depend upon how narrowly or broadly the court defines the scope of what is natural and probable. Other courts have limited a breaching defendant’s liability for unforeseeable harms by stating that he is liable only to plaintiffs who were within the “scope of the foreseeable risk.” This proximate cause test bears similarity to a key test for determining whether the duty element of a negligence claim exists. As earlier discussion noted, courts typically hold that a defendant owes no duty to those who are not foreseeable “victims” of his actions. The Restatement (Second) of Torts takes yet another approach to the proximate cause question. It suggests that a defendant’s breach of duty is not the legal (i.e., proximate) cause of a plaintiff’s injury if, looking back after the harm, it appears “highly extraordinary” to the court that the breach would have brought about the injury. Further discussion of proximate cause issues can be found in the Stahlecker case, which appears in this chapter’s later discussion of intervening causes. In Black v. William Insulation Co., which follows, the court rests its decision on the duty element of a negligence claim but engages in considerable discussion of the proximate cause concept.

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Part Two Crimes and Torts

Black v. William Insulation Co.   141 P.3d 123 (Wyo. 2006) William Insulation Co. (WIC) was a subcontractor on an expansion project at the Exxon/LaBarge Shute Creek Plant. The plant was located in a remote Wyoming area approximately 26 and 40 miles, respectively, from the nearest population centers, the towns of Green River and Kemmerer. Given the remoteness of the work site, WIC provided $30 per day in subsistence pay to each of its employees to defer part of the cost of a motel room or apartment in Green River or Kemmerer. WIC did not require its employees to spend the money on lodging. The employees were free to spend it—or not spend it—as they saw fit. David Ibarra-Viernes, a WIC employee, was assigned to work on the above-described expansion project. Ibarra-Viernes received the $30 per day subsistence pay from WIC but elected to make the commute to the plant from his home in Evanston, Wyoming, which was 90 miles away. Ibarra-Viernes carpooled with a group of co-workers, who took turns driving. Ibarra-Viernes’s work schedule was ­Monday through Friday, 7:00 A.M. to 5:30 P.M., with a half-hour lunch and no, or minimal, breaks. In addition to his employment with WIC, Ibarra-Viernes worked a second job at night, washing dishes at a restaurant. Ibarra-Viernes completed his regular shift at the plant on a Tuesday and returned to Evanston at 8:30 P.M. He then worked his second job before going to bed around 11:00 P.M. Ibarra-Viernes rose at 4:00 A.M. on Wednesday to get his vehicle and collect his co-workers for the daily commute to the plant, where he worked his normal shift. The car pool, with Ibarra-Viernes driving, left the plant around 6:00 P.M. Shortly thereafter, Ibarra-Viernes fell asleep at the wheel. His vehicle crossed the centerline of the highway and collided head-on with a vehicle in which Richard Black was a passenger. Richard Black died in the accident. His widow, Peggy Ann Cook Black, acting in her own right and as personal representative of her late husband’s estate, filed a negligence-based wrongful death action against WIC in a Wyoming state court. In her lawsuit, Black claimed that WIC owed a duty of care to other travelers on the highway to prevent injury caused by employees who had become exhausted after being required to commute long distances and work long hours. She contended in her complaint that WIC breached its duty by “failing to take precautionary measures to prevent employees from becoming so exhausted that they pose a threat of harm to the traveling public and failing to provide alternative transportation to its exhausted employees or, in the alternative, failing to provide living quarters to its employees within a reasonable distance from the plant site.” The district court granted WIC’s motion for summary judgment, concluding that WIC did not owe a duty to the decedent. Black appealed to the Supreme Court of Wyoming. Hill, Justice Black sets out [this issue] on appeal: Did the trial court err in failing to recognize a duty of care from an employer to innocent third parties who are injured, or in this case, killed, by its employees who are exhausted due to the working conditions imposed by the employer and thus fall asleep at the wheel? WIC responds [by arguing that] Wyoming law does not, and should not, impose a legal duty of reasonable care on Wyoming employers to protect the motoring public from the negligence of their off-duty employees when those off-duty employees drive to and from their Wyoming worksites in their personal vehicles outside the scope of their employment. “Whether a legal duty exists is a question of a law, and absent a duty, there is no liability.” [Citation omitted.] A duty may arise by contract, statute, common law, “or when the relationship of the parties is such that the law imposes an obligation on the defendant to act reasonably for the protection of the plaintiff.” [Citation omitted.] In deciding whether to adopt a particular tort duty, a court’s focus must be much broader than just the case at hand. “The judge’s function in a duty determination involves complex considerations of legal and social policies which will

directly affect the essential determination of the limits to government protection. Consequently, . . . the imposition and scope of a legal duty is dependent not only on the factor of foreseeability but involves other considerations, including the magnitude of the risk involved in defendant’s conduct, the burden of requiring defendant to guard against that risk, and the consequences of placing that burden upon the defendant.” [Citations omitted.] In Gates v. Richardson, 719 P.2d 193 (Wyo. 1986), we further detailed the factors to be considered: (1) the foreseeability of harm to the plaintiff, (2) the closeness of the connection between the defendant’s conduct and the injury suffered, (3) the degree of certainty that the plaintiff suffered injury, (4) the moral blame attached to the defendant’s conduct, (5) the policy of preventing ­future harm, (6) the extent of the burden upon the defendant, (7) the consequences to the community and the court ­system, and (8) the availability, cost and prevalence of insurance for the risk involved. [Citations omitted.] Before we can proceed to our analysis, we must identify the nature of the duty that Black seeks to impose on WIC. Black insists that she is not seeking . . . to establish a broad duty of care for



Chapter Seven Negligence and Strict Liability

an employer to control an off-duty employee’s conduct. Instead, she argues that an employer has an obligation to ensure that the conditions of employment do not cause an employee to become fatigued and, to the extent that they do, the employer has a duty to take reasonable actions to protect the traveling public from the foreseeable consequences of those employees traveling from their worksite. Essentially, the question of duty that we must determine in this case is whether WIC’s actions and/or inactions prior to the accident created a foreseeable risk of harm that the employer had a duty to guard against. In other words: whether or not Ibarra- Viernes’s fatigue arose out of, and in the course of, his employment. We turn to the first Gates factor: The foreseeability of harm to the plaintiff. We recently stated that this factor is essentially a consideration of proximate cause. Proximate cause [exists when] “the accident or injury [is] the natural and probable consequence of the act of negligence.” [Citation omitted.] The ultimate test of proximate cause is foreseeability of injury. In order to qualify as a legal cause, the conduct must be a substantial factor in bringing about the plaintiff’s injuries. The question then is whether or not WIC’s conduct was a substantial factor in bringing about the death of the decedent. Or more precisely, a showing of causation necessitates a showing that Ibarra-Viernes’s work was a substantial contributing factor to his fatigue. This means that for an “employer to be liable for the actions of a fatigued employee on a theory of negligence, the fatigue must arise out of and in the course of employment . . . [because] . . . [t]o hold otherwise would charge an employer with knowledge of circumstances beyond his control.” [Citation of quoted article omitted.] Black contends that the accident was a foreseeable consequence of WIC’s conduct. Specifically, she claims that . . . WIC required its employees to work long hours and make long commutes. She argues that workers who were commuting and working twelve to fourteen hours a day would not have sufficient time in the day to take care of life activities and still get sufficient sleep. Given these conditions, Black contends that without employer supplied alternatives such as bus transport, it was foreseeable that sleep-deprived workers would likely fall asleep and cause injury to other travelers on the roads. The most obvious factor within the employer’s control that could cause fatigue in an employee is the number of hours the employee is required to work. On the day of the accident and those preceding it, Ibarra-Viernes worked his normal shift of ten hours. A ten-hour shift within a twenty-four-hour period is not, on its face, an objectively unreasonable period of work when compared with those situations where an employer was held liable for the damages caused by a fatigued employee driving home from work. Compare Robertson v. LeMaster, 301 S.E.2d 563, 568–69 (W. Va. 1983) (employee required to work 32 consecutive hours) and Faverty v. McDonald’s Restaurants of Oregon,

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Inc., 892 P.2d 703, 705 (Ore. App. 1995) (18-year-old employee worked 121⁄2 hours in a 17-hour period). Crucially, in both of those cases, the employers had actual knowledge of their employee’s fatigued state. There is no evidence that WIC had notice that Ibarra-Viernes was fatigued on the day of the accident. Black seeks to expand Ibarra-Viernes’s hours of work to include the time of his commute, claiming that WIC “required” him to make the lengthy drive to and from the plant [by not providing alternative transportation such as a bus]. First, Black cites no authority for the proposition that WIC was required to provide its employees with alternatives, such as busing, to commuting. Furthermore, WIC did, in fact, provide an alternative to long-­distance commuting for its employees: WIC provided its employees, including Ibarra-Viernes, with a daily $30 subsistence payment to partially offset the cost of taking lodging closer to the worksite. Ibarra-Viernes, however, elected to pocket that money and commute every day from his home in Evanston. That was a voluntary choice made by Ibarra-Viernes. In making her argument, Black fails to address a significant factor: Ibarra-Viernes’s decision to work a second job. After returning to Evanston upon completion of his work day for WIC, IbarraViernes would go to a second job at a restaurant. On the night before the accident, Ibarra-Viernes stated that he returned home about 8:30 pm and then went to work [at] his second job. IbarraViernes said he got to bed around 11:00 pm that night. Certainly, the second job had an effect on Ibarra-Viernes’s ability to get rest, if not actual sleep. Ibarra-Viernes admitted that he normally got only about five to six hours of sleep a night. Nevertheless, Black neglects to discuss the consequences of the second job in her brief. Her failure to do so seriously undermines her argument. Ibarra-Viernes had 131⁄2 hours between shifts during the work week. The burden was on him to manage his own time to ensure that he was capable of performing his job. Ibarra-Viernes elected to expend a significant portion of his time making a lengthy commute and working a second job. These were voluntary decisions made by Ibarra-Viernes for which he is responsible. Under these circumstances, it cannot be said that his employment was the substantial factor in contributing to Ibarra-Viernes’s fatigue. We conclude that decedent’s injuries were not the “natural and probable consequence of ” any acts of negligence by WIC in the course of Ibarra-Viernes’s employment; rather, the decisions and conduct of Ibarra-Viernes were the substantial factor that brought about the injuries. Since the harm to Black’s decedent was not a foreseeable consequence of WIC’s actions (or inactions), we decline to impose a duty under the circumstances. Given this conclusion, the remaining Gates factors are not persuasive, and we decline to discuss them.

Grant of summary judgment to WIC affirmed.

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Part Two Crimes and Torts

Later Acts, Forces, or Events In some cases, an act, force, or event occurring after a defendant’s breach of duty may play a significant role in bringing about or worsening the plaintiff’s injury. For example, suppose that after Davis negligently starts a fire, a high wind comes up and spreads the fire to Parker’s home, or that after Davis negligently runs Parker down with his car, a thief steals Parker’s wallet while he lies unconscious. If the later act, force, or event was foreseeable, it will not relieve the defendant of liability. So, if high winds are an occurrence that may reasonably be expected from time to time in the locality, Davis is liable for the damage to Parker’s home even though his fire might not have spread that far under the wind conditions that existed when he started it. In the second example, Davis is liable not only for Parker’s physical injuries but also for the theft of Parker’s wallet if the theft was foreseeable, given the time and location of the accident. (The thief, of course, would also be liable for the theft.) LO7-9

Explain what an intervening cause is and what effect it produces.

Intervening Causes On the other hand, if the later act, force, or event that contributes to the plaintiff’s injury was unforeseeable, most courts hold that it is an intervening cause, which absolves the defendant of liability for harms that resulted directly from the intervening cause. For example, Dalton negligently starts a fire that causes injury to several persons. The driver of an ambulance summoned to the scene has been drinking on duty and, as a result, loses control of his ambulance and runs up onto a sidewalk, injuring several pedestrians. Given the nature of the ambulance driver’s position, his drinking while on duty is likely to make the ambulance crash an unforeseeable event and thus an intervening cause. Most courts, therefore, would not hold Dalton responsible for the pedestrians’ injuries. The ambulance driver, of course, would be liable to those he injured. An important exception to the liability-absolving effect of an intervening cause deals with unforeseeable later events that produce a foreseeable harm identical to the harm risked by the defendant’s breach of duty. Why should the defendant escape liability on the basis that an easily foreseeable

consequence of its conduct came about through unforeseeable means? For example, if the owners of a concert hall negligently fail to install the number of emergency exits required by law, the owners will not escape liability to those burned and trampled during a fire just because the fire was caused by an insane concertgoer who set himself ablaze. As suggested by some of the examples used above, when a defendant’s breach of duty is followed by a third party’s criminal or other wrongful act, the later act may be either foreseeable or unforeseeable, depending on the facts and circumstances. This state of affairs reflects the prevailing modern approach, which differs sharply from the traditional view that third parties’ criminal acts were unforeseeable as a matter of law and thus were always intervening causes serving to limit or eliminate the original defendant’s negligence liability. Today, courts do not hesitate to classify a third party’s criminal act as foreseeable if the time and place of its commission and other relevant facts point to such a conclusion. Assume, for instance, that XYZ Inc. owns an apartment complex at which break-ins and prior instances of criminal activity had occurred. XYZ nevertheless fails to adopt the security-related measures that a reasonable apartment complex owner would adopt. As a result, a criminal intruder easily enters the complex. He then physically attacks a tenant. Because the intruder’s act is likely to be seen as foreseeable— and thus not an intervening cause—XYZ faces negligence liability to the tenant for the injuries that the intruder directly inflicted on the tenant. (The intruder, of course, would face both criminal and civil liability for battery, but if his financial assets are limited, the injured tenant may find collecting a damages award from him either difficult or impossible.) Note that for purposes of the tenant’s negligence claim, XYZ’s breach of duty was a substantial factor in bringing about the plaintiff’s injuries because the lack of reasonable security measures allowed the intruder to gain easy access to the premises. XYZ’s breach thus would be considered the actual cause of the tenant’s injuries under the previously discussed substantial factor test. It would also be considered the proximate cause under the various tests described earlier. The Stahlecker case, which follows, illustrates the operation of intervening cause principles.

Stahlecker v. Ford Motor Co.   667 N.W.2d 244 (Neb. 2003) During the early morning hours, Amy Stahlecker was driving a 1997 Ford Explorer equipped with Firestone Wilderness AT radial tires in a remote area of Nebraska. One of the tires failed, rendering the vehicle inoperable. Richard Cook encountered Amy while she was stranded as a result of the tire failure. Cook abducted Amy, sexually assaulted her, and then murdered her.



Chapter Seven Negligence and Strict Liability

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Susan and Dale Stahlecker, acting on behalf of themselves and as personal representatives of their daughter’s estate, brought a wrongful death action in a Nebraska court against Cook, the Ford Motor Co. (manufacturer of the Explorer), and Bridgestone/Firestone Inc. (manufacturer of the tire that failed). The Stahleckers sought to make out negligence claims against Ford and Firestone. The plaintiffs alleged that Ford and Firestone knew of prior problems with the model of tire that was on the Explorer driven by Amy; knew those problems posed a greater-than-normal danger of tire failure; continued using a problematic model of Firestone tire on Explorers despite knowledge that tire failure would create a special risk of rollover and vehicle inoperability; failed to warn consumers of these dangers; and continued to advertise their tires and vehicles as suitable for uses of the sort Amy made immediately prior to the tire failure, even though they knew that drivers could become stranded in the event of tire failure. There was no allegation that the tire failure directly caused Amy to sustain physical harm prior to the obvious harm inflicted by Cook. A state district court sustained demurrers filed by Ford and Firestone and dismissed the case as to those parties. The court concluded that the Stahleckers had not stated a valid cause of action against Ford and Firestone because Cook’s criminal acts constituted an intervening cause that would relieve Ford and Firestone of any liability they might otherwise have had. The Stahleckers successfully petitioned to bypass the Nebraska Court of Appeals and pursue their appeal in the Supreme Court of Nebraska. Stephan, Judge In order to withstand a demurrer, a plaintiff must plead . . . “a narrative of events, acts, and things done or omitted which show a legal liability of the defendant to the plaintiff.” [Citation omitted.] In determining whether a cause of action has been stated, a petition is to be construed liberally. In order to prevail in a negligence action, a plaintiff must establish the defendant’s duty to protect the plaintiff from injury, a failure to discharge that duty, and damages proximately caused by the failure to discharge that duty. The concept of “foreseeability” is a component of both duty and proximate cause, although its meaning is somewhat different in each context. We have noted this distinction in recent cases: Foreseeability as a determinant of a [defendant’s] duty of care . . . is to be distinguished from foreseeability as a determinant of whether a breach of duty is a proximate cause of an ultimate injury. Foreseeability as it impacts duty determinations refers to the knowledge of the risk of injury to be apprehended. The risk reasonably to be perceived defines the duty to be obeyed; it is the risk reasonably within the range of apprehension, of injury to another person, that is taken into account in determining the existence of the duty to exercise care. . . . Foreseeability that affects proximate cause, on the other hand, relates to the question of whether the specific act or omission of the defendant was such that the ultimate injury to the plaintiff reasonably flowed from defendant’s breach of duty. . . . Foreseeability in the proximate cause context relates to remoteness rather than the existence of a duty. [Citations omitted.] [B]y alleging that Ford and Firestone failed to exercise reasonable care in designing and manufacturing their tires, and failed to warn users of potential tire defects, the Stahleckers have alleged the existence of a legal duty and a breach thereof by both Ford

and Firestone. The remaining issue is whether the breach of this duty was the proximate cause of Amy’s harm. The proximate cause of an injury is “that cause which, in a natural and continuous sequence, without any efficient, intervening cause, produces the injury, and without which the injury would not have occurred.” [Citation omitted.] Stated another way, a plaintiff must meet [these] basic requirements in establishing [causation]: (1) [the actual cause requirement] that without the negligent action, the injury would not have occurred, commonly known as the “but-for” rule; [and] (2) [the proximate cause requirement] that the injury was a natural and probable result of the negligence. [In addition, there cannot have been] an efficient intervening cause. As to the first requirement, a defendant’s conduct is the cause of the event if “the event would not have occurred but for that conduct; conversely, the defendant’s conduct is not a cause of the event if the event would have occurred without it.” [Citation omitted.] The petition alleges that Cook “found Amy alone and stranded as a direct result of the failure of the Firestone Wilderness AT Radial Tire and proceeded to abduct, terrorize, rape and murder Amy.” Firestone concedes that under the factual allegations of the Stahleckers’ petition—that “but for” the failure of its tire—Amy would not have been at the place where she was assaulted and murdered. The [tests governing] proximate cause [and intervening cause] are somewhat interrelated. Was the criminal assault and murder the “natural and probable” result of the failure to warn of potential tire failure, or did the criminal acts constitute an effective intervening cause that would preclude any causal link between the failure to warn and the injuries and wrongful death for which damages are claimed in this action? An efficient intervening cause is a new, independent force intervening between the defendant’s negligent act and the plaintiff’s injury. This force may be the conduct of a third person who had full control of the

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situation, whose conduct the defendant could not anticipate or contemplate, and whose conduct resulted directly in the plaintiff’s injury. An efficient intervening cause must break the causal connection between the original wrong and the injury. In Shelton v. Board of Regents, 320 N.W.2d 748 (Neb. 1982), we considered whether criminal conduct constituted an intervening cause. Shelton involved wrongful death claims brought on behalf of persons who were poisoned by a former employee of the Eugene C. Eppley Institute for Research in Cancer and Allied Diseases (the Institute). In their actions against the Institute . . . , the plaintiffs alleged that [even though] the former employee had a prior criminal conviction involving an attempted homicide, the Institute hired him as a research technologist and gave him access to the poisonous substance which he subsequently used to commit the murders. The plaintiffs alleged that the Institute was negligent in hiring the employee, in allowing him to have access to the poisonous substance, and in failing to monitor its inventory of the substance. The plaintiffs further alleged that the Institute’s negligence was the proximate cause of the injuries and deaths of the victims. The district court sustained a demurrer filed by the Institute and dismissed the actions. This court affirmed, holding . . . that the criminal acts of stealing the drug and administering it to the victims “were of such nature as to constitute an efficient intervening cause which destroys any claim that the alleged negligence of the [Institute] was the proximate cause of the appellants’ injuries and damage.” In reaching this conclusion, we relied upon Restatement (Second) of Torts § 448 (1965), which states the following rule: The act of a third person in committing an intentional tort or crime is a superseding cause of harm to another resulting therefrom, although the actor’s negligent conduct created a situation which afforded an opportunity to the third person to commit such a tort or crime, unless the actor at the time of his negligent conduct realized or should have realized the likelihood that such a situation might be created, and that a third person might avail himself of the opportunity to commit such a tort or crime. We held [in Shelton] that the employee’s criminal acts were the cause of the injuries for which damages were claimed and that “nothing which the [plaintiffs] claim the . . . Institute failed to do was in any manner related to those acts, nor could they have been reasonably contemplated by the . . . Institute.” We have, however, determined in certain premises liability cases and in cases involving negligent custodial entrustment that the criminal act of a third person does not constitute an efficient intervening cause. For example, in [one such case], a patron of a bar was seriously injured by another patron in the parking lot after the two were instructed by the bartender to take their argument “outside.” The injured patron sued the owner of the bar,

alleging that the owner negligently failed to contact law enforcement, maintain proper security on the premises, and properly train his personnel. [R]evers[ing] a judgment on a jury verdict in favor of the owner, . . . [w]e reasoned that because the harm resulting from a fight is precisely the harm against which [the owner] is alleged to have had a duty to protect [the patron], the “intervention” of [the other patron] cannot be said to be an independent act that would break the causal connection between [the owner’s] negligence and [the patron’s] injuries. [Citation omitted.] We employed similar reasoning in [two other cases that] involved negligent placement of juvenile wards of the state in foster homes without disclosure of their known histories of violent acts. In each of those cases, we held that criminal acts of foster children perpetrated upon members of the foster parents’ households could not be asserted as intervening causes to defeat liability for the negligent placement. Similarly, we recently held that a psychiatric patient’s criminal assault upon a nurse was not an intervening cause as to the negligence of a state agency which breached its duty to disclose the violent propensities of the patient at the time of his admission to the hospital where the assault occurred. These decisions were based upon the principle . . . that “once it is shown that a defendant had a duty to anticipate [a] criminal act and guard against it, the criminal act cannot supersede the defendant’s liability.” [Citation omitted.] This principle requires that we determine whether the duty owed to Amy by Ford and Firestone, as manufacturers and sellers of the allegedly defective tires, included a duty to anticipate and guard against criminal acts perpetrated against the users of such tires. [As illustrated by the previously discussed cases dealing with juvenile wards and psychiatric patients,] we have recognized a duty to anticipate and protect another against criminal acts where the party charged with the duty has some right of control over the perpetrator of such acts or the physical premises upon which the crime occurs. [We have] recognized a duty on the part of the owner of business premises to protect invitees from criminal assault where there had been documented criminal activity in the immediate vicinity of the premises. [In addition, we have] held that a university had a duty to protect a student from physical hazing conducted in a fraternity house where similar incidents were known to have occurred previously[, and] that a university “owes a landownerinvitee duty to its students to take reasonable steps to protect against foreseeable acts of violence on its campus and the harm that naturally flows therefrom.” [Citation omitted.] However, we have adopted Restatement (Second) of Torts § 315 (1965), which provides:



Chapter Seven Negligence and Strict Liability

There is no duty so to control the conduct of a third person as  to prevent him from causing physical harm to another ­unless . . . a special relation exists between the actor and the third person which imposes a duty upon the actor to control the third person’s conduct, or . . . a special relation exists ­between the actor and the other which gives to the other a right to protection. We have found no authority recognizing a duty on the part of the manufacturer of a product to protect a consumer from criminal activity at the scene of a product failure where no physical harm is caused by the product itself. The Stahleckers argue that a duty to anticipate criminal acts associated with product failure arises from their allegations that Ford and Firestone knew or should have known of “the potential for similar dangerous situations arising as a result of a breakdown of a Ford Explorer and/or its tires.” They also allege that Ford and Firestone had or should have had “knowledge, to include statistical information, regarding the likelihood of criminal conduct and/or sexual assault against auto and tire industry consumers as a result of unexpected auto and/or tire failures in general.” Assuming the truth of these allegations, the most that can be inferred is that Ford and Firestone had general knowledge that criminal assaults can occur at the scene of a

Special Rules Whatever test for proximate cause a court adopts, most courts agree on certain basic causation rules. In case of a conflict, these rules supersede the proximate cause and intervening cause rules stated earlier. One such rule is that persons who are negligent “take their victims as they find them.” This means that a negligent defendant is liable for the full extent of her victim’s injuries if those injuries are aggravated by some preexisting physical susceptibility of the victim—even though this susceptibility could not have been foreseen. Similarly, negligent defendants normally are liable for diseases contracted by their victims while in a weakened state caused by their injuries. Negligent defendants typically are jointly liable—along with medical personnel—for negligent medical care that their victims receive for their injuries.

Res Ipsa Loquitur In some cases, negligence may be difficult to prove because the defendant has superior knowledge of the circumstances surrounding the plaintiff’s injury. It may not be in the defendant’s best interests to disclose those circumstances if they point to liability on his part. The classic example is an 1863 case, Byrne v. Boadle.

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vehicular product failure. However, it is generally known that violent crime can and does occur in a variety of settings, including the relative safety of a victim’s home. The facts alleged do not present the type of knowledge concerning a specific individual’s criminal propensity, or right of control over premises known to have been the scene of prior criminal activity, upon which we have recognized a tort duty to protect another from criminal acts. The Stahleckers have not alleged, and could not allege, any special relationship between Ford and Firestone and the criminal actor (Cook) or the victim of his crime (Amy) that would extend their duty, as manufacturers and sellers of products, to protect a consumer from harm caused by a criminal act perpetrated at the scene of a product failure. In the absence of such a duty, [we must] conclude as a matter of law that the criminal assault constituted an efficient intervening cause which precludes a determination that negligence on the part of Ford and Firestone was the proximate cause of the harm [to Amy]. [Therefore,] the district court did not err in sustaining the demurrers of Ford and Firestone . . . and in dismissing the action as to them. District court’s decision affirmed.

The plaintiff was a pedestrian who had been hit on the head by a barrel of flour that fell from a warehouse owned by the defendant. The plaintiff had no way of knowing what caused the barrel to fall; he merely knew he had been injured. The only people likely to have known the relevant facts were the owners of the warehouse and their employees, but they most likely were the ones responsible for the accident. After observing that “[a] barrel could not roll out of a warehouse without some negligence,” the court required the defendant owner to show that he was not at fault. Byrne v. Boadle eventually led to the doctrine of res ipsa loquitur (“the thing speaks for itself”). Res ipsa applies when (1) the defendant has exclusive control of the instrumentality of harm (and therefore probable knowledge of, and responsibility for, the cause of the harm); (2) the harm that occurred would not ordinarily occur in the absence of negligence; and (3) the plaintiff was in no way responsible for his own injury. Most courts hold that when these three elements are satisfied, a presumption of breach of duty and causation arises. The defendant then runs a significant risk of losing the case if he does not produce evidence to rebut this presumption.

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Part Two Crimes and Torts

CYBERLAW IN ACTION Gentry v. eBay, Inc., 99 Cal. App. 4th 816 (2002), was a case brought by buyers of sports memorabilia that bore autographs later determined not to be genuine. The plaintiffs contended that eBay, an online marketplace on which the items were sold, should bear legal responsibility on various legal grounds, including negligence. According to the plaintiffs, eBay had been negligent (1) by maintaining an online forum that allowed any user, regardless of his or her purchase history, to give positive or negative feedback regarding dealers and (2)  by endorsing certain dealers on the basis of this feedback and the dealers’ sales volume. The plaintiffs contended that these actions by eBay created a false sense of confidence in the collectibles’ authenticity because most, if not all, of the positive feedback about a dealer would be generated either by that dealer or by another cooperating dealer.

Negligence Defenses The common law tradition-

ally recognized two defenses to negligence: contributory negligence and assumption of risk. In many states, however, these traditional defenses have been superseded by new defenses called comparative negligence and comparative fault. Explain the difference between traditional contributory

LO7-10 negligence and the comparative negligence doctrine now

followed by almost all states.

Contributory Negligence Contributory negligence is the plaintiff’s failure to exercise reasonable care for her own safety. In the very limited number of states where it still applies, contributory negligence is a complete defense for the defendant if it was a substantial factor in producing the plaintiff’s injury. So, if Preston steps into the path of Doyle’s speeding car without first checking to see whether any cars are coming, Preston would be denied any recovery against Doyle, in view of the clear causal relationship between Preston’s injury and his failure to exercise reasonable care for his own safety. LO7-11 Explain the difference in operation between pure

comparative negligence and mixed comparative negligence.

Comparative Negligence Traditionally, even a plaintiff’s fairly minor failure to exercise reasonable care for his own safety—only a slight departure from the standard of reasonable self-protectiveness—gave the defendant a complete contributory negligence defense. This rule, which

A California appellate court held in Gentry that § 230 of the federal Communications Decency Act provided eBay a meritorious defense against the plaintiffs’ negligence claim. Section 230 states that “[n]o provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.” The court reasoned that eBay was a “provider . . . of an interactive computer service” and that the plaintiffs’ negligence claim amounted, in substance, to an attempt to have eBay held liable for the effects of statements made by “another information content provider” or providers (i.e.,  those who, in the online forum, posted arguably misleading “feedback”). The court therefore regarded the plaintiffs’ negligence claim as an effort to have eBay treated as the “publisher” of information provided by another party. Section 230, the court held, prohibited such treatment of eBay.

probably stemmed from the 19th-century desire to protect railroads and infant manufacturing interests from negligence liability, came under increasing attack in the 20th century. The main reasons were the traditional rule’s harsh impact on many plaintiffs. The rule frequently prevented slightly negligent plaintiffs from recovering any compensation for their losses, even though the defendants may have been much more at fault. In response to such complaints, almost all states have adopted comparative negligence systems either by statute or by judicial decision. The details of these systems vary, but the principle underlying them is essentially the same: Courts seek to determine the relative negligence of the parties and award damages in proportion to the degrees of negligence determined. The formula is: Plaintiff’s recovery = Defendant’s percentage share of the negligence causing the injury × Plaintiff’s proven damages For example, assume that Dunne negligently injures Porter and that Porter suffers $100,000 in damages. A jury determines that Dunne was 80 percent at fault and Porter 20 percent at fault. Under comparative negligence, Porter would recover $80,000 from Dunne. What if Dunne’s share of the negligence is determined to be 40 percent and Porter’s 60 percent? Here, the results vary depending on whether the state in question has adopted a pure or a mixed comparative negligence system. Under a pure system, courts apply the preceding formula regardless of the plaintiff’s and the defendant’s percentage shares of the negligence. Porter therefore would recover



Chapter Seven Negligence and Strict Liability

$40,000 in a pure comparative negligence state. Under a mixed system, the formula operates only when the defendant’s share of  the negligence is greater than (or, in some states, greater than or equal to) 50 percent. If the plaintiff’s share of the negligence exceeds 50 percent, mixed systems provide that the defendant has a complete defense against liability. In such states, therefore, Porter would lose the case. Currie v. Chevron USA, Inc., which appears earlier in the chapter, illustrates the operation of comparative negligence principles. In that wrongful death case arising out of a Chevron clerk’s negligence in authorizing a gas pump, the court reduced the amount of damages awarded to the plaintiff because the plaintiff’s decedent had been partially at fault (presumably through participating in a fight that, when it escalated, resulted in her death). The plaintiff still won a substantial damages award, but the amount was reduced in accordance with the percentage of fault attributed to her decedent. Assumption of Risk Assumption of risk is the plaintiff’s voluntary consent to a known danger. Voluntariness means that the plaintiff accepted the risk of her own free will; knowledge means that the plaintiff was aware of the nature and extent of the risk. Often, the plaintiff’s knowledge and voluntariness are inferred from the facts. This type of assumption of risk is sometimes called implied assumption of risk. For example, Pilson voluntarily goes for a ride in Dudley’s car, even though Dudley has told Pilson that her car’s brakes frequently fail. Pilson probably has assumed the risk of injury from the car’s defective brakes. (For a court ­decision on whether implied assumption of risk ­applies, see Coomer v. Kansas City Royals Baseball Corp., a text case included in Chapter 1.) A plaintiff can also expressly assume the risk of injury by entering into a contract that purports to relieve the defendant of a duty of care he would otherwise owe to the plaintiff. Such contract provisions are called exculpatory clauses. Chapter 15 discusses exculpatory clauses and the limitations that courts have imposed on their enforceability. The most important such limitations are that the plaintiff have knowledge of the exculpatory clause (which often boils down to a question of its conspicuousness) and that the plaintiff must accept it voluntarily (which does not happen when the defendant has greatly superior bargaining power). What happens to assumption of risk in comparative negligence states? Some of these states maintain assumption of risk as a separate and complete defense. Most other states now incorporate implied assumption of risk within the state’s comparative negligence scheme. In such states,

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comparative negligence basically becomes comparative fault. Although the terms comparative negligence and comparative fault often are used interchangeably, technically the former involves only negligence and the latter involves all kinds of fault. In a comparative fault state, therefore, the fact-finder determines the plaintiff’s and the defendant’s relative shares of the fault—including assumption of risk—that caused the plaintiff’s injury.

Strict Liability LO7-12

Identify circumstances in which strict liability principles, rather than those of negligence, control a case.

Strict liability is liability without fault or, perhaps more precisely, irrespective of fault. This means that in strict liability cases, the defendant is liable even though he did not intend to cause the harm and did not bring it about through recklessness or negligence. The imposition of strict liability is a social policy decision that the risk associated with an activity should be borne by those who pursue it, rather than by innocent persons who are exposed to that risk. Such liability is premised on the defendant’s voluntary decision to engage in a particularly risky activity. When the defendant is a corporation that has engaged in such an activity, the assumption is that the firm can pass the costs of liability on to consumers in the form of higher prices for goods or services. Through strict liability, therefore, the economic costs created by certain harms are “socialized” by being transferred from the victims to defendants to society at large. Strict liability, however, does not apply to the vast majority of activities. It therefore becomes important to consider which activities do trigger the liability-without- fault approach. The owners of trespassing livestock and the keepers of naturally dangerous wild animals were among the first classes of defendants on whom the courts imposed strict liability. Today, the two most important activities subject to judicially imposed strict liability are abnormally dangerous (or ultrahazardous) activities and the manufacture or sale of defective and unreasonably dangerous products. We discuss the latter in Chapter 20 and the former immediately below.

Abnormally Dangerous Activities Abnormally

dangerous (or ultrahazardous) activities are those necessarily involving a risk of harm that cannot be eliminated by the exercise of reasonable care. Among the activities

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Part Two Crimes and Torts

treated as abnormally dangerous are blasting, crop dusting, stunt flying, and, in one case, the transportation of large quantities of gasoline by truck. (Most courts, however, would be unlikely to label the latter as abnormally dangerous.) Traditionally, contributory negligence has

not been a defense in ultrahazardous activity cases, but assumption of risk has been a defense. In the Toms case, which follows, the court considers the factors to be taken into account in deciding whether strict liability is appropriate.

Toms v. Calvary Assembly of God, Inc.   132 A.3d 866 (Md. Ct. App. 2016) Andrew Toms operated a dairy farm in Maryland. He owned a herd of approximately 90 dairy cows. A party other than Toms owned a 40-acre tract of land that was adjacent to Toms’s farm. With permission from the possessor of that tract of land, Calvary Assembly of God Inc. (a church) hosted a fireworks display on that property as part of a youth crusade. Calvary retained a professional fireworks company to handle the fireworks display. That company applied for and received the permit required by a Maryland statute. The fireworks company volunteered to have a 300-foot firing radius around the specific site at which the fireworks would be fired. The 300-foot radius exceeded the 250-foot minimum radius that state law required for the amount of fireworks to be discharged. The fireworks display was open to the public. A deputy fire marshal was present to supervise the event. Approximately 250 shells were discharged over a 15-minute period, without any misfires. At the time of the event, Toms’s cattle were inside the barn that was located on his property. The barn was located more than 300 feet—perhaps roughly 500 feet—from the firing location. Toms arrived at the barn a few minutes after the discharging of fireworks began. According to Toms, the explosions startled his dairy cows and caused them to stampede inside the barn. In the lawsuit referred to below, Toms contended that the stampede resulted in the deaths of four cows. In addition to the loss of the four cows, Toms sustained property damage to fences and gates, disposal costs, and lost milk revenue. Toms sent a demand letter to Calvary outlining the damages he claimed, but Calvary and the fireworks company denied liability. Toms then filed a lawsuit in which he sought to have Calvary and the fireworks company held liable on two alternative theories: negligence and strict liability. After a bench trial, a Maryland district court held that the defendants were not negligent and that strict liability was inapplicable. Toms appealed to a Maryland circuit court, which affirmed. The Maryland Court of Appeals then granted Toms’s request that it decide whether the lower courts ruled correctly on the strict liability question.

Greene, Judge In this case, we address whether noise emanating from the discharge of a fireworks display constitutes an abnormally dangerous activity, which would warrant the imposition of strict liability. Whether an activity constitutes an abnormally dangerous activity is a question of law. Maryland [recognizes] the doctrine of strict liability, which does not require a finding of fault in order to impose liability on a party. See Yommer v. McKenzie, 257 A.2d 138 (Md. 1969). The modern formulation of the strict liability doctrine is found in the  Restatement (Second) of Torts §§ 519–520 (1977). This court adopted that formulation in Yommer, while the Restatement (Second) was still in its tentative draft. Restatement (Second) § 519 defines strict liability [this way]: One who carries on an abnormally dangerous activity is subject to liability for harm to the person, land or chattels of another resulting from the activity, although he has exercised the utmost care to prevent the harm. . . . This strict liability is limited to the kind of harm, the possibility of which makes the activity abnormally dangerous.

To determine whether an activity is abnormally dangerous, a court uses six factors. These factors are: a. existence of a high degree of risk of some harm to the person, land or chattels of others; b. likelihood that the harm that results from it will be great; c. inability to eliminate the risk by the exercise of reasonable care; d. extent to which the activity is not a matter of common usage; e. inappropriateness of the activity to the place where it is carried on; and f. extent to which its value to the community is outweighed by its dangerous attributes. Restatement (Second) § 520. As the Restatement (Second) reminds us: Because of the interplay of these various factors, it is not possible to reduce abnormally dangerous activities to any definition. The essential question is whether the risk created is so unusual, either because of its magnitude or because of the circumstances surrounding it, as to justify the imposition of



Chapter Seven Negligence and Strict Liability

strict liability for the harm that results from it, even though it is carried on with all reasonable care. Restatement (Second) § 520, comment f. The Reporter’s Note for this section identifies typical abnormally dangerous activities, such as the storage of large quantities of water or explosives in dangerous locations, and conducting blasting operations in the middle of a city. [W]e weigh each Restatement factor independently. [I]t is not necessary to have all six factors weigh in favor of a particular party. More emphasis is placed on the fifth factor: the appropriateness of the activity in relation to its location. In Yommer, the owners of a gasoline station were held strictly liable for damages resulting from gasoline contamination of the well water of an adjacent residential property. There, we applied the Restatement factors, and found the fifth factor to be the most persuasive factor: No one would deny that gasoline stations as a rule do not present any particular danger to the community. However, when the operation of such activity involves the placing of a large tank adjacent to a well from which a family must draw its water for drinking, bathing and laundry, at least that aspect of the activity is inappropriate to the locale, even when equated to the value of the activity. Yommer, 257 A.2d at 139. “We accept the test of appropriateness as the proper one: that the unusual, the excessive, the extravagant, the bizarre are likely to be non-natural uses which lead to strict liability.” Id. Though the doctrine of strict liability has evolved . . . , the policy concerns in favor of limiting its application remain. [For example, in] Gallagher v. H.V. Pierhomes, LLC, 957 A.2d 628 (Md. Ct. Spec. App. 2008), the Court of Special Appeals held that pile-driving was not an abnormally dangerous activity. There, pile-driving operations at the Inner Harbor in Baltimore City caused minor damage in a 200-year-old residence located 325 feet away from the construction site. The intermediate appellate court found that the defendants had acted appropriately in obtaining the proper permits, conducting geotechnical studies, and carefully monitoring the vibrations produced by the pile driving operations. The court concluded that the risk of harm produced by pile driving operations “is not a high degree of risk which requires the application of strict liability” because that risk can be eliminated “through the exercise of ordinary care.”  Whether fireworks discharge constitutes an abnormally dangerous activity is a case of first impression in Maryland. Some jurisdictions, however, have addressed the issue of whether fireworks are abnormally dangerous. Although fireworks liability cases often share similar facts, jurisdictions disagree on whether discharging fireworks is an abnormally dangerous activity. The highest appellate court in Washington, for instance, held pyrotechnicians strictly liable when a shell exploded

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improperly and injured spectators at a public fireworks show. Klein v. ­Pyrodyne Corp., 810 P.2d 917 (Wash. 1991). [The court] stated that Restatement factors (a) through (d) weighed in favor of imposing strict liability, because discharging fireworks creates a “high risk of serious bodily injury or property damage” due to the possibility of a malfunction or similar issue.  Id. at 922. [The court added that] “[t]he dangerousness . . . is evidenced by the elaborate scheme of administrative regulations with which pyrotechnicians must comply[,]” including licensing and insurance requirements. Id. at 920. Under factor (d), [the court] further determined that discharging fireworks was not a matter of common usage, because the licensing scheme restricts the general public from engaging in that activity. In addition to the high risk discharging fireworks creates, the court determined that public policy and fairness warranted strict liability. Otherwise, the injured spectators would have been subject to the “problem of proof” because “all evidence was destroyed as to what caused the misfire of the shell that injured the [plaintiffs].” Id. at 921–22. Other jurisdictions, however, have come to the opposite conclusion, and have held that the level of risk involved with a fireworks discharge does not warrant strict liability. In Haddon v. Lotito, 161 A.2d 160 (Pa. 1960), Pennsylvania’s highest appellate court applied the ultrahazardous activity test, and determined that strict liability . . . did not apply in a case involving spectator injuries at a public fireworks display. Critically, that court distinguished lawful from unlawful fireworks displays: [A] public fireworks display, handled by a competent operator in a reasonably safe area and properly supervised (and there is no proof to the contrary herein), is not so dangerous an activity. . . . Where one discharges fireworks illegally or in such a manner as to amount to a nuisance and causes injury to another, some jurisdictions have held that liability follows without more. But the production of a public fireworks display, under the circumstances presented herein, is neither illegal nor a nuisance and, consequently, liability, if existing, must be predicated upon proof of negligence. Id. at 162. Other courts have ruled similarly. [We now consider] whether strict liability for an abnormally dangerous activity should be imposed on a . . . fireworks display [that was otherwise lawful under Maryland law]. [A Maryland statute] defines fireworks as “combustible, implosive or explosive compositions, substances, combinations of substances, or articles that are prepared to produce a visible or audible effect by combustion, explosion, implosion, deflagration, or detonation.” We disagree with Toms that our analysis should be so narrow as to focus solely on the audible component—the noise produced— by a fireworks display. [T]he noise itself is a by-product of the activity of discharging fireworks. By definition, under  [the relevant statute], fireworks “are prepared to produce a visible or

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audible effect. . . .” Therefore, when applying the multi-factor test from  § 520 of the Restatement (Second), we will consider all the characteristics and the nature of the risks associated with discharging fireworks. After all, we are also mindful that “[o]ne who carries on an abnormally dangerous activity is not under strict liability for every possible harm that may result from carrying it on.” Restatement (Second) § 519, comment e.  We [now] apply the Restatement factors to the instant case: (a) existence of a high degree of risk of some harm to the person, land, or chattels of others. Special events requiring the use of large, professional “display fireworks” are heavily regulated in Maryland pursuant to [a statutory scheme that requires a detailed application for a permit, supervision by a qualified person, and both official inspection and approval of the site for the display. All of those steps took place here.] We hold that  a lawful fireworks display does not pose a high degree of risk, because the statutory scheme in place is designed to significantly reduce the risks associated with fireworks, namely mishandling, misfires, and malfunctions. Furthermore, the required firing radius of 250 feet was voluntarily extended by [the professional fireworks company] to 300 feet. Critically, in enacting the [statutory scheme, the legislature] did not regulate the audible effects of display fireworks, which indicates that any risk associated with the decibel level of a fireworks discharge is minimal or non-existent. Lawful fireworks displays do not pose a significant risk because [the Maryland Code provides that] “[a] person who possesses or discharges fireworks in violation” of the permitting process “is guilty of a misdemeanor and on conviction is subject to a fine not exceeding $250 for each offense.” To impose a relatively light penalty for an unlawful fireworks display is telling. If an unlawful fireworks display is only a misdemeanor offense with no possibility of incarceration, why then should strict liability be imposed for risks associated with a lawful fireworks display? (b) likelihood that the harm that results from it will be great. This factor also weighs in favor of not imposing strict liability, because the purpose of a 300-foot perimeter surrounding the firing location is to mitigate the likelihood of harm. The statutory scheme regulating the use of fireworks is specifically designed to reduce risk. Because Toms’s dairy barn, and therefore his cows, were not located within the fallout zone, the likelihood of harm to the public and property was significantly reduced. The 300-foot firing radius was effective because no shells fired that night malfunctioned, and no debris littered Toms’s property. (c) inability to eliminate the risk by the exercise of reasonable care. We disagree with Toms that reasonable care cannot reduce the risk of harm to livestock to acceptable levels. [In the statutory scheme, the legislature] took care to implement

sufficient precautions so as to ensure that lawful fireworks displays can be a safe and enjoyable activity. This is evidenced by the active role the State Fire Marshal and authorities having jurisdiction have over the permitting process. Health and safety, therefore, are of paramount concern, and we are satisfied that the regulations sufficiently protect the public and property. Only qualified professional fireworks companies and their agents—authorized shooters—may apply for a permit.  The  requirements of mandatory insurance coverage, a physical site inspection, and event supervision is [sic] evidence of reasonable care that reduces the risk of harm. The site inspection and prior approval of an authority having jurisdiction ensures that the firing location is appropriate and that injury is unlikely. Importantly, additional measures are required if other properties are located within the fallout zone, including notice and permission from that property owner for their property to be used in the fallout zone. The 300-foot firing radius is sufficient. Furthermore, notice to Toms was not necessary, because his dairy barn was located beyond the firing radius. In our view, the Restatement does not require the elimination of all risk, and because the risks inherent with a fireworks discharge can be reduced to acceptable levels, this ­factor does not support a conclusion of an abnormally dangerous activity. (d) extent to which the activity is not a matter of common usage. [W]e define “common usage,” as it pertains to this case, broadly to include not only the professionals who discharge fireworks, but also the spectators who partake in the fireworks display. Almost by definition, lawful fireworks displays involve two parties: the shooter and the audience. We conclude that lawful fireworks displays are a matter of common usage.  (e) inappropriateness of the activity to the place where it is carried on. When this court adopted the Restatement (Second)’s multi-factor test for abnormally dangerous activities, this particular factor was identified as being the most crucial. See Yommer, supra. Implicit in the granting of a permit to discharge fireworks is the lawfulness of that proposed fireworks display. At trial, two deputy fire marshals testified about the procedures entailed with the permitting process, that a physical site inspection showed that the proposed firing location was appropriate, that the event was supervised and properly executed, and that the defendants complied with all applicable laws. Furthermore, a deputy fire marshal testified that although the state required a perimeter of 250 feet from the firing location, the defendants voluntarily extended it to 300 feet. In sum, we agree that a lawful fireworks display does not fall within the context of “the unusual, the excessive, the extravagant, the bizarre . . . non-natural uses which lead to strict liability.” Yommer, supra. (f) extent to which its value to the community is outweighed by its dangerous attributes. Here, a church-sponsored fireworks display celebrated a youth crusade, and the event was open to



Chapter Seven Negligence and Strict Liability

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the public. As a symbol of celebration, fireworks play an important role in our society, and are often met with much fanfare. The statutory scheme regulating its use minimizes the risk of accidents, thus reinforcing the popularity of these displays. [We] conclude that the social desirability of fireworks appears to outweigh their dangerous attributes. Policy considerations. We are mindful that  the doctrine of strict liability for abnormally dangerous activities is narrowly applied in order to avoid imposing “grievous burdens” on landowners and occupiers of land.  [Citation omitted.] The use of fireworks, especially in public fireworks displays, is heavily regulated [by the state]. [According to the statute,] a permit to discharge fireworks cannot be obtained unless the State Fire Marshal determines that proposed fireworks display will “not

endanger health or safety or damage property. . . .” In light of this policy, the defendants cannot be held strictly liable, because they lawfully complied with the conditions of the permit as well as applicable laws. At trial, Toms did not present any evidence concerning what noise levels should be appropriate for public fireworks display. Sufficient evidence was not presented to the trier of fact that a lawful fireworks display was abnormally dangerous to livestock. Lawful fireworks displays are not an abnormally dangerous activity, because the statutory scheme regulating the use of fireworks significantly reduces the risk of harm associated with  the discharge of fireworks.

Statutory Strict Liability Strict

include the tendency toward somewhat greater imposition of strict liability, increases in the frequency and size of punitive damage awards, and similar increases in awards for noneconomic harms such as pain and suffering. The greater costs imposed on defendants, some observers say, operate to increase the price and diminish the availability of liability insurance. In some cases, therefore, businesses may be required to self-insure or go without insurance coverage. In others, they may be able to obtain insurance—but only at a price that cannot be completely passed on to consumers. Where the costs can be fully passed on, the argument continues, they depress the economy by diminishing consumers’ purchasing power or adding to inflation, or both. In addition, the argument concludes, the liability explosion impedes the development of new products and technologies that might result in huge awards for injured plaintiffs. These beliefs have fueled a movement for tort reform. By roughly 2000, many states had enacted some form of tort reform legislation. Such legislation typically follows one or both of two strategies: (1) limiting defendants’ tort liability (plaintiffs’ ability to obtain a judgment) and (2)  limiting the damages plaintiffs can recover once they get a judgment. The battle for tort reform has not ended, however. Proponents continue to seek additional reform measures. Tort reform opponents who lost the fight in the legislature have sometimes continued it in the courts. They have done so primarily by challenging tort reform measures on state constitutional grounds. Such challenges have succeeded in some states but have been rebuffed in others.

liability principles are also embodied in modern legislation. The most important examples are the workers’ compensation acts passed by most states early in this century. Chapter 51 contains more detailed discussion of such statutes, which allow employees to recover statutorily limited amounts from their employers without any need to show fault on the employer’s part and without any consideration of contributory fault on the employee’s part. Employers participate in a compulsory liability insurance system and are expected to pass the costs of the system on to consumers, who then become the ultimate bearers of the human costs of industrial production. Other examples of statutory strict liability vary from state to state.

Tort Reform The risk-spreading strategy of tort law has not been troublefree. During roughly the past three decades, there has been considerable talk about a supposed crisis in the liability insurance system. From time to time over that period, the insurance system has been marked by refusals of coverage, reductions in coverage, and escalating premiums when coverage remains available. To some, this intermittent problem is largely the fault of the insurance industry. Among other things, such observers argue that insurers have manufactured the supposed crisis to obtain unjustified premium increases and to divert attention from insurer mismanagement of invested premium income. To other observers, however, the reason for the supposed crisis is an explosion in tort liability. Examples cited

Circuit Court judgment affirmed.

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Part Two Crimes and Torts

In recent years, there have been calls in some quarters for Congress to enact caps on dollar amounts of damages for pain and suffering and similar noneconomic harm in certain negligence cases, most notably those involving alleged medical malpractice. Critics argue that damage caps’ major effect is a perverse one: limiting the rights of those who have experienced the worst and most long-lasting

Problems and Problem Cases: 1. During the evening hours, Hen Horn, a truck driver employed by Ralphs Grocery Co. (Ralphs), was driving in California on Interstate 10 as part of his job duties. Horn stopped his tractor-trailer rig on a large dirt shoulder alongside the highway in order to eat a snack he had brought with him. He regularly stopped for a snack in that spot when driving in the vicinity. The dirt shoulder was part of a somewhat larger dirt area that sat between Interstate 10 and an intersecting highway. Near the spot where Horn parked, California’s Department of Transportation had placed an “Emergency Parking Only” sign. Horn saw the sign from where he parked, approximately 16 feet from the outermost traffic lane of Interstate 10. That same evening, Adelelmo Cabral was driving home from work alone in his pickup truck on Interstate 10. Juan Perez was driving behind Cabral on that same highway. Perez saw Cabral’s vehicle, which was traveling at 70 to 80 miles per hour, swerve within its lane, then change lanes rapidly, and then pass other vehicles. Cabral’s pickup truck crossed the outermost lane of traffic, left the highway, and traveled parallel to the road along the adjacent dirt until it hit the rear of Horn’s trailer. Perez saw no brake lights or other indications of an attempt on Cabral’s part to slow down before the collision. A toxicology report on Cabral, who died at the scene, was negative. Because there was no evidence of intoxication, suicide, or mechanical defect in the pickup, it appeared that Cabral had either fallen asleep or had been victimized by an unknown medical condition. Cabral’s widow, Maria Cabral, sued Ralphs for the allegedly wrongful death of her husband. She contended that Ralphs should be liable because its employee (Horn) had caused her husband’s death through negligence in stopping for nonemergency reasons on the freeway shoulder. Ralphs responded by denying that Horn was negligent and by asserting that

or debilitating injuries (and thus may be among the plaintiffs most deserving of recovery). Only those plaintiffs with quite severe injuries, the argument continues, have cases in which the potential damages would be likely to approach the ceiling set in the damage cap. As of the time this book went to press, no such federal measures had been enacted.

the decedent’s own negligence was the real cause of the accident. A California jury concluded that both Cabral and Horn were negligent and that their respective negligent acts were substantial factors in causing Cabral’s death. The jury returned a verdict in favor of Maria Cabral, but, as required by California law, the trial court reduced the amount of damages awarded by the jury in order to allow for the fact that the decedent’s own negligence had partially accounted for his death. Ralphs appealed to the California Court of Appeal, which reversed the lower court’s decision. The Court of Appeal held that there was no basis for holding Ralphs liable for negligence because neither Ralphs nor Horn owed the decedent a duty of reasonable care to prevent a collision with Horn’s parked-off-the-roadway rig. Maria Cabral appealed to the Supreme Court of California. Was the Court of Appeal correct in its conclusion that neither Horn nor Ralphs owed a duty to the decedent? In any event, why would Ralphs even be at risk of liability? If there was negligence here, wasn’t it Horn’s? Why wouldn’t the decedent’s own negligence in falling asleep at the wheel bar Cabral from recovery, regardless of whether Horn or Ralphs was negligent? 2. Alvin and Gwendolyn Kallman retained All American Pest Control (AAPC) to treat and prevent pest infestation at their Virginia home on a quarterly basis. AAPC employee Patric Harrison performed one of the quarterly treatments. Three days before treating the Kaltmans’ home, Harrison had treated a commercial establishment with Orthene pesticide. After applying Orthene at that business, Harrison did not thoroughly clean his pesticide application equipment. As a result, he ended up applying a diluted spray of Orthene to the baseboards and adjoining floor surfaces throughout the Kaltmans’ home and to the concrete surfaces in the home’s basement and garage. As the pesticide was being applied, the Kaltmans complained to Harrison about the unusual and extraordinarily pungent odor. Harrison told them that the smell would dissipate, but it did not. Later that day, the Kaltmans telephoned AAPC to report their concern about



Chapter Seven Negligence and Strict Liability

the overwhelming stench. They were told that Harrison had applied an inappropriate pesticide that had a very strong and unpleasant odor. The Kaltmans reported the incident to the Virginia Department of Agriculture and Consumer Services (VDACS). During the investigation by VDACS, Harrison admitted that he applied an Orthene dilution to the Kaltmans’ home. Harrison also admitted that he falsified the pertinent work order by documenting that he applied different pesticides. Laboratory analyses performed by VDACS revealed concentrations of acephate—a toxic ingredient in Orthene PCO Pellets— in the Kaltmans’ home. Exposure to acephate has been shown to cause nerve damage and cancer in laboratory animals. Orthene PCO Pellets are not licensed for residential use by VDACS. The Material Safety Data Sheet required by law for Orthene PCO Pellets states that the product “is not for indoor residential use,” “is for use in places other than private homes,” and should not be used on “unpainted masonry floors in poorly ventilated areas such as garages or basements . . . since persistent odor could develop.” AAPC informed the Kaltmans that although the odor from Orthene was unpleasant, it did not represent a health hazard. The Kaltmans therefore made more than a dozen attempts to eradicate the odor by washing the treated surfaces. They also had their home professionally cleaned. However, high concentrations of acephate remained. Because of the noxious fumes, their home was rendered uninhabitable for a year. The Kaltmans sued AAPC and Harrison on a negligence per se theory in an effort to recover damages for their physical and emotional harms and for expenses they incurred. The trial court granted the defendants’ motion to have the “Pest Control Service Agreement” between the plaintiffs and AAPC made part of the pleadings. This agreement listed the pests to be controlled and stated that AAPC would “apply chemicals to control above-named pests in accordance with terms and conditions of this Service Agreement. All labors and materials will be furnished to provide the most efficient pest control and maximum safety required by federal, state and city regulations.” AACP and Harrison then filed demurrers to the negligence per se claim (i.e., they asked the court to dismiss the Kaltmans’ complaint for failure to state a valid course of action against them). The defendants argued that any duties they owed the plaintiffs stemmed from the parties’ contract and that the plaintiffs therefore could not assert a negligence per se claim. The trial court sustained the defendants’ demurrers. Was the trial

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court correct in doing so? Were the Kaltmans entitled to proceed on a negligence per se theory? 3. Ludmila Hresil and her niece were shopping at a Sears retail store. There were few shoppers in the store at the time. Hresil spent about 10 minutes in the store’s women’s department, where she observed no other shoppers. After Hresil’s niece completed a purchase in another part of the store, the two women began to walk through the women’s department. Hresil, who was pushing a shopping cart, suddenly lost her balance and struggled to avoid a fall. As she did so, her right leg struck the shopping cart and began to swell. Hresil observed a “gob” on the floor where she had slipped. Later, a Sears employee said that “it looked like someone spat on the floor, like it was phlegm.” Under the reasonable person standard, did Sears breach a duty to Hresil by not cleaning up the gob? Hint: Assume that Hresil could prove that the gob was on the floor only for the 10 minutes she spent in the women’s department. 4. Five months after the September 11, 2001, hijackings of airplanes and less than two months after a passenger on a Paris to Miami flight attempted to detonate explosives hidden in his shoe, Bryan and Jennifer Cook took an Atlantic Coast Airlines flight from Indianapolis to New York City. While passengers waited to board, a man later identified as French national Frederic Girard ran toward the gate and abruptly stopped. Mr.  Cook observed that the unaccompanied Girard had two tickets in his possession and that airline security had detained him at the boarding gate before allowing him to board. Mr. Cook further noticed that Girard’s face was red and that his eyes were bloodshot and glassy. In boarding the 32-passenger plane, Girard ran up the steps and jumped inside. Rather than proceeding to his assigned seat, he attempted to sit in a seat nearest the cockpit. However, the flight attendant instructed him to sit in the back row. After taking a seat there, Girard repeatedly pressed the attendant call button and light switch above his head. Prior to takeoff, Mr. Cook approached the flight attendant and expressed concern that Girard was a possible security threat. The attendant acknowledged as much and explained that he had directed Girard to sit in the rear of the plane so he could keep an eye on him. During takeoff, Girard ignored instructions to remain seated. He lit a cigarette, disregarding directives from the flight attendant that smoking onboard was prohibited. Despite this admonition, Girard was permitted to retain his lighter. Mr. Cook approached three male passengers and asked for their assistance

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in the event that Girard’s behavior grew dangerous. Girard moved about the plane, sat in various empty seats, and finally walked up the aisle toward the cockpit. Mr. Cook blocked his path and instructed him to sit. Without any physical contact with Mr. Cook, Girard returned to his seat and lit another cigarette. The flight attendant again told him to extinguish the cigarette, and in response Girard stood and shouted, “Get back! Get back!” Mr. Cook and other passengers approached Girard and ordered him to sit down. Instead, Girard stomped his feet and shouted, mostly in French. The Cooks were able to discern the words “World Trade Center,” “Americans,” and “New York City.” Eventually, a Delta employee convinced Girard to sit after speaking to him in French. The employee spent the remainder of the flight sitting across from Girard in the rear of the plane. The pilot diverted the flight to Cleveland, where police arrested Girard. The flight then continued to New York City. Recalling the events of September 11th and reports of the shoe-bomber incident, the Cooks described their ordeal as one in which they “have never been so scared in their entire lives” (quoting a brief they filed in the litigation about to be described). They filed a small claims court action in Marion County, Indiana, naming Atlantic Coast as a defendant. The Cooks sought damages for negligent infliction of emotional distress. After the small claims court entered judgment against the Cooks, they appealed to the Marion County Superior Court, which denied Atlantic Coast’s motion for summary judgment. The Indiana Court of Appeals upheld the Superior Court’s denial of the summary judgment motion. Atlantic Coast then appealed to the Supreme Court of Indiana. Did the lower courts rule correctly in denying Atlantic Coast’s motion for summary judgment? 5. Performance Plumbing and Heating (Performance) was in the business of installing water and sewer plumbing at Denver-area constitution sites. Unless assigned a company vehicle, Performance employees used their own vehicles to commute to and from work. Because employees were sometimes expected to drive for the company during the workday in order to transport job materials and company tools from Performance’s construction trailers to job sites (and vice versa), Performance required employment applicants to hold a valid driver’s license. However, Performance relied on the applicant’s truthfulness in stating whether he held a valid license. Performance checked driver’s licenses and driving records only as required by its insurance

company when it assigned an employee a company vehicle to drive. Performance hired Cory Weese as an apprentice plumber. Weese had completed an employment application in which he stated that he had a valid driver’s license and had not been cited for traffic violations. These statements were untrue. His license had been suspended because of numerous traffic violations, including careless driving and driving without a license. Because he would not be assigned a company vehicle, Performance hired Weese without checking to see whether his statements on the application were true. About a year after hiring Weese, Performance had his personal truck equipped with a rack for transporting pipe from construction trailers to work sites. Therefore, Performance intended that Weese drive during the day for the company, though it evidently did not check on his driving record at that time because he was not being assigned a company vehicle. (Weese’s license apparently had been reinstated before Performance had the pipe rack installed on his truck, however.) On a later date, when Weese’s work hours had ended and he was driving home, his truck collided with two cars. The collision resulted solely from Weese’s negligence. Carolyn Raleigh and her son were severely injured in the collision. They sued Performance. (Weese was liable to the Raleighs, of course, but this question pertains to their claims against Performance.) The Raleighs alleged two theories of recovery against Performance: respondeat superior (the doctrine under which an employer is liable for a tort committed by its employee if the tort was committed within the scope of employment) and negligent hiring. Was Performance liable on respondeat superior grounds? Was Performance liable on negligent hiring grounds? 6. Neal Berberich entered into a contract with Naomi Jack to perform work on her South Carolina home. During the course of the project, a controversy arose regarding Jack’s use of an automatic sprinkler system that came on periodically in various zones in the yard. In connection with an eventual lawsuit brought by Berberich against Jack, Berberich alleged that he asked Jack to shut off the sprinklers because he and his crew were having difficulty working with the sprinklers on. According to Berberich, Jack refused, told him to “make the best of the situation and work around it,” and became upset when Berberich turned the sprinklers off on several occasions. Berberich also stated that Jack threatened to lock the controls if the sprinklers were turned off again. Jack denied this but admitted that she



Chapter Seven Negligence and Strict Liability

did instruct one of Berberich’s crew members that her sprinkler system was not to be shut off again. At a time when Berberich was working alone on the exterior of Jack’s home, he saw the sprinklers come on in an area of the yard. He noticed that the controls had been locked, so he could not turn the system off. Berberich then moved to the front of the house, away from the sprinklers, to work on the windows. He ascended an eight-foot ladder to reach the top of a tall bay window to clean some caulking. As he was working, the sprinklers came on in the zone where his ladder was located. While coming down the ladder, Berberich slipped on a wet rung and fell to the ground, injuring himself. Berberich stated that he told Jack he had fallen and that he asked her to call for an ambulance, but that she ignored his request. As he walked away from Jack’s home, he collapsed in her driveway. Berberich used his cell phone to call for an ambulance, which arrived shortly after his call. He received medical treatment for his injuries, which included a lumbar strain and contusion, abrasions on his back and his left shoulder, and a swollen right ankle. Jack, in contrast, denied that Berberich told her he had fallen and that he had asked her to call an ambulance. Berberich sued Jack in a South Carolina court, alleging that his injuries “were directly and proximately caused by [Jack’s] negligence . . . and recklessness.” His complaint sought recovery for medical expenses, lost wages, and other actual damages. At trial, Berberich contended that Jack’s actions in locking the controls and refusing to turn off the sprinklers constituted reckless conduct (not merely negligence). He asked the trial judge to charge the jury on the definition of recklessness. He also asked for the jury to be instructed that ordinary negligence is not a defense to a heightened degree of wrongdoing (so that if there were ordinary negligence on his part, it could not be compared to Jack’s allegedly reckless conduct). The trial judge denied the requests, concluding that the requested instructions were relevant only if punitive damages had been at issue (and they were not). The trial court instructed the jury on South Carolina’s comparative ­negligence rule, but not in the way Berberich ­requested. The jury returned a verdict for the defense. The jury found Berberich 75 percent negligent and Jack 25 ­percent at fault in causing the accident, resulting in no recovery for Berberich because South Carolina utilizes a mixed comparative negligence approach. When the trial court denied Berberich’s motions for a judgment notwithstanding the verdict and a new trial, Berberich

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appealed to the Supreme Court of South Carolina. If  Jack’s fault consisted of negligence, was the jury verdict in favor of Jack correct in light of South Carolina’s comparative negligence statute? If the trial judge should have given the requested instruction on recklessness and if a proper instruction in that regard could have caused the jury to conclude that Jack acted recklessly, was Berberich correct in his argument that any negligence on his part should not be compared with Jack’s alleged recklessness? 7. LuAnn Plonski alleged that after shopping at a Kroger Co. grocery store in Indianapolis, Indiana, during afternoon hours, she proceeded to the store’s parking lot (where her car was parked), placed her purse in the shopping cart she was using, opened the trunk of her car, and began loading her groceries into the trunk. She noticed that a man was walking toward her. He did not appear to be a Kroger employee (and, in fact, was not a Kroger employee). The man began running toward Plonski, who grabbed her purse and tried to run away but did not succeed. The man grabbed Plonski and her purse. He then picked her up, threw her in the trunk of the car, and began slamming the trunk lid on her legs. When the man looked away, Plonski jumped out of the trunk and ran into the Kroger store. The man then left the scene with Plonski’s purse. In an effort to collect damages for her injuries and the loss of her purse, Plonski filed a negligence lawsuit against Kroger in an Indiana court. After completion of discovery in the case, Kroger moved for summary judgment. Kroger argued that it owed no duty to Plonski and that even if it did owe a duty, there was no breach. In connection with its motion, Kroger provided affidavits from its risk manager and safety manager. Those affidavits asserted that the Kroger store in whose parking lot the incident occurred is located in a part of the city that has a reputation for low levels of criminal activity and that in the two-year period before the incident at issue, there had been only one report of criminal activity occurring on the store’s premises. Plonski responded to Kroger’s motion by citing her deposition testimony and other evidence. The trial court denied Kroger’s summary judgment request, and the Indiana Court of Appeals affirmed. Kroger appealed to the Supreme Court of Indiana. How did that court rule on whether Kroger owed a duty to Plonski and on whether Kroger was entitled to summary judgment? 8. On August 24, William Garris III and David Billups flew from Raleigh, North Carolina, to Joplin, Missouri,

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on a business trip for their employer, Carolina Forge Co. The trip was scheduled to take place from August 24 to August 27, in Joplin. The primary purpose of the trip was to participate in a golf outing at the invitation of F.A.G. Bearings, a Carolina Forge customer. In advance of the trip, Carolina Forge paid for the airline tickets for Garris and Billups and for their rental car. Carolina Forge also paid for hotel rooms for the men. In addition, Carolina Forge gave Garris and Billups $600 in cash to pay for expenses incurred during the trip. The $600 was intended to pay for entertaining customers and for gas in the rental car. Carolina Forge also had a policy of reimbursing employees for additional out-of-pocket expenses during business trips, including meals, snacks, and alcoholic beverages. Carolina Forge was aware that alcohol would likely be consumed on the particular business trip Garris and Billups would be taking. Garris and Billups arrived in Joplin on the evening of August 24 and checked into their hotel. The next morning, they visited the F.A.G. Bearings headquarters. Next, Garris and Billups arrived at another F.A.G. facility, where they took a tour and then delivered a presentation to company representatives. Following the presentation, Garris and Billups toured another portion of the facility. Garris and Billups then took three F.A.G. Bearings representatives to lunch in Joplin. After lunch, Garris and Billups played golf with F.A.G. Bearings representatives at a course just outside Joplin. Later, Garris and Billups had dinner and drinks at a Joplin steakhouse. No F.A.G. Bearings representatives joined Garris and Billups for dinner. Garris and Billups then went to a casino located approximately 30 miles west of Joplin. No representatives from F.A.G. Bearings accompanied Garris and Billups to the casino. After spending several hours at the casino (where they used their own money for drinks and for gambling), Garris and Billups decided to return to their hotel in Joplin. Upon leaving the casino, Billups drove the rental car. Because Billups took the wrong appropriate ramp for the relevant interstate highway, he and Garris were going away from Joplin rather than toward it. When Billups attempted to turn around, he negligently caused the rental car to collide with a truck in which Charles and Jennifer Sheffer and their son were riding. All three Sheffers were injured in the collision, as was Garris. Billups died in the accident. The Sheffers sued Carolina Forge on two theories: respondeat superior, under which an employer is liable for an employee’s tort if it was committed within the scope of employment, and negligent entrustment of a

vehicle (the rental car) to Billups and Garris. The trial court granted summary judgment in favor of Carolina Forge on both claims. Was the trial court correct in granting summary judgment to Carolina Forge on the respondeat superior claim? Was the trial court correct in granting summary judgment to Carolina Forge on the negligent entrustment claim? 9. On April 16, 1947, the SS Grandchamp, a cargo ship owned by the Republic of France and operated by the French Line, was loading a cargo of fertilizer grade ammonium nitrate (FGAN) at Texas City, Texas. A fire began on board the ship, apparently as a result of a longshoreman’s having carelessly discarded a cigarette or match into one of the ship’s holds. Despite attempts to put out the fire, it spread quickly. Approximately an hour after the fire was discovered, the Grandchamp exploded with tremendous force. Fire and burning debris spread throughout the waterfront, touching off further fires and explosions in other ships, refineries, gasoline storage tanks, and chemical plants. When the conflagration was over, 500 persons had been killed and more than 3,000 had been injured. The United States paid out considerable sums to victims of the disaster. The United States then sought to recoup these payments as damages in a negligence case against the Republic of France and the French Line. The evidence revealed that even though ammonium nitrate (which constituted approximately 95 percent of the FGAN) was known throughout the transportation industry as an oxidizing agent and a fire hazard, no one in charge on the Grandchamp had made any attempt to prohibit smoking in the ship’s holds. The defendants argued that they should not be held liable because FGAN was not known to be capable of exploding (as opposed to simply being a fire hazard) under circumstances such as those giving rise to the disaster. Did the defendants succeed with this argument? 10. Vera Dyer and her sons owned a Maine home believed to be more than 70 years old. The home had a cement foundation and floor. A stand-alone garage with a cement floor was constructed in the 1980s. In September 2004, Maine Drilling & Blasting distributed a notice informing the Dyers that it would soon begin blasting rock near the home in connection with a construction project to replace a bridge and bridge access roads. The notice stated that Maine Drilling uses “the most advanced technologies available . . . to measure the seismic effect to the area” and assured the Dyers “that ground vibrations associated with the blasting [would] not exceed the established limits that could potentially



Chapter Seven Negligence and Strict Liability

cause damage.” As offered in the notice, Maine Drilling provided a pre-blast survey of the Dyer home. The survey report recorded the surveyor’s observation of “some concrete deterioration to [the] west wall” and “cracking to [the] concrete floor,” and a slight tilt to a retaining wall behind the garage. Maine Drilling conducted more than 100 blasts between October 2004 and August 2005. The closest blast was approximately 100 feet from the Dyer home. Vera was inside the home for at least two of the blasts and felt the whole house shake. During other blasts, she was not in the home because Maine Drilling employees advised her to go outside. In the early spring of 2005, the Dyers observed several changes from the pre-blasting condition of the home and the garage: (1) the center of the basement floor had dropped as much as three inches; (2) the center beam in the basement that supported part of the first floor was sagging, and as a result, the first floor itself was noticeably un-level; (3) there was a new crack between the basement floor and the cement pad that formed the foundation of the chimney in the basement; (4) new or enlarged cracks radiated out across the basement floor from the chimney foundation; and (5) cracks that had previously existed in the garage floor were noticeably wider and more extensive. The Dyers also noticed that a flowerbed retaining wall that helped to support the rear wall of the garage had moved demonstrably. The Dyers sued Maine Drilling in a Maine court. They alleged strict liability and negligence causes of action. Following completion of discovery, Maine Drilling moved for summary judgment. The court granted Maine Drilling summary judgment on the strict liability claim because Maine precedents indicated that blasting activities were to be governed by negligence principles rather than those of strict liability. The court also granted the defendant summary judgment on the negligence claim because, in the court’s view, the Dyers had failed to establish the elements of a negligence claim. The Dyers appealed to the Supreme Judicial Court of Maine. Did the lower court rule correctly on which set of legal principles— those of negligence or, instead, those of strict liability— should control the case? 11. Appalachian Power Co. (APCO) owns the Philip Sporn power plant (Sporn), a coal-fired power plant that generates electricity by burning coal to create steam and then passing the steam through a turbine. The power plant’s precipitators remove granular ash particles (“fly ash”) from the gases produced by

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burning coal. Precipitators generate significant heat, which can cause corrosion to its exterior steel siding and result in fly ash leakage. Industrial Contractors Inc. (ICI) was hired by APCO to perform general maintenance at Sporn. This included welding metal patches to the exterior of the precipitators to prevent fly ash leakage. Roger ­Hoschar was a boilermaker employed by ICI from March 2006 to March 2007. During that period, he worked ­exclusively at Sporn. One of his frequent assignments consisted of hanging from a suspended platform and welding steel patches over corroded portions of the ducts leading into and out of Sporn’s Unit 5 precipitator. Before welding any steel patches, Hoschar and other workers had to remove debris that had built up in the steel channels. Because Unit 5 is an outdoor structure, pigeons sometimes perched on its steel channels and left their droppings behind. Therefore, the debris usually consisted of approximately three- to four-inch accumulations of bird manure and two-inch accumulations of fly ash. Hoschar removed the debris from the steel channels by hand, with a wire brush, or by using compressed air. When removing debris and while welding the steel patches, Hoschar wore a respirator over his face. In March 2007, Hoschar’s employment with ICI ended. A 2009 chest X-ray revealed the presence of a mass on his right lung. He was diagnosed with histoplasmosis, an infectious disease caused by inhaling the spores of a naturally occurring soil-based fungus called Histoplasma capsulatum. The Histoplasma capsulatum fungus is endemic in the Ohio Valley region, where Sporn is located, because it grows best in soils with high nitrogen content. Once an individual inhales the fungus, it colonizes the lungs. However, the vast majority of people infected by histoplasmosis do not experience any symptoms of infection or suffer any ill effects. While Hoschar was working at Sporn, the Occupational Safety and Health Administration website maintained a page titled “Respiratory Protection: Hazard Recognition.” One of the reference documents found on that page was a publication by the National Institute for Occupational Safety and Health titled “Histoplasmosis: Protecting Workers at Risk.” This publication explained that the Histoplasma capsulatum fungus “seems to grow best in soils having a high nitrogen content, especially those enriched with bird manure or bat droppings.” It further noted that the fungus “can be carried on the wings, feet, and beaks of birds and infect soil under roosting sites or manure accumulations inside or outside buildings.”

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Hoschar and his wife sued APCO for negligence. They alleged that Hoschar contracted histoplasmosis while working at Sporn as a result of inhaling contaminated dust when he swept out the mixtures of bird manure and fly ash that had accumulated in Unit 5’s steel channels. They also alleged APCO did not provide any written or verbal warnings concerning the presence of aged bird manure around Unit 5 or of the health risks associated with accumulations of bird manure, such as histoplasmosis. The court granted APCO’s motion for summary judgment, reasoning that under the circumstances, APCO did not owe Hoschar a duty of reasonable care. Was the court correct in that ruling? 12. Betty Webb ventured out in the rain to shop at a Dick’s Sporting Goods store. Upon her arrival, Webb noticed puddles in the parking lot and proceeded cautiously to the store’s entrance. As she entered the store, she stepped onto floor mats that Dick’s had placed in the entryway to soak up water tracked in by customers. Webb saw that the floor mats had shifted from their customary parallel formation into a “V” shape. A visible pool of water had formed in the center of the “V.” According to Webb, the mats were wet and spongy. There were no signs at the front of the store to warn customers that the floor could be wet. A crowd of other customers entering the store at the same time surrounded Webb. In an attempt to avoid the visible pool of water in the “V,” Webb stepped from one of the mats to a tile that appeared to her to be dry but was, in fact, wet. As she stepped onto the tile, she

slipped and fell forward, injuring her knees, arms, and shoulders. A store employee witnessed the fall. Webb later filed a negligence lawsuit against Dick’s in a Kentucky trial court. In her deposition, she stated that there were a number of fellow customers entering the store at the same time, which made it difficult for her to avoid the pool without pausing and waiting for people to pass. Webb acknowledged that her shoes were wet and that the lighting in the store was bright. Webb also admitted that if Dick’s had placed a sign near the entrance to warn of a wet floor, the warning probably would not have dissuaded her from entering the store. Dick’s moved for summary judgment, asserting that the wet floor was an open-and-obvious condition that eliminated any duty potentially owed to Webb. The trial court agreed and granted summary judgment in favor of Dick’s. Webb appealed to the Kentucky Court of Appeals, which reversed the lower court’s decision after concluding that according to a precedent decision from the Supreme Court of Kentucky, a property owner may still owe a duty of reasonable care to persons lawfully on the premises even when a danger on the property is open and obvious. The Court of Appeals held that Dick’s had a duty to take reasonable steps to eliminate or reduce the open-and-obvious hazard and that whether Dick’s satisfied its duty was a question for the jury. Dick’s appealed to the Supreme Court of Kentucky. How did the Supreme Court rule? Did Dick’s owe the duty identified by the Court of Appeals?

CHAPTER 8

Intellectual Property and Unfair Competition

T

he term intellectual property has received frequent mention in business circles in recent years, usually as part of a comment emphasizing the importance of protecting intellectual property rights. The names of key forms of intellectual property and the areas of law that apply to them—patent, copyright, trademark, and trade secret—are also often heard. However, many people who find these names familiar lack a clear understanding of the differences among the forms of intellectual property and the respective legal treatments they receive. This chapter seeks to provide such an understanding, as well as an awareness of how to protect intellectual property and how to avoid violating others’ rights in that regard. Study the chapter and you will understand that patent, copyright, and trademark are not interchangeable terms, even though they sometimes are used in such an erroneous fashion in media reports and ordinary conversation. Let’s begin with a pretest, of sorts. Each of the bullet-pointed items listed below could be the subject of intellectual property protection, though in some instances, more facts would be necessary in order to know for certain. Before reading beyond this introductory exercise, jot down, for each listed item, the name of the potentially relevant area of intellectual property law (patent, copyright, trademark, or trade secret). For most items, only one area of law would potentially apply, though in some instances there could be more than one. Here is the list: • A brand name for a product • A new electronic device • A TV commercial • Computer software • A three-word advertising slogan • The formula for a beverage • A logo regularly used by a business firm • A pharmaceutical product • A highly detailed customer list • A song • The recognizable shape of a beverage bottle Keep in mind the above list of items as you read the chapter and learn about intellectual property concepts and principles. Then look back at the list when you complete the chapter and check the accuracy or inaccuracy of your initial impressions.

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Part Two Crimes and Torts

LEARNING OBJECTIVES After studying this chapter, you should be able to: 8-1 List the categories of potentially patentable subject matter and explain what is contemplated by each of the requirements of patentability (novelty, nonobviousness, and utility). 8-2 Explain the rights a patent owner holds and the length of time those rights exist. 8-3 Explain what a patent owner must prove in order to establish that patent infringement occurred and identify defenses to a patent infringement claim. 8-4 List types of works that may carry copyright protection. 8-5 Explain how long copyrights last. 8-6 Explain the rights copyright owners hold and the relationship of those rights to claims for copyright infringement. 8-7 List the fair use factors and apply them to fact patterns in which the fair use defense to copyright infringement liability is invoked. 8-8 State what a trademark does and provide examples of potentially protectable trademarks.

THIS CHAPTER DISCUSSES LEGAL rules that allow civil recoveries for abuses of free competition. These abuses are (1) infringement of intellectual property rights protected by patent, copyright, and trademark law; (2) misappropriation of trade secrets; (3) the intentional torts of injurious falsehood, interference with contractual relations, and interference with prospective advantage; and (4) the various forms of unfair competition addressed by § 43(a) of the Lanham Act. Indeed, the term unfair competition describes the entire chapter. In general, competition is deemed unfair when (1) it discourages creative endeavor by robbing creative people of the fruits of their innovations or (2) it renders commercial life too uncivilized for the law to tolerate.

Protection of Intellectual Property Patents Patent law is exclusively federal in nature. In fact, Congress’s authority to regulate patents is embedded in the U.S. Constitution under Article 1, Section 8. But while the source of Congress’s power comes from the

8-9 Identify the key requirement for registration of a mark on the Principal Register (distinctiveness) and explain the role of secondary meaning when registration of a nondistinctive mark is sought. 8-10 Identify and apply the elements of trademark infringement. 8-11 Identify and apply the elements of trademark dilution. 8-12 Explain what a trade secret is and what the trade secret owner must prove in order to win a misappropriation case. 8-13 List the elements that a plaintiff must prove in order to win an injurious falsehood case. 8-14 Explain the elements of interference with contractual relations. 8-15 Identify key issues on which courts focus in false advertising cases brought under Lanham Act § 43(a).

Constitution, the U.S.’s actual patent laws come from the patent statutes, particularly the Patent Act, which has been revised numerous times. As such, a patent may be viewed as an agreement between an inventor and the federal government. Under that agreement, the inventor obtains the exclusive right (for a limited time) to exclude others from making, using, or selling his invention in return for making the invention public by giving the government certain information about it. The patent holder’s (or patentee’s) monopoly encourages the creation and disclosure of inventions by stopping third parties from appropriating them once they become public. Who is the “inventor,” for purposes of the above discussion? Until a recent change, U.S. law has historically opted for a literal interpretation with a “first-to-invent” rule—­ meaning that only the true inventor would be eligible for a patent on his or her invention. Under that rule, a person who created an invention after the true inventor had already done so was not entitled to a patent even if she came up with her invention independently (without knowledge of what the true inventor had done) and filed a patent application before the true inventor did. The first-to-invent rule put U.S. law at odds with the patent laws in many nations, which



Chapter Eight Intellectual Property and Unfair Competition

contemplate a “first-to-file” approach that would allow the independent developer of an invention to obtain a patent if she filed a patent application before the earlier inventor did. In a major change, the American Invents Act of 2011 (AIA) switched the United States from a first-to-invent system to a first-to-file system. Although the AIA was enacted in 2011, its provisions took effect in March 2013. Now, one who independently developed an invention after someone else did is considered an inventor entitled to a U.S. patent if he, she, or it files a patent application before the prior inventor does. Independent development is critical to this rule. One who had access to the prior inventor’s work before supposedly inventing largely the same thing did not independently create and therefore would not be a qualifying inventor for purposes of the first-to-file rule. The change from first-to-invent to first-to-file helps eliminate one set of potentially difficult issues when an inventor seeks patent protection in various nations under the country-by-country approach discussed in a Global Business Environment box that appears later in the chapter. What Is Patentable? List the categories of potentially patentable subject matter and explain what is contemplated by each of the LO8-1 requirements of patentability (novelty, nonobviousness, and utility).

Assuming that the novelty, nonobviousness, and utility requirements discussed later in the chapter are also satisfied, an inventor may obtain a patent on (1) a process (a mode of treatment of certain materials to produce a given result), (2) a machine,  (3) a manufacture (here, a noun effectively meaning “product”), (4) a composition of matter (a combination of elements with qualities not present in the elements taken individually, such as a new chemical compound), or (5) an improvement of any of the above. Patents issued for any of these inventions are classified as utility patents. The Patent Act also permits different types of patents to be issued for ornamental designs for a product (often called design patents) and for plants produced by asexual reproduction. Our main focus in this chapter will be on utility patents. The Patent Act section listing the above categories of inventions eligible for utility patents has long been interpreted by the courts as being subject to a rule that laws of nature and natural phenomena are ineligible for a patent. Therefore, one who discovers a wild plant whose existence was previously unknown has made a nice discovery but cannot obtain a patent on it. Recent years’ advancements

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and discoveries in medicine and other scientific fields have caused the U.S. Patent and Trademark Office (PTO) and the courts to struggle with difficult questions of patentability. For instance, think about a test that correlates the level of metabolites in the blood of a patient who has a certain disease with a drug dosage likely to be effective for that particular patient. Is this test a patentable process, or is it nonpatentable because of the law-of-nature prohibition? (Note, of course, that the drug itself may well have been a patentable composition of matter at some point, as many pharmaceutical products are.) In Mayo Collaborative Services v. Prometheus Laboratories, Inc., 132 S. Ct. 1289 (2012), the Supreme Court held that the PTO erred in granting a patent on the drug-dosage correlation test and that the law-ofnature bar should have controlled. The Court noted that applications of laws of nature may sometimes be patentable, but that the test at issue was not such an application because it merely contemplated adding data-gathering and other conventional scientific activity to the metabolite-level information that was a law of nature. The Supreme Court again addressed law-of-nature concerns in a 2013 decision. At issue in Association for Molecular Pathology v. Myriad Genetics, Inc., 133 S. Ct. 2107 (2013), were patents pertaining to the discovery of the precise location and sequence of certain human genes that, in the event of mutations in a particular patient, would substantially increase the patient’s risk of breast or ovarian cancer. The Court held that the patents should not have been granted because the genetic information and structure were naturally occurring phenomena and hence not patent-eligible. Additionally, courts refuse to allow patents for abstract ideas, which can include anything from how to electronically track utility customers’ energy use to electronic paywalls. However, distinguishing patentable inventions from abstract ideas has been a frequent challenge for courts. This is especially true in attempts to patent certain methods of doing business. For example in Bilski v. Kappos, 561 U.S. 593 (2010), the Supreme Court declined an opportunity to rule that business methods in general cannot be patented. The Court held that the business method at issue—a method for hedging risk in certain financial transactions—was merely an abstract idea and therefore nonpatentable. For discussion of Bilski, see Alice Corporation Ltd. v. CLS Bank International, which follows shortly.  Alice also deals with computer software, another type of creative activity over which there has been uncertainty concerning patentability. The Court indicates in Alice that in order to be patentable, software and any business method to which it relates must go beyond expressing an abstract idea and using mathematical principles. Clearly, however, a computer program that forms part of an otherwise patentable process may be held protected and

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Part Two Crimes and Torts

therefore not fair game for others to copy during the patent period.1 Even though an invention fits within one of the categories enumerated earlier, it is not patentable if it lacks novelty, is obvious, or has no utility.2 The novelty requirement requires the invention to be new and truly different from what has gone before in the relevant field of inventive activity. This means an inventor cannot obtain a patent if any of the following occurred before the patent application for an invention was filed: the invention was already patented; the invention was already in public use, on sale, or otherwise available to the public; or the invention had already been described in a printed publication. However, in what may be described as the one-year window exception to the before-application test, an inventor who makes a public disclosure of the invention has one year from the making of the disclosure to file a patent application. Public disclosure is the nonconfidential sharing of information about the invention and can come in many forms such as “pitching” the As discussed later in this chapter, computer programs may obtain copyright and trade secret protection. 1

Plant and design patents are subject to requirements that are slightly different from those stated here. 2

invention to investors without a nondisclosure agreement or selling the invention to the public. The inventor’s filing of a patent application within one year after his, her, or its public disclosure leaves the inventor still able to pass the novelty requirement and obtain a patent, but the filing of an application outside the one-year window will be too late. Just because someone has never filed a patent application for an invention does not make it patentable. While it may satisfy the novelty requirement, the Patent Act also requires inventions to be nonobvious. This nonobviousness requirement means that if an invention could have been easily made by someone skilled in the relevant field and familiar with the subject matter of the invention, then it is not worthy of a patent. An example of nonobviousness can be seen in the ZUP, LLC v. Nash Manufacturing, Inc. case. There, the federal circuit court found that a wakeboard design that allowed a user to pull him or herself up using foot bindings and handles was obvious in light of prior wakeboard designs. A final requirement for patentability is utility. The utility requirement requires that the invention have some qualitative benefit. Therefore, if an invention is illegal or immoral, it cannot be patented. Similarly, if an invention such as a drug has no demonstrated usefulness, it cannot be patented.

Alice Corporation Ltd. v. CLS Bank International    134 S. Ct. 2347 (2014)

Alice Corporation is the assignee of several patents that disclose a method for mitigating settlement risk (the risk that only one party to an agreed-upon financial exchange will satisfy its obligation). The patent claims are designed to facilitate the exchange of financial obligations between two parties by using a computer system as a third-party intermediary. Under the method contemplated by the patents, the intermediary creates “shadow” credit and debit records (i.e., account ledgers) that mirror the balances in the parties’ real-world accounts at “exchange institutions” (e.g., banks). The intermediary updates the shadow records in real time as transactions are entered, allowing only those transactions for which the parties’ updated shadow records indicate sufficient resources to satisfy their mutual obligations. At the end of the day, the intermediary instructs the relevant financial institutions to carry out the “permitted” transactions in accordance with the updated shadow records, thus mitigating the risk that only one party will perform the agreed-upon exchange. The claimed method requires the use of a computer and involves a computer-readable medium containing program code for performing the method of exchanging obligations. CLS Bank International and an affiliated entity (referred to collectively as CLS Bank) operate a global network that facilitates currency transactions. CLS Bank sued Alice, seeking a declaration that Alice’s patents were invalid. A federal district court and the U.S. Court of Appeals for the Federal Circuit held that the patents were invalid because they applied to merely an abstract idea. The U.S. Supreme Court granted Alice’s petition for a writ of certiorari. (In the following edited version of the Supreme Court’s decision, Alice is sometimes referred to as the petitioner.) Thomas, Justice The patents at issue in this case disclose a computer-implemented scheme for mitigating settlement risk by using a third-party intermediary. The question presented is whether these claims are patent-eligible under 35 U.S.C. § 101, or are instead drawn to a patent-ineligible abstract idea.

Section 101 of the Patent Act defines the subject matter eligible for patent protection. It provides: “Whoever invents or discovers any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent therefor, subject to the conditions and requirements of this title.” “We have long held that this



Chapter Eight Intellectual Property and Unfair Competition

provision contains an important implicit exception: Laws of nature, natural phenomena, and abstract ideas are not patentable.” Association for Molecular Pathology v. Myriad Genetics, Inc., 133 S. Ct. 2107 (2013). We have interpreted § 101 and its predecessors in light of this exception for more than 150 years. We have described the concern that drives this exclusionary principle as one of pre-emption. See, e.g., Bilski v. Kappos, 561 U.S. 593 (2010) (upholding the patent [at issue there] “would pre-empt use of this approach in all fields, and would effectively grant a monopoly over an abstract idea”). Laws of nature, natural phenomena, and abstract ideas are “the basic tools of scientific and technological work.” Myriad, supra. “[M]onopolization of those tools through the grant of a patent might tend to impede innovation more than it would tend to promote it,” thereby thwarting the primary object of the patent laws. Mayo Collaborative Services v. Prometheus Laboratories, Inc., 132 S. Ct. 1289 (2012). See U.S. Const., Art. I, § 8, cl. 8 (Congress “shall have Power . . . To promote the Progress of Science and useful Arts”). We have “repeatedly emphasized this . . . concern that patent law not inhibit further discovery by improperly tying up the future use” of these building blocks of human ingenuity. Mayo, supra. At the same time, we tread carefully in construing this exclusionary principle lest it swallow all of patent law. At some level, “all inventions . . . embody, use, reflect, rest upon, or apply laws of nature, natural phenomena, or abstract ideas.” Id. Thus, an invention is not rendered ineligible for patent simply because it involves an abstract concept. See Diamond v. Diehr, 450 U.S. 175 (1981). “[A]pplication[s]” of such concepts “‘to a new and useful end,’” we have said, remain eligible for patent protection. Gottschalk v. Benson, 409 U.S. 63 (1972). In Mayo, we set forth a framework for distinguishing patents that claim laws of nature, natural phenomena, and abstract ideas from those that claim patent-eligible applications of those concepts. First, we determine whether the claims at issue are directed to one of those patent-ineligible concepts. If so, we then ask, “[w]hat else is there in the claims before us?” [S]tep two of this analysis [is] a search for an “inventive concept”—i.e., an element or combination of elements that is “sufficient to ensure that the patent in practice amounts to significantly more than a patent upon the [ineligible concept] itself.” Mayo, supra. We must first determine whether the claims at issue are directed to a patent-ineligible concept. We conclude that they are: These claims are drawn to the abstract idea of intermediated settlement. The “abstract ideas” category embodies “the longstanding rule that an idea of itself is not patentable.” Gottschalk v. Benson, supra. In Benson, for example, this Court rejected as ineligible patent claims involving an algorithm for converting binary-coded decimal numerals into pure binary form, holding that the claimed patent was “in practical effect . . . a patent on the algorithm itself.” And in Parker v. Flook, 437 U.S. 584 (1978), we held that a mathematical

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formula for computing “alarm limits” in a catalytic conversion process was also a patent-ineligible abstract idea. We most recently addressed the category of abstract ideas in Bilski v. Kappos, 561 U.S. 593 (2010). The claims at issue in Bilski described a method for hedging against the financial risk of price fluctuations. Claim 1 recited a series of steps for hedging risk, including: (1) initiating a series of financial transactions between providers and consumers of a commodity; (2) identifying market participants that have a counterrisk for the same commodity; and (3) initiating a series of transactions between those market participants and the commodity provider to balance the risk position of the first series of consumer transactions. Claim 4 “pu[t] the concept articulated in claim 1 into a simple mathematical formula.” The remaining claims were drawn to examples of hedging in commodities and energy markets. All members of the Court agreed that the patent at issue in Bilski claimed an “abstract idea.” Specifically, the claims described “the basic concept of hedging, or protecting against risk.” The Court explained that “[h]edging is a fundamental economic practice long prevalent in our system of commerce and taught in any introductory finance class.” The concept of hedging as recited by the claims in suit was therefore a patent-ineligible “abstract idea, just like the algorithms at issue in Benson and Flook.” It follows from our prior cases, and Bilski in particular, that the claims at issue here are directed to an abstract idea. On their face, the claims before us are drawn to the concept of intermediated settlement, i.e., the use of a third party to mitigate settlement risk. Like the risk hedging in Bilski, the concept of intermediated settlement is “a fundamental economic practice long prevalent in our system of commerce.” Bilski, supra. The use of a third-party intermediary (or “clearing house”) is also a building block of the modern economy. [Citations omitted.] Thus, intermediated settlement, like hedging, is an “abstract idea” beyond the scope of § 101. Because the claims at issue are directed to the abstract idea of intermediated settlement, we turn to the second step in Mayo’s framework. [W]e must examine the elements of the claim to determine whether it contains an “‘inventive concept’” sufficient to “transform” the claimed abstract idea into a patent-eligible application. A claim that recites an abstract idea must include “additional features” to ensure “that the [claim] is more than a drafting effort designed to monopolize the [abstract idea].” Mayo, supra. Mayo made clear that transformation into a patent-eligible application requires “more than simply stat[ing] the [abstract idea] while adding the words ‘apply it.’” Id. Mayo itself is instructive. The patents at issue in Mayo claimed a method for measuring metabolites in the bloodstream in order to calibrate the appropriate dosage of thiopurine drugs in the treatment of autoimmune diseases. The respondent in that case contended that the claimed method was a patent-eligible application of natural laws that describe the relationship between the

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concentration of certain metabolites and the likelihood that the drug dosage will be harmful or ineffective. But methods for determining metabolite levels were already “well known in the art,” and the process at issue amounted to “nothing significantly more than an instruction to doctors to apply the applicable laws when treating their patients.” Mayo, supra. “Simply appending conventional steps, specified at a high level of generality,” was not “enough” to supply an “‘inventive concept.’” Id. The introduction of a computer into the claims does not alter the analysis at Mayo step two. In Benson, for example, we considered a patent that claimed an algorithm implemented on a general-purpose digital computer. Because the algorithm was an abstract idea, the claim had to supply a new and useful application of the idea in order to be patent-eligible. But the computer implementation did not supply the necessary inventive concept; the process could be “carried out in existing computers long in use.” Benson, supra. We accordingly “held that simply implementing a mathematical principle on a physical machine, namely a computer, [i]s not a patentable application of that principle.” Mayo, supra (discussing Benson). Flook is to the same effect. There, we examined a computerized method for using a mathematical formula to adjust alarm limits for certain operating conditions (e.g., temperature and pressure) that could signal inefficiency or danger in a catalytic conversion process. Once again, the formula itself was an abstract idea, and the computer implementation was purely conventional. Thus, “Flook stands for the proposition that the prohibition against patenting abstract ideas cannot be circumvented by attempting to limit the use of [the idea] to a particular technological environment.” Bilski, supra. In Diehr, 450 U.S. 175, by contrast, we held that a computerimplemented process for curing rubber was patent-eligible, but not because it involved a computer. The claim employed a wellknown mathematical equation, but it used that equation in a process designed to solve a technological problem in “conventional industry practice.” The invention in Diehr used a “thermocouple” to record constant temperature measurements inside the rubber mold—something “the industry ha[d] not been able to obtain.” The temperature measurements were then fed into a computer, which repeatedly recalculated the remaining cure time by using the mathematical equation. These additional steps, we recently explained, “transformed the process into an inventive application of the formula.” Mayo, supra (discussing Diehr). In other words, the claims in Diehr were patent-eligible because they improved an existing technological process, not because they were implemented on a computer.

These cases demonstrate that the mere recitation of a generic computer cannot transform a patent-ineligible abstract idea into a patent-eligible invention. Stating an abstract idea “while adding the words ‘apply it’” is not enough for patent eligibility. Mayo, supra. Nor is limiting the use of an abstract idea “to a particular technological environment.” Bilski, supra. Stating an abstract idea while adding the words “apply it with a computer” simply combines those two steps, with the same deficient result. Thus, if a patent’s recitation of a computer amounts to a mere instruction to “implemen[t]” an abstract idea “on . . . a computer,” Mayo, supra, that addition cannot impart patent eligibility. This conclusion accords with the pre-emption concern that undergirds our § 101 jurisprudence. Given the ubiquity of computers, wholly generic computer implementation is not generally the sort of additional feature that provides any “practical assurance that the process is more than a drafting effort designed to monopolize the [abstract idea] itself.” Mayo, supra. In light of the foregoing, the relevant question is whether the claims [in the patents held by Alice] do more than simply instruct the practitioner to implement the abstract idea of intermediated settlement on a generic computer. They do not. Taking the claim elements separately, the function performed by the computer at each step of the process is “[p]urely conventional.” Mayo, supra. Using a computer to create and maintain “shadow” accounts amounts to electronic recordkeeping—one of the most basic functions of a computer. The same is true with respect to the use of a computer to obtain data, adjust account balances, and issue automated instructions; all of these computer functions are well-understood, routine, conventional activities previously known to the industry. In short, each step does no more than require a generic computer to perform generic computer functions. Considered “as an ordered combination,” the computer components of petitioner’s method “ad[d] nothing . . . that is not already present when the steps are considered separately.” Id. Viewed as a whole, petitioner’s method claims simply recite the concept of intermediated settlement as performed by a generic computer. The method claims do not, for example, purport to improve the functioning of the computer itself. Nor do they effect an improvement in any other technology or technical field. Instead, the claims at issue amount to nothing significantly more than an instruction to apply the abstract idea of intermediated settlement using some unspecified, generic computer. Under our precedents, that is not enough to transform an abstract idea into a patent-eligible invention. Federal Circuit decision affirmed; patents held invalid.



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ZUP, LLC v. Nash Manufacturing, Inc.    896 F.3d 1365 (Fed. Cir. 2018)

ZUP, LLC (ZUP) is the inventor of the “ZUP Board,” which it brought to market in 2012. ZUP’s U.S. Patent 8,292,681 (the ’681 Patent) covered the board and method for riding the board, where a rider can use handles and foot bindings to achieve a standing position while riding. 940

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ZUP’s competitor, Nash Manufacturing, Inc (Nash) brought a similar board to market in 2014, the “Versa Board.” Like the ZUP Board, the Versa Board has a tow hook on the front section of the board. Unlike the ZUP Board, however, the Versa Board has several holes on the top surface of the board that allow users to attach handles or foot bindings in various configurations. Although Nash warns against having the handles attached to the board while standing, a user could theoretically ignore Nash’s warnings and attach the handles and foot bindings in a configuration that mirrors the configuration of the ZUP Board. ZUP filed a lawsuit in the U.S. District Court for the Eastern District of Virginia and alleged (1) contributory infringement of the ’681 patent, (2) induced infringement of the ’681 patent, (3) trade secret misappropriation under the Virginia Uniform Trade Secrets Act, and (4) breach of contract. Nash counterclaimed, seeking declaratory relief as to noninfringement and invalidity. The district court granted Nash’s summary judgment motion with respect to invalidity, thus rendering the infringement claims moot. Specifically, the district court held that certain claims in ZUP’s ’681 patent were obvious in light of a combination of prior patents involving water boards, and therefore the patent was invalid. Prost, Chief Judge The primary issue in this case is whether claims 1 and 9 of the ’681 patent are invalid as obvious under 35 U.S.C. § 103(a). Although the “ultimate judgment of obviousness is a legal determination,” it is based on underlying factual inquiries, including (1) the scope and content of the prior art; (2) the differences between the claims and the prior art; (3) the level of ordinary skill in the pertinent art; and (4) any secondary considerations of non-obviousness. Graham v. John Deere Co., 383 U.S. 1, 17–18 (1966). Likewise, whether one of skill in the art would have had a motivation to combine pieces of prior art in the way claimed by the patent is also a factual determination.

Here, there appears to be no dispute with respect to the content of the prior art or the differences between the prior art and the ’681 patent. And, the parties agree that the relevant level of skill in the art is “a person with at least 3–5 years’ experience in the design and manufacture of water recreational devices or [who has] a bachelor’s degree in mechanical engineering.” The only issues raised on appeal pertain to (1) whether a person of ordinary skill in the art would have been motivated to combine the prior art references in the way claimed in the ’681 patent, and (2) whether the district court properly evaluated ZUP’s evidence of secondary considerations.

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Part Two Crimes and Torts

A “motivation to combine may be found explicitly or implicitly in market forces; design incentives; the ‘interrelated teachings of multiple patents’; ‘any need or problem known in the field of endeavor at the time of invention and addressed by the patent’; and the background knowledge, creativity, and common sense of the person of ordinary skill.” Plantronics, Inc. v. Aliph, Inc., 724 F.3d 1343, 1354 (Fed. Cir. 2013). The district court first found that all the elements of the claimed invention existed in the prior art. Specifically, the district court pointed to earlier patents on water recreational boards that included the same elements used in the ’681 patent: a riding board, a tow hook, handles, foot bindings, and a plurality of rails on the bottom surface of the riding board. From this, the district court explained that the ’681 patent “identifie[s] known elements in the prior art that aided in rider stability while engaging a water recreational device and simply combined them in one apparatus and method.” The district court then concluded that one of ordinary skill in the art would have been motivated to combine the various elements from the prior art references, noting that such motivation would have stemmed from a desire “to aid in rider stability, to allow a wide variety of users to enjoy the device, and to aid users in maneuvering between positions on a water board”—all motivations that were “a driving force throughout the prior art and have

been shared by many inventors in the water recreational device industry.” The record evidence supports the district court’s analysis. Although ZUP contends that a person of skill in the art would have been focused on achieving rider stability in a predetermined riding position, the evidence contradicts this assertion. Helping riders switch between riding positions had long been a goal of the prior art. . . . The prior art accomplished this goal of helping riders maneuver between positions by focusing on rider stability. Indeed, ZUP even admits that achieving rider stability is an “age-old motivation in this field.” Such stability was enhanced in the prior art through the same components employed in the ’681 patent: tow hooks, handles, foot bindings, and other similar features. In the face of the significant evidence presented by Nash regarding the consistent desire for riders to change positions while riding water recreational boards (and the need to maintain stability while doing so), and given that the elements of the ’681 patent were used in the prior art for this very purpose, there is no genuine dispute as to the existence of a motivation to combine.

Obtaining a Patent The U.S. Patent and Trademark Office handles patent applications. The application must include both a specification and claims. A specification must describe the invention with sufficient detail and clarity to enable a person skilled in the relevant field to make and use the invention. The claims in a patent application must show how the invention satisfies the various requirements of patentability—novelty, nonobviousness, and utility. The application must also contain a drawing when necessary for understanding the subject matter to be patented. The PTO then determines whether the invention meets the various tests for patentability. If the application is rejected, the applicant may resubmit it. Once any of the applicant’s claims have been rejected twice, the applicant may appeal to the Patent and Trademark Appeals Board (PTAB). Subsequent appeals are also possible, but they can only be made to the U.S. District Court for the District of Columbia or the U.S. Court of Appeals for the Federal Circuit.

Ownership and Transfer of Patent Rights

District court decision affirmed; patent held invalid.

LO8-2

Explain the rights a patent owner holds and the length of time those rights exist.

Until a change in federal law during the mid-1990s, a patent normally gave the patentee exclusive rights regarding the patented invention for 17 years from the date the patent was granted. In order to bring the United States into compliance with the General Agreement on Tariffs and Trade (an international agreement commonly known as GATT), Congress amended the patent law to provide that the patentee’s exclusive rights to exclude others from making, using, or selling the patented invention generally exist until the expiration of 20 years from the date the patent application was filed. This duration rule applies to utility patents. (A design patent, however, exists for 14 years from the date it was granted.) A 1999 enactment of Congress allowed for the possible extension of a patent’s duration if the Patent



Chapter Eight Intellectual Property and Unfair Competition

Office delayed an unreasonably long time in acting on and approving the patentee’s application. The patentee may transfer ownership of the patent by making a written assignment of it to another party. Alternatively, the patentee may retain ownership and license others to make, use, or sell the patented invention. The terms of the licensing agreement are normally whatever the parties agree upon, subject to the rule that even if the agreement does not specify an ending date for the licensee’s duty to pay royalties to the patent owner, the licensee has no obligation to continue paying royalties once the 20-year patent period expires. As the Supreme Court made clear in Quanta Computer v. LG Electronics, 553 U.S. 617 (2008), once the patent owner or licensee sells an item embodying the patented invention, the sale of the item exhausts the patent owner’s rights regarding that item. For instance, if A licenses B to produce and sell an item that requires use of A’s patent, B’s production and sale of the item entitles A, of course, to payment of the licensing fee called for by the agreement between A and B. However, A is not entitled to enforce its patent against C in the event that B sells the licensed item to C. B’s sale of the item to C—a sale contemplated by the license A granted B—exhausted A’s patent rights in regard to the item purchased by C.

LOG ON The applications of successful patents are by their nature publicly available. You can easily search complete applications, including those for international patents, through Google’s Patent search, found at patents.google.com.

Employers and Employees As we have seen, the Patent Act contemplates that the creator of an invention is entitled to obtain a patent if the necessary requirements are met. What happens, however, when the creator of the invention is an employee and her employer seeks rights in the invention? If the invention was developed by an employee hired to do inventive or creative work, she must use the invention solely for the employer’s benefit and must assign any patents she obtains to the employer. (Prior to the America Invents Act (AIA), the patent in such a situation had to be issued in the name of the employee, who would then be obligated to assign the patent to the employer. The AIA now would permit the patent to be issued in the name of the employer in such an instance, if proper procedures are followed.) If the employee was hired for purposes other than invention or creation, however, she owns any patent she acquires. Finally, regardless of the purpose for which the employee was hired, the shop right doctrine gives the employer a nonexclusive, royalty-free license to use the employee’s invention

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if it was created on company time and through the use of company facilities. Any patent the employee might retain is still effective against parties other than the employer. Patent Infringement Explain what a patent owner must prove in order to

LO8-3 establish that patent infringement occurred and identify

defenses to a patent infringement claim.

Patent infringement occurs when a defendant, without authorization from the patentee, usurps the patentee’s rights by making, using, or selling the patented invention. Because the Patent Act does not have an extraterritorial reach, the allegedly infringing activities must have occurred within the United States in order for a valid infringement claim to be triggered. The making of an item that would infringe a U.S. patent if the item were made within the United States will not constitute infringement if the item is made, for instance, in China. However, a provision of the Patent Act potentially allows infringement liability to be imposed on a party who ships “all or a substantial portion” of the components of the patented invention from the United States with the intended result that the components are assembled, in another country, to produce an item covered by the terms of the patent.  In Life Technologies Corp. v. Promega Corp., 137 S. Ct. 734 (2017), the Supreme Court held that the provision just noted did not give rise to liability when the defendant supplied, to an overseas assembler, only a single component of the plaintiff’s patented, multicomponent invention. The Court reasoned that if an invention has multiple components, a single component is not a “substantial portion” for purposes of the statute. Direct infringement may be established under principles of literal infringement or under a judicially developed approach known as the doctrine of equivalents. Infringement is literal in nature when the subject matter made, used, or sold by the defendant clearly falls within the stated terms of the claims of invention set forth in the patentee’s application. Under the doctrine of equivalents, a defendant may be held liable for infringement even though the subject matter he made, used, or sold contained elements that were not identical to those described in the patentee’s claims of invention, if the elements of the defendant’s subject matter nonetheless may be seen as equivalent to those of the patented invention. A traditional formulation of the test posed by the doctrine of equivalents is whether the alleged infringer’s subject matter performs substantially the same function as the protected invention in substantially the same way, in order to obtain the same result.

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Part Two Crimes and Torts

During the 1990s, an alleged infringer sought to convince the Supreme Court to abolish the doctrine of equivalents on the ground that it effectively allows patentees to extend the scope of patent protection beyond the stated terms approved by the PTO when it issued the patent. In WarnerJenkinson Co. v. Hilton Davis Chemical Co., 520 U.S. 17 (1997), however, the Court rejected this attack on the doctrine. The Court observed that in view of courts’ longstanding use of the doctrine (use in which Congress seemingly acquiesced by not legislatively prohibiting it), arguments for abolishing the doctrine would be better addressed to Congress. The forms of direct infringement discussed above are regarded as strict liability violations of the patent owner’s rights because they do not require proof that the defendant intended to infringe and because a defendant’s good-faith beliefs do not constitute a defense. In addition to the forms of direct infringement, the Patent Act sets forth further bases on which a defendant may be held liable for infringement. The statute provides that one who “actively induces” another party’s infringement of a patent “shall be liable as an infringer.” The Supreme Court has held in recent decisions that inducement liability cannot exist in the absence of proven direct infringement and in the absence of proof that the alleged inducer knew of the infringing ­nature of the induced acts. In an inducement case, is it a defense to liability if the defendant had a good-faith—though ­erroneous—belief that the plaintiff’s patent was invalid? The Supreme Court answered “no” in Commil USA, LLC v. Cisco Systems, Inc., 135 S. Ct. 1920 (2015). Another section of the Patent Act provides that one may be held liable for contributory infringement if he sells a direct patent infringer a component of the patented invention, or something useful in employing a patented process, and does so with knowledge not only of the patent’s existence, but also of the component’s or other item’s role in an infringing use. The thing sold must be a material part of the invention and must not be a staple article of commerce with some other significant use. For example, suppose that Irving directly infringes Potter’s patent on a certain electronic device by selling essentially identical electronic devices. If Davis sells Irving sophisticated circuitry with knowledge of Potter’s patent and of the circuitry’s role in Irving’s infringing use, Davis may be liable for contributory infringement (assuming that the circuitry is an important component of the electronic devices at issue and does not have other significant uses). Presumably the previously noted Commil rule—that a goodfaith, but erroneous, belief in the supposed invalidity of the patent is not a defense to inducement ­liability—also applies in the contributory infringement setting. The basic recovery for patent infringement is damages adequate to compensate for the infringement plus court costs

and interest. The damages cannot be less than a reasonable royalty for the use made of the invention by the infringer. The court may in its discretion award damages of up to three times those actually suffered. Injunctive relief is also available, and attorney fees may be awarded in exceptional cases. Because injunctions have so frequently been issued against defendants held liable for patent infringement, some courts had concluded that injunctions were effectively a mandatory remedy. However, in eBay, Inc. v. MercExchange, LLC, 547 U.S. 388 (2006), the Supreme Court ruled that courts are not required to issue an injunction against a defendant who committed patent infringement, if damages would be an adequate remedy and the public interest would not be served by the granting of an injunction. Defenses to Patent Infringement Explain what a patent owner must prove in order to LO8-3 establish that patent infringement occurred and identify defenses to a patent infringement claim.

Defendants in patent infringement cases cannot expect to avoid liability by pointing to their good-faith, but erroneous, belief that the plaintiff’s patent was invalid. However, if the defendant establishes the invalidity of the patent, the defendant has a good defense against liability. Sometimes the patent’s invalidity stems from the supposed invention’s failure to fall within a patentable category or from its effectively amounting to a law of nature or an abstract idea. See the previous discussion of such issues, as well as the Alice decision that appears earlier in the chapter. Often, the patent invalidity defense rests on the argument that the invention was not sufficiently novel or was obvious, and thus did not merit a patent. Despite the fact that the patent was issued by the PTO, courts have the ability to second-guess the PTO and order the cancellation of a patent on the ground of invalidity. Challenges to the validity of patents prove to be successful with reasonable frequency. In Microsoft Corp. v. i4i Ltd. Partnership, 131 S. Ct. 2238 (2011), the Supreme Court held that a party challenging a patent on the ground of invalidity must prove the facts underlying the invalidity contention by clear and convincing evidence rather than a mere preponderance of the evidence. Furthermore, one may also challenge a patent’s validity without first being sued for infringement by filing a declaratory judgment action that seeks a court ruling of invalidity. In appropriate cases, the defendant can assert that the patentee has committed patent misuse. This is behavior that unjustifiably exploits the patent monopoly. For example, the patentee may require the purchaser of a license on his patent



Chapter Eight Intellectual Property and Unfair Competition

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to buy his unpatented goods, or may tie the obtaining of a license on one of his patented inventions to the purchase of a license on another. One who refuses the patentee’s terms and later infringes the patent may attempt to escape liability by arguing that the patentee misused his monopoly position.

tries to balance these purposes against the equally compelling public interest in the free movement of ideas, information, and commerce. It does so mainly by limiting what a copyright on a work protects and by allowing the fair use defense described later.

Other Changes Resulting from the America Invents Act Probably the most significant change brought about by the AIA was the previously discussed switch to the first-to-file approach. Other AIA provisions that made important changes to the Patent Act included the following:

Coverage

• An expansion of the ability of other parties to pursue, within the PTO, post-patent-issuance review of a patent’s validity. • Creation of an opportunity for third parties, during the patent application review process, to provide the PTO with relevant information bearing upon whether the applied-for patent should be granted. • Expansion of the independent discovery defense to patent infringement so that the defense may be invoked not only as to business method patents, but also as to patents on processes or machines that have been used by a business for more than one year prior to another party’s filing of a patent application. Although controversy continues over whether business methods should be patentable, the AIA did not address that set of issues. Also left out of the AIA were measures directly restricting damage awards in patent infringement cases, despite calls in some quarters for such measures. Neither did the AIA deal with another subject of controversy in recent years: the emergence of the so-called patent trolls—parties that acquire patents from others, not for the purpose of producing the patented items themselves, but solely to exercise licensing leverage against users of the invention. However, recent Supreme Court decisions appear to contemplate greater ability on the part of courts to assess attorney fees against an apparent troll that loses an arguably frivolous patent infringement case.

LOG ON U.S. government websites contain a wealth of information on patent, copyright, and trademark law and procedures. For information on patents and trademarks, visit the site of the U.S. Patent and Trademark Office, at www.uspto.gov. Information on copyrights may be found at www.copyright.gov, the site of the U.S. Copyright Office.

Copyrights Copyright

law gives certain exclusive rights to creators of original works of authorship. It prevents others from using their work, gives them an incentive to innovate, and thereby benefits society. Yet copyright law also

LO8-4 List types of works that may carry copyright protection.

The federal Copyright Act protects a wide range of works of authorship, including books, periodical articles, dramatic and musical compositions, works of art (“pictorial, graphic, and sculptural works”), motion pictures and other audiovisual works, sound recordings, lectures, computer programs, and architectural plans. To merit copyright protection, such works must be fixed—set out in a tangible medium of expression from which they can be perceived, reproduced, or communicated. They also must be original (the author’s own work) and creative (reflecting exercise of the creator’s judgment). Unlike the inventions protected by patent law, however, copyrightable works need not satisfy a novelty requirement. Copyright protection does not extend to ideas, facts, procedures, processes, systems, methods of operation, concepts, principles, or discoveries. Instead, it protects the ways in which such things are expressed. For instance, an author’s phrasing of a descriptive passage in a novel or the story line of a play would be expression protected by the copyright on the novel or play, but the ideas, themes, or messages underlying the work would not be protected. Similarly, the expression in nonfiction works and compilations of facts would be protected by the copyright on such works, even though the facts present in them would be fair game for all to use. Computer programs involve their own special problems. It is fairly well settled that copyright law protects a program’s object code (program instructions that are machinereadable but not intelligible to humans) and source code (instructions intelligible to humans). There is less agreement, however, about the copyrightability of a program’s nonliteral elements such as its organization, its structure, and its presentation of information on the screen. Most courts that have considered the issue hold that nonliteral elements may sometimes be protected by copyright law, but courts differ about the extent of this protection. Copyright protection does not extend to utilitarian objects, which the Copyright Act refers to as “useful articles.” However, works of art that are incorporated into useful articles may sometimes be protected by copyright. In the Star Athletica case, which follows, the Supreme Court addresses such issues with regard to the design of cheerleading uniforms.

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Part Two Crimes and Torts

Star Athletica, LLC v. Varsity Brands, Inc.    137 S. Ct. 1002 (2017)

The Copyright Act of 1976, in 17 U.S.C. § 102(a), lists categories of copyrightable “works of authorship.” One category, noted in § 102(a) (5), is “pictorial, graphic, and sculptural works.” The following definition of “pictorial, graphic, and sculptural works” appears in § 101 of the statute: “Pictorial, graphic, and sculptural works” include two-dimensional and three-dimensional works of fine, graphic, and applied art, photographs, prints and art reproductions, maps, globes, charts, diagrams, models, and technical drawings, including architectural plans. Such works shall include works of artistic craftsmanship insofar as their form but not their mechanical or utilitarian aspects are concerned; the design of a useful article, as defined in this section, shall be considered a pictorial, graphic, or sculptural work only if, and only to the extent that, such design incorporates pictorial, graphic, or sculptural features that can be identified separately from, and are capable of existing independently of, the utilitarian aspects of the article. Section 101 goes on to define “useful article” as “an article having an intrinsic utilitarian function that is not merely to portray the appearance of the article or to convey information. An article that is normally a part of a useful article is considered a ‘useful article.’” Varsity Brands, Inc.; Varsity Spirit Corporation; and Varsity Spirit Fashions & Supplies Inc. design, make, and sell cheerleading uniforms. The Varsity entities have obtained or acquired more than 200 U.S. copyright registrations for two-dimensional designs appearing on the surface of their uniforms and other garments. These designs, as described in their applications for copyright registrations, are primarily “combinations, positionings, and arrangements of elements” that include “chevrons . . . , lines, curves, stripes, angles, diagonals, inverted [chevrons], coloring, and shapes.” Star Athletica, LLC (referred to here as Star or as petitioner) also markets and sells cheerleading uniforms. The Varsity entities sued Star for infringing their copyrights in five designs. The federal district court entered summary judgment for Star, reasoning that the designs did not qualify as copyrightable pictorial, graphic, or sculptural works under the Copyright Act provisions quoted above. The district court concluded that the designs served the useful, or “utilitarian,” function of identifying the garments as cheerleading uniforms and therefore could not satisfy the § 101 requirement of being separable from the uniform’s utilitarian aspects. The Varsity entities appealed to the U.S. Court of Appeals for the Sixth Circuit, which reversed the district court’s decision. In the Sixth Circuit’s view, the designs were separately identifiable from, and capable of existing independently of, the uniform for purposes of § 101. The U.S. Supreme Court granted Star’s petition for certiorari.

Thomas, Justice Congress has provided copyright protection for original works of art, but not for industrial designs. The line between art and industrial design, however, is often difficult to draw. This is particularly true when an industrial design incorporates artistic elements. Congress has afforded limited protection for these artistic elements by providing that “pictorial, graphic, or sculptural features” of the “design of a useful article” are eligible for copyright protection as artistic works if those features “can be identified separately from, and are capable of existing independently of, the utilitarian aspects of the article.” 17 U.S.C. § 101. We granted certiorari to [identify] the proper test for implementing § 101’s separate identification and independent-existence requirements.  The Copyright Act of 1976 defines copyrightable subject matter as “original works of authorship fixed in any tangible medium of expression.” 17 U.S.C. § 102(a). “Works of authorship” include “pictorial, graphic, and sculptural works,” § 102(a)(5), which the statute defines [in § 101] to include “two-dimensional and threedimensional works of fine, graphic, and applied art, photographs,

prints and art reproductions, maps, globes, charts, diagrams, models, and technical drawings, including architectural plans.”  The  Copyright Act  also establishes a special rule for copyrighting a pictorial, graphic, or sculptural work incorporated into a “useful article,” which is defined as “an article having an intrinsic utilitarian function that is not merely to portray the appearance of the article or to convey information.” § 101. The statute does not protect useful articles as such. Rather, “the design of a useful article” is “considered a pictorial, graphical, or sculptural work only if, and only to the extent that, such design incorporates pictorial, graphic, or sculptural features that can be identified separately from, and are capable of existing independently of, the utilitarian aspects of the article.” Id. Courts, the Copyright Office, and commentators have described the analysis undertaken to determine whether a feature can be separately identified from, and exist independently of, a useful article as “separability.” In this case, our task is to determine whether the arrangements of lines, chevrons, and colorful shapes appearing on the surface of respondents’ cheerleading



Chapter Eight Intellectual Property and Unfair Competition

uniforms are eligible for copyright protection as separable features of the design of those cheerleading uniforms. This is not a free-ranging search for the best copyright policy, but rather “depends solely on statutory interpretation.” Mazer v. Stein, 347 U.S. 201, 214 (1954). The statute provides that a “pictorial, graphic, or sculptural featur[e]” incorporated into the “design of a useful article” is eligible for copyright protection if it (1) “can be identified separately from,” and (2) is “capable of existing independently of, the utilitarian aspects of the article.” § 101. The first requirement—separate identification—is not onerous. The decisionmaker need only be able to look at the useful article and spot some two- or three-dimensional element that appears to have pictorial, graphic, or sculptural qualities. The independent-existence requirement is ordinarily more difficult to satisfy. The decisionmaker must determine that the separately identified feature has the capacity to exist apart from the utilitarian aspects of the article. In other words, the feature must be able to exist as its own pictorial, graphic, or sculptural work as defined in § 101 once it is imagined apart from the useful article. If the feature is not capable of existing as a pictorial, graphic, or sculptural work once separated from the useful article, then it was not a pictorial, graphic, or sculptural feature of that article, but rather one of its utilitarian aspects. Of course, to qualify as a pictorial, graphic, or sculptural work on its own, the feature cannot itself be a useful article or “[a]n article that is normally a part of a useful article” (which is itself considered a useful article). § 101. Nor could someone claim a copyright in a useful article merely by creating a replica of that article in some other medium—for example, a cardboard model of a car. Although the replica could itself be copyrightable, it would not give rise to any rights in the useful article that inspired it. The statute as a whole confirms our interpretation.  The Copyright Act provides “the owner of [a] copyright” with the “exclusive righ[t] . . . to reproduce the copyrighted work in copies.”  § 106(1). The statute clarifies that this right “includes the right to reproduce the [copyrighted] work in or on any kind of article, whether useful or otherwise.” § 113(a). Section 101 is, in essence, the mirror image of § 113(a). Whereas § 113(a) protects a work of authorship first fixed in some tangible medium other than a useful article and subsequently applied to a useful article, § 101 protects art first fixed in the medium of a useful article. The two provisions make clear that copyright protection extends to pictorial, graphic, and sculptural works regardless of whether they were created as freestanding art or as features of useful articles. The ultimate separability question, then, is whether the feature for which copyright protection is claimed would  have been eligible for copyright protection as a pictorial, graphic, or sculptural work had it originally been fixed in some tangible medium other than a useful article before being applied to a useful article.

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This interpretation is also consistent with the history of the  Copyright Act. In  Mazer, a case decided under the  1909 Copyright Act, the respondents copyrighted a statuette depicting a dancer. The statuette was intended for use as a lamp base, with electric wiring, sockets and lamp shades attached. Copies of the statuette were sold both as lamp bases and separately as statuettes. The petitioners copied the statuette and sold lamps with the statuette as the base. They defended against the respondents’ infringement suit by arguing that the respondents did not have a copyright in a statuette intended for use as a lamp base.  Two of  Mazer’s holdings are relevant here. First, the Court held that the respondents owned a copyright in the statuette even though it was intended for use as a lamp base. 347 U.S. at 214. In doing so, the Court approved the Copyright Office’s regulation extending copyright protection to works of art that might also serve a useful purpose. Second, the Court held that it was irrelevant to the copyright inquiry whether the statuette was initially created as a freestanding sculpture or as a lamp base. Id. at 218–19. Mazer thus interpreted the 1909 Act consistently with the rule discussed above: If a design would have been copyrightable as a standalone pictorial, graphic, or sculptural work, it is copyrightable if created first as part of a useful article. Shortly thereafter, the Copyright Office enacted a regulation implementing the holdings of Mazer. The regulation introduced the modern separability test to copyright law. Congress [later] essentially lifted the language governing protection for the design of a useful article directly from the post-Mazer regulation and placed it into § 101 of the 1976 Act. Consistent with Mazer, the approach we outline today interprets §§ 101 and 113 in a way that would afford  copyright protection to the statuette in  Mazer  regardless of whether it was first created as a standalone sculptural work or as the base of the lamp. In sum, a feature of the design of a useful article is eligible for copyright if, when identified and imagined apart from the useful article, it would qualify as a pictorial, graphic, or sculptural work either on its own or when fixed in some other tangible medium. Applying this test to the surface decorations on the cheerleading uniforms is straightforward. First, one can identify the decorations as features having pictorial, graphic, or sculptural qualities. Second, if the arrangement of colors, shapes, stripes, and chevrons on the surface of the cheerleading uniforms were separated from the uniform and applied in another medium—for example, on a painter’s canvas—they would qualify as “two-dimensional . . . works of . . . art” [for purposes of] § 101. And imaginatively removing the surface decorations from the uniforms and applying them in another medium would not replicate the uniform itself. Indeed, respondents have applied the designs in this case to other media of expression—different types of clothing—without replicating the uniform. The decorations are therefore separable from the uniforms and eligible for copyright protection. (We do not today hold,

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Part Two Crimes and Torts

however, that the surface decorations are copyrightable. [We hold only that they are eligible for copyright protection.] We express no opinion on whether these works are sufficiently original to qualify for copyright protection, or on whether any other prerequisite of a valid copyright has been satisfied.) The dissent argues that the designs are not separable because imaginatively removing them from the uniforms and placing them in some other medium of expression—a canvas, for example—would create “pictures of cheerleader uniforms.”  Petitioner similarly argues that the decorations cannot be copyrighted because, even when extracted from the useful article, they retain the outline of a cheerleading uniform. This is not a bar to copyright.  Just as two-dimensional fine art corresponds to the shape of the canvas on which it is painted, twodimensional applied art correlates to the contours of the article on which it is applied. A fresco painted on a wall, ceiling panel, or dome would not lose copyright protection, for example, simply because it was designed to track the dimensions of the surface on which it was painted. Or consider, for example, a design etched or painted on the surface of a guitar. If that entire design is imaginatively removed from the guitar’s surface and placed on an album cover, it would still resemble the shape of a guitar. But the image on the cover does not “replicate” the guitar as a useful article. Rather, the design is a two-dimensional work of art that corresponds to the shape of the useful article to which it was applied. The statute protects that work of art whether it is first drawn on the album cover and then applied to the guitar’s surface, or vice versa. Failing to protect that art would create an anomaly: It would extend protection to two-dimensional designs that cover a part of a useful article but would not protect the same design if it covered the entire article. The statute does not support that distinction. To be clear, the only feature of the cheerleading uniform eligible for a copyright in this case is the two-dimensional work of art fixed in the tangible medium of the uniform fabric. Even if respondents ultimately succeed in establishing a valid copyright in the surface decorations at issue here, respondents have no right to prohibit any person from manufacturing a cheerleading uniform of identical shape, cut, and dimensions to the ones on which

the decorations in this case appear. They may prohibit only the reproduction of the surface designs in any tangible medium of expression—a uniform or otherwise.  Petitioner argues that allowing the surface decorations to qualify as a “work of authorship” is inconsistent with congressional intent to entirely exclude industrial design from copyright. Petitioner notes that Congress refused to pass a provision that would have provided limited copyright protection for industrial designs, including clothing, when it enacted the 1976 Act, and that it has enacted laws protecting designs for specific useful articles—semiconductor chips and boat hulls—while declining to enact other industrial design statutes. From this history of failed legislation, petitioner reasons that Congress intends to channel intellectual property claims for industrial design into design patents. It therefore urges us to approach this question with a presumption against copyrightability.  We do not share petitioner’s concern. As an initial matter,  “[c]ongressional inaction lacks persuasive significance” in most circumstances. [Citation omitted.] Moreover, we have long held that design patent and copyright are not mutually exclusive. See  Mazer, 347 U.S. at 217. Congress has provided for limited copyright protection for certain features of industrial design, and approaching the statute with presumptive hostility toward protection for industrial design would undermine Congress’s choice. In any event, as explained above, our test does not render the shape, cut, and physical dimensions of the cheerleading uniforms eligible for copyright protection. We hold that an artistic feature of the design of a useful article is eligible for copyright protection if the feature (1) can be perceived as a two- or three-dimensional work of art separate from the useful article and (2) would qualify as a protectable pictorial, graphic, or sculptural work either on its own or in some other medium if imagined separately from the useful article. Because the designs on the surface of respondents’ cheerleading uniforms in this case satisfy these requirements, the [designs are eligible for copyright protection.]

Creation and Notice A copyright comes into existence upon the creation and fixing of a protected work. Although a copyright owner may register the copyright with the U.S. Copyright Office, registration is not necessary for the copyright to exist. However, registration normally is a procedural prerequisite to filing a suit for copyright infringement. Even though it is not required, copyright

owners often provide notice of the copyright. Federal law authorizes a basic form of notice for use with most copyrighted works. A book, for example, might include the term Copyright (or the abbreviation Copr. or the symbol ©), the year of its first publication, and the name of the copyright owner in a location likely to give reasonable notice to readers.

Sixth Circuit’s decision affirmed.



Chapter Eight Intellectual Property and Unfair Competition

Duration LO8-5 Explain how long copyrights last.

The U.S. Constitution’s Copyright and Patents Clause (Article I, § 8) empowers Congress to “promote the Progress of Science and useful Arts” by enacting copyright and patent laws that “secur[e] for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.” Thus, copyrights and patents cannot last forever. Even so, the history of copyright protection in the United States has featured various significant lengthenings of the “limited time” a copyright endures. When a copyright’s duration ends, the underlying work enters the public domain and becomes available for any uses other parties wish to make of it. The former copyright owner, therefore, loses control over the work and forfeits what had been valuable legal rights. With the enactment of the Sonny Bono Copyright Term Extension Act (hereinafter CTEA) in 1998, Congress conferred a substantial benefit on copyright owners. The CTEA added 20 years to the duration of copyrights, not only for works created after the CTEA’s enactment,  but also for any preexisting work that was still under valid copyright protection as of the CTEA’s 1998 effective date. Copyright owners—especially some high-profile corporations whose copyrights on older works would soon have expired if not for the enactment of the CTEA—mounted a significant lobbying effort in favor of the term extension provided by the CTEA. The CTEA’s effect cannot be understood without discussion of the copyright duration rules that existed immediately before the CTEA’s enactment. One set of rules applied to works created in 1978 or thereafter; another set applied to pre-1978 works. The copyright on pre-1978 works was good for a term of 28 years from first publication of the work, plus a renewal term of 47 years. (The renewal term had been only 28 years until Congress changed the law in 1976 and added 19 more years to the renewal term for any work then under valid copyright protection.) As a result, 75 years of protection was available for pre1978 works. For works created in 1978 or thereafter, Congress scrapped the initial-term-plus-renewal-term approach, opting instead for a normally applicable rule that the copyright lasts for the life of the author/creator plus 50 years. This basic duration rule did not apply, however, if the copyrighted work, though created in 1978 or thereafter, was a work-for-hire. (The two types of work-for-hire will be explained below.) In a work-for-hire situation, the copyright would exist for 75 years

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from first publication of the work or 100 years from creation of it, whichever came first. The CTEA tacked on 20 years to the durations contemplated by the rules discussed in the preceding two paragraphs. A pre-1978 work that was still under valid copyright protection as of 1998 (when the CTEA took effect) now has a total protection period of 95 years from first ­publication—a 28-year initial term plus a renewal term that has been lengthened from 47 to 67 years. The copyright on Disney’s “Steamboat Willie” cartoon—best known for its introduction of the famous Mickey Mouse character—serves as an example. The protection period for the Steamboat Willie copyright began to run in the late 1920s, when the cartoon was released and distributed (i.e., published, for purposes of copyright law). Given the rule that existed immediately before the CTEA’s enactment (an initial term of 28 years plus a renewal term of 47 years), the Steamboat Willie copyright would have expired within the first few years of the current century. The CTEA, however, gave Disney an additional 20 years of rights over the Steamboat Willie cartoon before it would pass into the public domain. With the enactment of the CTEA, the basic duration rule for works created in 1978 or thereafter is now life of the author/creator plus 70 years (up from 50). The duration rule for a work-for-hire is now 95 years from first publication (up from 75) or 120 years from creation (up from 100), whichever comes first. Critics of the CTEA mounted a constitutional challenge to the statute in Eldred v. Ashcroft, a case that made its way to the Supreme Court. Those challenging the CTEA argued that the statute violated the purpose of the “limited Times” provision in the Constitution’s Copyright Clause by making copyright protection so lengthy in duration. They also contended that the Copyright Clause’s language empowering Congress to enact copyright laws to “promote the Progress of Science and useful Arts” served as an incentive-to-create limitation on the exercise of that power, and that the CTEA—at least insofar as it applied to works already created as of 1998—­unconstitutionally violated the incentive-to-create limitation. In its 2003 decision in Eldred, 537 U.S. 186, the Supreme Court rejected the constitutional challenge to the CTEA. The Court concluded that the CTEA may have been an unwise enactment as a matter of public policy, but that it fell within the authority extended to Congress by the Copyright Clause. Works-for-Hire A work-for-hire exists when (1) an employee, in the course of her regular employment duties, prepares a copyrightable work or (2) an individual or corporation and an independent contractor (i.e., nonemployee) enter into a written agreement under which the independent contractor is to prepare, for the retaining individual

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Part Two Crimes and Torts

or corporation, one of several types of copyrightable works designated in the Copyright Act. In the first situation, the employer is legally classified as the work’s author and copyright owner. In the second situation, the party who (or which) retained the independent contractor is considered the resulting work’s author and copyright owner. Ownership Rights LO8-6

Explain the rights copyright owners hold and the relationship of those rights to claims for copyright infringement.

A copyright owner has exclusive rights to reproduce the copyrighted work, prepare derivative works based on it (e.g., a movie version of a novel), and distribute copies of the work by sale or otherwise. With certain copyrighted works, the copyright owner also obtains the exclusive right to perform the work or display it publicly.  Copyright ownership initially resides in the creator of the copyrighted work, but the copyright may be transferred to another party. Also, the owner may individually transfer any of her ownership rights, or a portion of each, without losing ownership of the remaining rights. Most transfers of copyright ownership require a writing signed by the owner

or his agent. The owner may also retain ownership while licensing the copyrighted work or a portion of it. First Sale Doctrine An earlier discussion in this chapter dealt with patent law’s first sale doctrine. Copyright law recognizes such a doctrine as well. As in patent law, copyright law’s first sale doctrine extinguishes a copyright owner’s rights regarding a particular copy of the copyrighted work once that copy has been lawfully sold. For example, this book is a copyrighted work. Once the publishing company (the copyright owner in this instance) sells a copy of the book to, say, a bookstore, the copyright owner cannot control the further distribution of that copy of the book. The bookstore can sell it to you, you can sell or give that copy to someone else, and so on. Copies of the textbook in the above example were published in the United States. Does the first sale doctrine apply when the relevant copies were produced outside the United States? In Kirtsaeng v. John Wiley & Sons, which follows, the Supreme Court addresses that question. The Court also considers the relationship between the first sale doctrine and a separate federal law providing that a copyright owner’s right to distribute copies of the work is violated when copies of the work are acquired overseas and imported into the United States without the copyright owner’s authorization.

Kirtsaeng v. John Wiley & Sons, Inc.   568 U.S. 519 (2013) The Copyright Act grants certain “exclusive rights” to copyright owners. See 17 U.S.C. § 106. Among those rights is the right “to distribute copies” of the copyrighted work. Id. § 106(3). However, the copyright owner’s rights are qualified by limitations set out in §§ 107 through 122, including the “first sale” doctrine. This doctrine, as set forth in § 109(a), provides that “the owner of a particular copy or phonorecord lawfully made under this title . . . is entitled, without the authority of the copyright owner, to sell or otherwise dispose of the possession of that copy or phonorecord.” A separate provision in federal law, § 602(a)(1), states that “[i]mportation into the United States, without the authority of the owner of copyright under this title, of copies . . . of a work that have been acquired outside the United States is an infringement of the exclusive right to distribute copies . . . under section 106.” In Quality King Distributors v. L’anza Research Int’l, 523 U.S. 135, 145 (1998), the Supreme Court held that § 602(a)(1)’s reference to § 106(3) incorporates the §§ 107 through 122 limitations on copyright owners’ rights, including § 109(a)’s first sale doctrine. The importer in Quality King therefore was held entitled to invoke the first sale doctrine as a defense. The imported copy at issue in that case was initially manufactured in the United States and then sent abroad and sold. John Wiley & Sons Inc. (Wiley), an academic textbook publisher, often assigns to its wholly owned foreign subsidiary (Wiley Asia) rights to publish, print, and sell foreign editions of Wiley’s English-language textbooks abroad. As a result, there are often two essentially equivalent versions of a Wiley textbook (with each version being manufactured and sold with Wiley’s permission): (1) an American version printed and sold in the United States and (2) a foreign version manufactured and sold abroad. The books produced and sold by Wiley Asia contain notices stating that they are to be sold only in certain designated nations other than the United States or in certain designated regions of the world outside the United States and that they are not to be taken into the United States without Wiley’s permission. Supap Kirtsaeng, a citizen of Thailand, was a student in the United States. He asked friends and family to buy foreign edition English-language Wiley textbooks in Thai book shops, where they sold at low prices, and to mail them to him in the United States They did so. Kirtsaeng then sold the books, reimbursed his family and friends, and kept the profits.



Chapter Eight Intellectual Property and Unfair Competition

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Wiley sued Kirtsaeng, claiming that his unauthorized importation and resale of the books infringed Wiley’s § 106(3) right to distribute and § 602(a)(1)’s import prohibition. Kirtsaeng argued that because the books were “lawfully made” and acquired legitimately, § 109(a)’s first sale doctrine permitted importation and resale without Wiley’s further permission. A federal district court held that the first sale doctrine does not apply to copies produced outside the United States and that Kirtsaeng therefore could not assert this defense. The jury found that Kirtsaeng had willfully infringed Wiley’s copyrights and that Wiley was entitled to recover statutory damages totaling $600,000. The U.S. Court of Appeals for the Second Circuit affirmed, concluding that § 109(a)’s “lawfully made under this title” language does not sweep in copies of American copyrighted works manufactured abroad. With other federal courts having ruled differently on whether the first sale doctrine applies only when the copies were produced in the United States, the Supreme Court agreed to decide the case in order to resolve the split among the lower courts. Breyer, Justice [E]ven though § 106(3) forbids distribution of a copy of [a] copyrighted novel [work] without the copyright owner’s permission, § 109(a) adds that, once a copy of [the work] has been lawfully sold (or its ownership otherwise lawfully transferred), the buyer of that copy and subsequent owners are free to dispose of it as they wish. In copyright jargon, the “first sale” has “exhausted” the copyright owner’s § 106(3) exclusive distribution right [as to that copy]. What, however, if the copy of [the work] was printed abroad and then initially sold with the copyright owner’s permission? Does the first sale doctrine still apply? Is the buyer, like the buyer of a domestically manufactured copy, free to bring the copy into the United States and dispose of it as he or she wishes? To put the matter technically, an “importation” provision, § 602(a)(1), says that “[i]mportation into the United States, without the authority of the owner of copyright under this title, of copies . . . of a work that have been acquired outside the United States is an infringement of the exclusive right to distribute copies . . . under section 106.” Thus § 602(a)(1) makes clear that importing a copy without permission violates the owner’s exclusive distribution right. But in doing so, § 602(a)(1) refers explicitly to the § 106(3) exclusive distribution right. [Section] 106 is by its terms “[s]ubject to” the various doctrines and principles contained in §§ 107 through 122, including § 109(a)’s first sale limitation. Do those same modifications apply—in particular, does the first sale modification apply—when considering whether § 602(a)(1) prohibits importing a copy? In Quality King Distributors v. L’anza Research Int’l, 523 U.S. 135, 145 (1998), we held that § 602(a)(1)’s reference to § 106(3)’s exclusive distribution right incorporates the later subsections’ limitations, including, in particular, the first sale doctrine of § 109. Thus, it might seem that, § 602(a)(1) notwithstanding, one who buys a copy abroad can freely import that copy into the United States and dispose of it, just as he could had he bought the copy in the United States. But Quality King considered an instance in which the copy, though purchased abroad, was initially manufactured in the United States (and then sent abroad and sold). This case is like Quality King but for one important fact. The copies at issue here were manufactured abroad. That fact is important because

§ 109(a) says that the first sale doctrine applies to “a particular copy or phonorecord lawfully made under this title.” And we must decide here whether the five words, “lawfully made under this title,” make a critical legal difference. Putting section numbers to the side, we ask whether the first sale doctrine applies to protect a buyer or other lawful owner of a copy (of a copyrighted work) lawfully manufactured abroad. Can that buyer bring that copy into the United States (and sell it or give it away) without obtaining permission to do so from the copyright owner? Can, for example, someone who purchases, say at a used bookstore, a book printed abroad subsequently resell it without the copyright owner’s permission? We must decide whether the words “lawfully made under this title” restrict the scope of § 109(a)’s first sale doctrine geographically. The Second Circuit, the Ninth Circuit, Wiley, and the Solicitor General (as amicus) all read those words as imposing a form of geographical limitation. The Second Circuit held that they limit the first sale doctrine to particular copies “made in territories in which the Copyright Act is law,” which (the Circuit says) are copies “manufactured domestically,” not “outside of the United States.” [Citation omitted.] [The Ninth Circuit has reached the same conclusion through similar reasoning. Wiley and the Solicitor General make essentially the same argument.] Under [such a] geographical interpretation, § 109(a)’s first sale doctrine would not apply to the Wiley Asia books at issue here. And, despite an American copyright owner’s permission to make copies abroad, one who buys a copy of any such book or other copyrighted work—whether at a retail store, over the Internet, or at a library sale—could not resell (or otherwise dispose of) that particular copy without further permission. Kirtsaeng, however, reads the words “lawfully made under this title” as imposing a non-geographical limitation. He says that they mean made “in accordance with” or “in compliance with” the Copyright Act. Brief for Petitioner. [Under that interpretation], § 109(a)’s first sale doctrine would apply to copyrighted works as long as their manufacture met the requirements of American copyright law. In particular, the doctrine would apply where, as here, copies are manufactured abroad with the permission of the copyright owner. See § 106 (referring to the owner’s right to authorize [the making of copies]).

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Part Two Crimes and Torts

In our view, § 109(a)’s language, its context, and the commonlaw history of the first sale doctrine, taken together, favor a nongeographical interpretation. [Authors’ note: The Court engaged in extensive explanation of the linguistic difficulties and potentially complex questions that a geographical interpretation would involve and stressed the relative simplicity and easier-to-apply nature of the nongeographical interpretation. In addition, the Court explained at length why a legislative history approach also favored a nongeographic interpretation, chiefly because a previous version of the statutory section outlining the first sale doctrine did not include a geographic limitation and because the language inserted in the current statutory section did not seem to add a geographic qualifier. The Court also explained that the common law version of the first sale doctrine (which existed before the doctrine was placed in statutory form) did not contemplate a geographic limitation. Details of the Court’s statutory language, legislative history, and common law discussions are omitted.] We also doubt that Congress would have intended to create the practical copyright-related harms with which a geographical interpretation would threaten ordinary scholarly, artistic, commercial, and consumer activities. Associations of libraries, usedbook dealers, technology companies, consumer-goods retailers, and museums point to various ways in which a geographical interpretation would fail to further basic constitutional copyright objectives, in particular “promot[ing] the Progress of Science and useful Arts.” U.S. Const., Art. I, § 8, cl. 8. The American Library Association tells us that library collections contain at least 200 million books published abroad (presumably, many were first published in one of the nearly 180 copyright-treaty nations and enjoy American copyright protection under 17 U.S.C. § 104); that many others were first published in the United States but printed abroad because of lower costs; and that a geographical interpretation will likely require the libraries to obtain permission (or at least create significant uncertainty) before circulating or otherwise distributing these books. Brief for American Library Association et al. as Amici Curiae. How, the American Library Association asks, are the libraries to obtain permission to distribute these millions of books? How can they find, say, the copyright owner of a foreign book, perhaps written decades ago? They may not know the copyright holder’s present address. And, even where addresses can be found, the costs of finding them, contacting owners, and negotiating may be high indeed. Are the libraries to stop circulating or distributing or displaying the millions of books in their collections that were printed abroad? Used-book dealers tell us that, from the time when Benjamin Franklin and Thomas Jefferson built commercial and personal libraries of foreign books, American readers have bought used books published and printed abroad. Brief for Powell’s Books Inc. et al. as Amici Curiae. The dealers say that they have “operat[ed] . . .

for centuries” under the assumption that the “first sale” doctrine applies. But under a geographical interpretation a contemporary tourist who buys, say, at Shakespeare and Co. (in Paris), a dozen copies of a foreign book for American friends might find that she had violated the copyright law. The used-book dealers cannot easily predict what the foreign copyright holder may think about a reader’s effort to sell a used copy of a novel. And they believe that a geographical interpretation will injure a large portion of the used-book business. Technology companies tell us that “automobiles, microwaves, calculators, mobile phones, tablets, and personal computers” contain copyrightable software programs or packaging. Brief for Public Knowledge et al. as Amici Curiae. Many of these items are made abroad with the American copyright holder’s permission and then sold and imported (with that permission) to the United States. A geographical interpretation would prevent the resale of, say, a car, without the permission of the holder of each copyright on each piece of copyrighted automobile software. Yet there is no reason to believe that foreign auto manufacturers regularly obtain this kind of permission from their software component suppliers. Without that permission, a foreign car owner [presumably] could not [lawfully] sell his or her used car [if the geographical interpretation were adopted]. Retailers tell us that over $2.3 trillion worth of foreign goods were imported in 2011. Brief for Retail Litigation Center. American retailers buy many of these goods after a first sale abroad. And, many of these items bear, carry, or contain copyrighted “packaging, logos, labels, and product inserts and instructions for [the use of] everyday packaged goods from floor cleaners and health and beauty products to breakfast cereals.” The retailers add that American sales of more traditional copyrighted works, “such as books, recorded music, motion pictures, and magazines,” likely amount to over $220 billion. A geographical interpretation would subject many, if not all, of them to the disruptive impact of the threat of infringement suits. Art museum directors ask us to consider their efforts to display foreign-produced works by, say, Cy Twombly, Rene Magritte, Henri Matisse, Pablo Picasso, and others. A geographical interpretation, they say, would require the museums to obtain permission from the copyright owners before they could display the work—even if the copyright owner has already sold or donated the work to a foreign museum. Brief for Association of Art Museum Directors et al. as Amici Curiae. What are the museums to do, they ask, if the artist retained the copyright, if the artist cannot be found, or if a group of heirs is arguing about who owns which copyright? [R]eliance upon the first sale doctrine is deeply embedded in the practices of those, such as booksellers, libraries, museums, and retailers, who have long relied upon its protection. [W]e believe that the practical problems that Kirtsaeng and his amici have described are too serious, too extensive, and too likely



Chapter Eight Intellectual Property and Unfair Competition

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to come about for us to dismiss them as insignificant—particularly in light of the ever-growing importance of foreign trade to America. The upshot is that copyright-related consequences along with language, context, and interpretive canons argue strongly against a geographical interpretation of § 109(a). Wiley [also argues] that our Quality King decision strongly supports [the] geographical interpretation [that Wiley favors]. [In that case,] an American copyright owner authorized the first sale and export of hair care products with copyrighted labels made in the United States, and [an overseas] buyer sought to import them back into the United States without the copyright owner’s permission. We held that the importation provision [§ 602(a)] did not prohibit sending the products back into the United States without the copyright owner’s permission. We pointed out that [the importation section made] importation an infringement of the “exclusive right to distribute . . . under § 106.” We noted that § 109(a)’s first sale doctrine limits the scope of the § 106 exclusive distribution right. We took as given the fact that the products at issue had at least once been sold. And we held that consequently, importation of the copyrighted labels did not violate [the importation section]. [Although the products at issue in Quality King had been produced in the United States before being sent overseas and then reimported, as opposed to being produced overseas, the Quality King holding did not depend on that fact. Any statement seeming

to suggest that production in the United States was a key fact on which that decision depended—or that Quality King was adopting a geographical limitation on the first-sale doctrine—was dictum and therefore not binding here.] [The nongeographical interpretation adopted here does not] make § 602(a)(1) pointless. Section 602(a)(1) would still [generally] forbid importing (without permission . . .) copies lawfully made abroad, for example, where (1) a foreign publisher operating as the licensee of an American publisher prints copies of a book overseas but, prior to any authorized sale, seeks to send them to the United States; (2) a foreign printer or other manufacturer (if not the “owner” for purposes of § 109(a), e.g., before an authorized sale) sought to send copyrighted goods to the United States; (3) a book publisher transports copies to a wholesaler and the wholesaler (not yet the owner) sends them to the United States; or (4) a foreign film distributor, having leased films for distribution, or any other licensee, consignee, or bailee sought to send them to the United States. These examples show that § 602(a)(1) retains significance. For [the foregoing] reasons we conclude that the considerations supporting Kirtsaeng’s nongeographical interpretation of the words “lawfully made under this title” are the more persuasive.

Infringement

substantial similarity must exist with regard to the copyrighted work’s protected expression. Copying of general ideas, facts, themes, and the like (i.e., copying of unprotected matter) is not infringement. The defendant’s having paraphrased protected expression does not constitute a defense to what otherwise appears to be infringement. Neither does the defendant’s having credited the copyrighted work as the source from which the defendant borrowed. Recent years’ explosion in Internet usage has led to difficult copyright questions. For instance, unlicensed services such as Napster, Grokster, and StreamCast allowed easy and free-of-charge access to musical recordings in digital files. Owners of copyrights on songs and recordings resorted to litigation against such providers on the theory that they materially contributed to or induced copyright infringement by their users. In the Grokster decision, the Supreme Court focused on the inducement basis for imposing liability. For discussion of that case, see the nearby Cyberlaw in Action box. The basic recovery for copyright infringement is the owner’s actual damages plus the attributable profits received by the infringer. In lieu of the basic remedy, however, the plaintiff may usually elect to receive statutory

LO8-6

Explain the rights copyright owners hold and the relationship of those rights to claims for copyright infringement.

Those who violate any of the copyright owner’s exclusive rights may be liable for copyright infringement. Infringement is fairly easily proven when direct evidence of significant copying exists; verbatim copying of protected material is an example. Usually, however, proof of infringement involves establishing that (1) the defendant had access to the copyrighted work; (2) the defendant engaged in enough copying—either deliberately or subconsciously—that the resemblance between the allegedly infringing work and the copyrighted work does not seem coincidental; and (3) there is substantial similarity between the two works. Access may be proven circumstantially, such as by showing that the copyrighted work was widely circulated. The copying and substantial similarity elements, which closely relate to each other, necessarily involve discretionary case-by-case determinations. Of course, the copying and

Second Circuit decision reversed; Kirtsaeng held entitled to invoke first sale doctrine; case remanded for further proceedings.

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Part Two Crimes and Torts

CYBERLAW IN ACTION Grokster Ltd. and StreamCast Networks Inc. distributed free software products allowing computer users to share electronic files through peer-to-peer networks in which users’ computers communicated directly with each other rather than through central servers. Although the networks these persons enjoyed through using the Grokster and StreamCast software could be employed for the sharing of any type of digital file, most users employed the networks in order to share copyrighted music and video files without authorization. Numerous copyright owners—including motion picture studios, recording companies, songwriters, and music publishers, but referred to here as MGM for convenience—filed separate lawsuits against Grokster and StreamCast in an effort to have them held liable for their users’ copyright infringements. The various cases were consolidated into one case in a federal district court. Evidence produced in the district court proceedings indicated that users who downloaded the Grokster and StreamCast software received the protocol to send requests for files directly to the computers of others using compatible software. If the requested file was found, the requesting user could download it directly from the computer where it was located. As this description indicates, Grokster and StreamCast used no servers to intercept the content of the search requests or to mediate the file transfers conducted by users of their software. Although Grokster and StreamCast therefore did not know when particular files were copied, searches using their software revealed what was available on the networks the software reached. A study by a statistician for MGM showed that nearly 90 percent of the files available for download by Grokster and StreamCast users were copyrighted works. Grokster and StreamCast disputed this figure, argued that free copying of copyrighted works is sometimes authorized by the copyright holders and asserted that potential noninfringing uses of its software were significant. Some musical performers, the defendants noted, had gained new audiences by distributing their copyrighted works for free across peer-to-peer networks, and some distributors of public domain content (e.g., Shakespeare’s plays) had used peer-to-peer networks to disseminate files. MGM provided evidence tending to indicate, however, that the vast majority of users’ downloads were acts of infringement.

damages. The statutory damages set by the trial judge or jury must fall within the range of $750 to $30,000 unless the infringement was willful, in which event the maximum rises to $150,000. These limits do not apply if the plaintiff elects the basic remedy, however. Injunctive relief and awards of costs and attorney fees are possible in appropriate cases. Although it seldom does so, the federal government may pursue a criminal copyright infringement prosecution if the infringement was willful and for purposes of commercial advantage or private financial gain.

The district court granted summary judgment in favor of Grokster and StreamCast because the fact that no files passed through servers they owned or controlled meant that they did not have knowledge of particular acts of infringement (even if they knew of infringing uses in general) and that they therefore had neither a duty nor the ability to police how their systems were being used. Therefore, the court reasoned, the defendants could not be held liable for contributory or vicarious infringement. After a federal court of appeals affirmed, the Supreme Court granted MGM’s request that it hear the case. The Supreme Court went in another direction, holding that Grokster and StreamCast could be held liable for infringement on the basis of inducement. For the Court, it was highly significant that the record produced at the district court level revealed considerable evidence of the defendants’ loud and public voicing— through electronic newsletters, electronic advertisements, and other means—of the objective that recipients of the Grokster and StreamCast software use it to download copyrighted works. MGM presented further evidence suggesting that after a successful lawsuit by copyright owners effectively shut down the Napster file-sharing service (which had routed files through Napster’s servers), Grokster and StreamCast sought to promote their software as devices by which former Napster users could obtain easy access to desired files. Although Grokster and StreamCast distributed their software free of charge, they made money by selling advertising space and streaming the advertising to users of the software. The Court observed that “[t]he question is under what circumstances the distributor of a product capable of both lawful and unlawful use is liable for acts of copyright infringement by third parties using the product.” Confirming that the inducement basis of liability exists as part of copyright law, the Court held that “one who distributes a device with the object of promoting its use to infringe copyright, as shown by clear expression or other affirmative steps taken to foster infringement, is liable for the resulting acts of infringement by third parties.” Under the Court’s reasoning, the fact that the Grokster and StreamCast systems could have been used for significant noninfringing purposes probably would have insulated the defendants against liability if they had not actively promoted the infringing uses to which their systems could be put.

Fair Use List the fair use factors and apply them to fact patterns

LO8-7 in which the fair use defense to copyright infringement

liability is invoked.

The fair use doctrine recognizes that the social purposes present in certain uses of copyrighted works may be important enough to excuse defendants’ uses of the works without permission. When a court concludes that the defendant is entitled to the protection of the fair use defense,



Chapter Eight Intellectual Property and Unfair Competition

the defendant avoids liability for what otherwise would have been copyright infringement. In many infringement cases, there is little or no dispute over whether the defendant’s actions would be infringing if the fair use defense did not apply. Therefore, whether the defendant’s use was or was not fair use frequently demands much of the court’s attention. In the Copyright Act, Congress singled out these uses as good candidates for fair use protection: criticism or comment; news reporting; and teaching, scholarship, or research. The words good candidates are important here because even a use that falls within the list just noted could be held not to be fair use once the court engages in the necessary weighing and balancing of relevant factors specified by Congress. Those factors are (1) the purpose and character of the use; (2) the nature of the copyrighted work; (3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and (4) the effect, if any, of the use on the potential markets for, or value of, the copyrighted work. The case-by-case nature of the inquiry makes fair use determinations highly fact-specific. Two leading Supreme Court decisions serve as useful examples. In Harper & Row, Publishers v. Nation Enterprises, 471 U.S. 539 (1985), the Court applied the factors noted above and concluded that the fair use defense did not protect a magazine against copyright infringement liability for using, in a magazine article, 300 to 400 words from an unpublished book manuscript (the memoirs of former President Gerald Ford). The Court held that fair use was not present even though the magazine argued that it was engaging in news reporting and an educational endeavor.

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In Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569 (1994), the Court ruled that use of portions of a copyrighted work for purposes of parody (a form of criticism or comment) will often have a strong claim to fair use protection. By stating that the fair use factors—especially the first but also the third and fourth—take into account whether the defendant’s use was “transformative” in nature, the Court enunciated a principle that has since received great emphasis when courts apply the fair use factors. Bouchat v. Baltimore Ravens Limited Partnership, which appears shortly, considers what makes a use transformative. Although Congress has specified that the factors listed earlier must be applied when courts decide fair use questions, courts are free to consider additional factors such as the public interest. The public interest consideration played a role in a court decision sustaining, as fair use, Google’s book search project (in which Google displays snippets from other parties’ copyrighted works in a program that enables persons to search for and within huge numbers of books). Similarly, the public interest consideration appears to have been a factor in a court decision holding that the fair use doctrine justified Google’s display of search results in the form of thumbnail-sized images of another party’s copyrighted pictures. The Bouchat case, which follows, is the fifth installment in a series of cases dealing with a copyrighted drawing whose expressive content served for a time as the basis of a professional football team’s logo. Besides applying the fair use factors in order to determine whether the uses at issue were fair use, the Bouchat court comments on the fair use determinations in the earlier cases in the series.

Bouchat v. Baltimore Ravens Limited Partnership    737 F.3d 932 (4th Cir. 2013)

In the latest chapter of extensive litigation dealing with uses of the “Flying B” logo, Frederick Bouchat sued the Baltimore Ravens Limited Partnership (hereinafter, Ravens) and the National Football League (hereinafter, NFL) for copyright infringement. Bouchat’s lawsuit was the fifth in a series of Flying B logo–related cases. Background on the earlier cases is useful to an understanding of the facts and issues in the fifth case (which led to the Fourth Circuit decision that appears in edited form below). In June 1996, two months before the beginning of the team’s first season, the Ravens unveiled the Flying B logo as its symbol. Bouchat noticed that the logo bore a strong resemblance to one he had previously created and provided (in the form of drawings) to the Maryland Stadium Authority’s chairperson, who was to pass it along to the Ravens franchise. Bouchat expected to be compensated if the Ravens decided to use the logo. In May 1997, after the team’s first season, Bouchat filed his first copyright infringement lawsuit against the Ravens and an NFL subsidiary. He contended that the Flying B logo infringed the copyrights on his drawings. After a jury concluded that the defendants infringed the copyright on one of Bouchat’s drawings, the U.S. Court of Appeals for the Fourth Circuit refused to set aside the verdict. See Bouchat v. Baltimore Ravens, Inc., 241 F.3d 350 (4th Cir. 2000) (Bouchat I). After the 1998 season, the Ravens adopted a new logo and no longer featured the Flying B on their uniforms and merchandise. The Fourth Circuit subsequently issued three more decisions in lawsuits brought by Bouchat regarding the Flying B logo: Bouchat v.

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Baltimore Ravens Football Club, Inc., 346 F.3d 514 (4th Cir. 2003) (Bouchat II) (affirming a jury award of zero dollars for the original infringement); Bouchat v. Bon-Ton Dep’t Stores, Inc., 506 F.3d 315 (4th Cir. 2007) (Bouchat III) (affirming a number of judgments in favor of NFL licensees that had used the Flying B logo because Bouchat was precluded from obtaining actual damages against them); and Bouchat v. Baltimore Ravens Limited Partnership, 619 F.3d 301 (4th Cir. 2010) (Bouchat IV) (holding that footage of the Flying B logo in season highlight films and in a short video shown on the large screen during Ravens home games was not fair use, but that the Ravens’ display of the logo in images in its corporate lobby was fair use). Bouchat commenced the case dealt with here in 2012. His claim against the NFL pertained to the league’s use of the Flying B logo in three videos featured on its television network and various websites (videos that were not at issue in Bouchat IV). His claim against the Ravens pertained to the team’s display of images that showed the logo in the context of historical exhibits in the “Club Level” seating area of the Ravens’ stadium. A federal district court granted summary judgment in favor of the defendants, ruling that they were entitled to the protection of the fair use defense. Bouchat appealed to the Fourth Circuit. Further pertinent facts appear in the following edited version of the Fourth Circuit’s decision. Wilkinson, Circuit Judge The power over patent and copyright granted to Congress in Article I, Section 8 of the Constitution “is intended to motivate the creative activity of authors and inventors by the provision of a special reward, and to allow the public access to the products of their genius after the limited period of exclusive control has expired.” Sony Corp. of America v. Universal City Studios, Inc., 464 U.S. 417, 429 (1984). To effectuate this public benefit, § 106 of the Copyright Act grants [various rights to the copyright owner, including the rights to make and distribute copies of the work and the right to display the work]. In order to vindicate the same “constitutional policy of promoting the progress of science and the useful arts” that underlies the Patent and Copyright Clause, . . . the doctrine of fair use [has been recognized in order to foster] new creation and innovation by limiting [, in appropriate cases,] the ability of writers and authors to control the use of their works. Harper & Row Publishers, Inc. v. Nation Enterprises, 471 U.S. 539, 549 (1985). [T]he fair use doctrine [serves] as “an equitable rule of reason, for which no generally applicable definition is possible.” [Citation omitted.] Nonetheless, Congress [has provided, in 17 U.S.C. § 107,] a list of four factors that guide the determination of whether a particular use is a fair use. These factors [, which are listed and applied in the discussion that follows,] cannot be treated in isolation from one another, but instead must be “weighed together, in light of the purposes of copyright.” Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 578 (1994). This balancing necessitates a “case-by-case analysis” in any fair use inquiry. Id. at 577. [We now consider whether the fair use doctrine protects the defendants against Bouchat’s claims of copyright infringement.] Uses of Flying B Logo in Videos The three videos Bouchat challenges were produced by the NFL for display on the NFL network, and were also featured on websites including NFL.com and Hulu.com. Two of the videos were part of the film series Top Ten, each episode of which features a countdown of ten memorable players, coaches, or events in NFL

history. The third video is part of the Sound FX series, which provides viewers with an inside look at the sights and sounds of the NFL. Top Ten: Draft Classes recounts and analyzes in short segments the ten best NFL draft classes of all time. The video features a four-minute segment on the Ravens’ 1996 draft class, rated number six by the show. It contains interviews with players, journalists, and Ravens front office personnel [and] shows historical footage from the day of the draft. These interviews and voiceovers make up the vast majority of the video. In two spots, however, the Flying B logo is visible for less than one second: once on a banner and a helmet at the opening of the segment, and again on the side of a helmet during game footage toward the end of the segment. The second video, Top Ten: Draft Busts, begins with narration explaining that the episode will showcase the least successful draft picks. It then features short segments on each unsuccessful pick or set of picks, including the number eight “bust” Lawrence Phillips, who was selected by the St. Louis Rams in 1996. The segment recounts Phillips’s promise as a football player and the [personal and legal] problems that prevented him from fulfilling it. At the end of the segment, a defensive player tackles Phillips, and . . . the Flying B logo on the [tackler’s] helmet [is visible] for [a] fraction of a second. The final video, Sound FX: Ray Lewis, features a collection of footage and audio of Ray Lewis throughout his career. The 24-minute video is split into eight sections, [one of which] focuses on Ray Lewis at training camp and lasts for roughly two minutes. During an eight-second period in the training camp segment, the Flying B logo is visible on some of the Ravens players’ helmets. And twice in other segments of the show, as Lewis makes a tackle, the Flying B logo is partially visible for less than one second. Otherwise, [a logo the Ravens used after dropping the Flying B as the team symbol] is the only logo visible throughout Sound FX: Ray Lewis. The first fair use factor focuses on “the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes.” 17 U.S.C. § 107(1). The



Chapter Eight Intellectual Property and Unfair Competition

preamble to § 107 lists examples of uses that are [good candidates for fair use treatment]: “criticism, comment, news reporting, teaching . . . scholarship, or research.” These examples serve as a guide for analysis under the first factor. The essential inquiry under the first factor can be separated into two parts: whether the new work is transformative, and the extent to which the use serves a commercial purpose. “A ‘transformative’ use is one that ‘employ[s] the quoted matter in a different manner or for a different purpose from the original,’ thus transforming it.” [Citations omitted.] Transformative works rarely violate copyright protections because “the goal of copyright, to promote science and the arts, is generally furthered by the creation of transformative works. Such works thus lie at the heart of the fair use doctrine’s guarantee of breathing space within the confines of copyright.” Campbell, 510 U.S. at 579. Importantly, a transformative use is one that “adds something new” to the original purpose of the copyrighted work. Id.; Bouchat IV, 619 F.3d at 314. Each of the videos in this case is intended to present a narrative about some aspect of Ravens or NFL history. [Although the Flying B logo is visible in the videos, the instances of visibility are limited in number and of brief duration.] The use of the Flying B logo in each of these videos differs from its original purpose. [The logo] initially served as the brand symbol for the team, its on-field identifier, and the principal thrust of its promotional efforts. None of the videos use the logo to serve the same purpose it once did. Instead, like the historical displays featuring the Flying B logo in the lobby of the Ravens’ headquarters in Bouchat IV, these videos used the Flying B as part of the historical record to tell stories of past drafts, major events in Ravens history, and player careers. See Bouchat IV, 619 F.3d at 314; see also Bill Graham Archives v. Dorling Kindersley Ltd., 448 F.3d 605, 609–10 (2d Cir. 2006) (noting that Grateful Dead posters reproduced in a biographical text served as “historical artifacts” that helped readers to understand the text). The logo, then, is being used “not for its expressive content, but rather for its . . . factual content,” and in such a manner that no doubt “adds something new.” Bouchat IV, 619 F.3d at 314. And contrary to Bouchat’s claims, it does not matter that the Flying B logo is unchanged in the videos, for “[t]he use of a copyrighted work need not alter or augment the work to be transformative in nature.” [Citation omitted.] Bouchat argues that the uses of the Flying B logo in the videos in this case are indistinguishable from those adjudicated in Bouchat IV. Both, he says, act to identify the team. In reality, however, the uses are strikingly different. In the season highlight films from Bouchat IV, the logo was shown again and again, always as a brand identifier for the Ravens organization and its players. As we found, the logo simply replicated its original function when footage of the seasons was shot, condensed, and reproduced in a summary film. But the current use, as noted above, differs in

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two important respects from the Bouchat IV videos. We found in that case that the season highlight videos did not change the way in which viewers experienced the logo, making the use non-transformative. Here, however, because the videos used the historical footage to tell new stories and not simply rehash the seasons, it used the Flying B logo for its “factual content” and was transformative. This finding of transformative use is reinforced by the exceptionally insubstantial presence of the Flying B logo in these videos. In the vast majority of its appearances, it is present for fractions of a second, and can be perceived only by someone who is looking for it. “The extent to which unlicensed material is used in the challenged work can be a factor in determining whether a . . . use of original materials has been sufficiently transformative to constitute fair use.” Bill Graham Archives, 448 F.3d at 611. The Flying B logo cannot be said to serve its original function of identifying the Ravens players and organization if it is all but imperceptible to those viewing the videos. It serves no expressive function at all, but instead acts simply as a historical guidepost—to those who even detect it—within videos that construct new narratives about the history of the Ravens and the NFL. The first factor also requires an inquiry into the commercial nature of the use at issue. While a commercial purpose “may weigh against a finding of fair use,” Campbell, 510 U.S. at 579, the ­Supreme Court has warned us not to over-emphasize its impact: “If, indeed, commerciality carried presumptive force against a finding of fairness, the presumption would swallow nearly all of the illustrative uses listed in the preamble paragraph of § 107, including news reporting, comment, criticism, teaching, scholarship, and research, since these activities are generally conducted for profit in this country.” Id. at 584. Vast numbers of fair uses occur in the course of commercial ventures. An overbroad reading of the commercial sub-prong would thus eviscerate the concept of fair use. Instead, the commerciality inquiry is most significant when the allegedly infringing use acts as a direct substitute for the copyrighted work. Id. at 591. Meanwhile, “the more transformative the new work, the less will be the significance of other factors, like commercialism, that may weigh against a finding of fair use.” Id. at 579. In this case, there is no doubt . . . that the NFL has produced and distributed these videos for commercial gain. But as the district court . . . noted, the substantially transformative nature of the use renders its commercial nature largely insignificant. [Further], the limited nature of the uses counsels against placing significant weight on their commercial nature. The key inquiry is the extent to which the Flying B logo itself—and not the videos as a whole— provides commercial gain to the NFL. The uses of the Flying B logo in these three videos can only properly be described as incidental to the larger commercial enterprise of creating historical videos for profit [and as therefore playing] an unquestionably minimal role in facilitating that gain.

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Part Two Crimes and Torts

The fleeting and transformative use of the Flying B logo in the videos means that the first factor in § 107 counsels strongly in favor of fair use. The remaining criteria do nothing to undermine this conclusion. The second factor concerns “the nature of the copyrighted work.” 17 U.S.C. § 107(2). The logo is a creative work, and therefore “closer to the core of works protected by the Copyright Act.” Bouchat IV, 619 F.3d at 311. Nonetheless, “if the disputed use of the copyrighted work is not related to its mode of expression but rather to its historical facts, then the creative nature of the work” matters much less than it otherwise would. [Citation omitted.] Indeed, as we noted in Bouchat IV, “the second factor may be of limited usefulness where the creative work of art is being used for a transformative purpose.” 619 F.3d at 315 (quoting Bill Graham Archives, 448 F.3d at 612) (internal quotation marks omitted). Thus, . . . the NFL’s transformative use lessens the importance of the Flying B logo’s creativity. Consequently, this factor is largely neutral. The third factor is “the amount and substantiality of the portion used in relation to the copyrighted work as a whole.” 17 U.S.C. § 107(3). The Flying B is reproduced in full in at least some of its appearances in the videos, [but] “the extent of permissible copying varies with the purpose and character of the use.” Campbell, 510 U.S. at 586–87. Here, the NFL had no choice but to film the whole logo in order to fulfill its legitimate transformative purpose of creating the historical videos at issue. [T] he transformativeness of the use and the character of Bouchat’s work lead us to give very little weight to this factor. It would be senseless to permit the NFL to use the Flying B logo for factual, historical purposes, but permit it to show only a half, or twothirds of it. The fourth factor is “the effect of the use upon the potential market for or value of the copyrighted work.” 17 U.S.C. § 107(4). We are required to “determine whether the defendants’ [use of the logo] would materially impair the marketability of the work and whether it would act as a market substitute for it.” [Citation omitted.] A transformative use renders market substitution less likely and market harm more difficult to infer. Campbell, 510 U.S. at 591. The transient and fleeting use of the Flying B logo, as well as its use for its factual, and not its expressive, content, leads us to conclude that it serves a different purpose in the videos than it does standing alone. As a result, the new, transformative use is unlikely to supplant any market for the original. The four § 107 factors indicate that the NFL’s fleeting and insubstantial use of the Flying B logo in these videos qualifies as fair use. The first factor . . . counsels strongly in favor of fair use. The remaining fair use factors are largely neutral, providing compelling arguments neither for nor against fair use. Consequently, in the aggregate, the four factors point in favor of a fair use finding. Our analysis under § 107 is confirmed by the Supreme Court’s explication of the underlying interests that inform copyright law

and its relationship to the First Amendment. Congress has attempted over the years to balance the importance of encouraging authors and inventors by granting them control over their work with “society’s competing interest in the free flow of ideas, information and commerce.” Absent any protection for fair use, subsequent writers and artists would be unable to build and expand upon original works, frustrating the very aims of copyright policy. Campbell, 510 U.S. at 575–76. For creation itself is a cumulative process; those who come after will inevitably make some modest use of the good labors of those who came before. Fair use, then, is crucial to the exchange of opinions and ideas. It protects filmmakers and documentarians from the inevitable chilling effects of allowing an artist too much control over the dissemination of his or her work for historical purposes. Copyright law has the potential to constrict speech, and fair use serves as a necessary “First Amendment safeguard[]” against this danger. Eldred v. Ashcroft, 537 U.S. 186, 219 (2003). Top Ten: Draft Classes, Top Ten: Draft Busts, and Sound FX: Ray Lewis share the qualities of other historical documentaries. Were we to require those wishing to produce films and documentaries to receive permission from copyright holders for fleeting factual uses of their works, we would allow those copyright holders to exert enormous influence over new depictions of historical subjects and events. Such a rule would encourage bargaining over the depiction of history by granting copyright holders substantial leverage over select historical facts. It would force those wishing to create videos and documentaries to receive approval and endorsement from their subjects, who could “simply choose to prohibit unflattering or disfavored depictions.” [Citation omitted.] Social commentary as well as historical narrative could be affected if, for example, companies facing unwelcome inquiries could ban all depiction of their logos. This would align incentives in exactly the wrong manner, diminishing accuracy and increasing transaction costs, all the while discouraging the creation of new expressive works. This regime, the logical outgrowth of Bouchat’s fair use position, would chill the very artistic creation that copyright law attempts to nurture. Uses of Flying B Logo in Stadium Display Bouchat next challenges the incidental use of the Flying B logo in certain historical displays located on the Club Level of the Baltimore Ravens’ stadium. The Club Level . . . provides a host of amenities, including, among other things, spacious seating, carpeted floors, refuge from the elements, attractive décor, specialty concessions, and enhanced customer service. [It] is accessible only to those who purchase Club Level tickets, [which] are priced between $175 and $355 per game. The three displays challenged by Bouchat—a timeline, a highlight reel, and a significant plays exhibit—are all located on the Club Level. Considered together, they cover an impressive span of



Chapter Eight Intellectual Property and Unfair Competition

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Baltimore football history. The Flying B logo plays an incidental role in only a fraction of the historical depictions featured in the displays. Overall, the exhibits document more than one hundred years of history preceding the advent of the Flying B logo and many significant historical events post-dating it. The timeline, which begins with the year 1881, covers those individual years that illustrate important events in the Baltimore football story. With respect to Bouchat’s challenge, the segment for [1996] includes, among other things, blown-up reproductions of the inaugural 1996 game-day program and ticket, each of which necessarily bears the Flying B logo. No other year in the extensive timeline display . . . includes even an incidental depiction of the logo. [The highlight reel and the important plays exhibit include instances in which the Flying B logo is very briefly displayed on a player’s helmet.] As with the timeline, both the highlight reel and the important plays exhibit . . . feature many significant historical depictions where the logo does not appear at all. The district court rejected Bouchat’s challenge to the Club Level displays, finding each display of the Flying B justified under the fair use doctrine. Its analysis rested in significant part on this court’s decision in Bouchat IV, which rejected an infringement challenge to a historical display located in the lobby of the Ravens’ corporate headquarters. That display, like the one at issue here, contained incidental reproductions of the Flying B logo. [M]uch of our analysis regarding the [challenge to] the documentaries discussed earlier is also applicable to Bouchat’s [Club Level] display challenge. [Authors’ note: In extensive analysis summarized here, the Fourth Circuit applied the fair use factors to the Club Level display in a manner similar to the way it applied those factors to the documentaries. The court concluded that the

images of the Flying B logo were displayed on the Club Level for historical purposes and were thus transformative. Moreover, the logo was displayed only briefly or otherwise in an incidental manner. Any commercial motivation was only indirect, in the sense that the historical display was a “fringe benefit of club membership” and not the primary reason why a fan would purchase a Club Level ticket to watch a Ravens game. Thus, the court concluded, the first fair use factor weighed strongly in favor of fair use. For reasons essentially the same as those expressed in the portion of the opinion dealing with the documentaries, the court concluded that the second and third fair use factors neither helped Bouchat nor caused a problem for the Ravens. As for the fourth fair use factor, the court noted that the transformative nature of the Ravens’ use probably meant that harm to any markets for Bouchat’s drawing was minimal or nonexistent. The court therefore held that the Club Level display was fair use.] Our rejection of Bouchat’s challenge to the incidental uses of the Flying B logo provides no support for a fair use defense where the alleged infringer exploits a protected work for profit based on its intrinsic expressive value. That scenario, however, is simply not presented on the facts before us. The uses here were not only transformative, but also—take your pick—fleeting, incidental, de minimis, innocuous. If these uses failed to qualify as fair, a host of perfectly benign and valuable expressive works would be subject to lawsuits. That in turn would discourage the makers of all sorts of historical documentaries and displays, and would deplete society’s fund of informative speech.

Trademarks Trademarks help purchasers identify fa-

Protected Marks The Lanham Act recognizes four kinds of marks. It defines a trademark as any word, name, symbol, device, or combination thereof used by a manufacturer or seller to identify its products and distinguish them from the products of competitors. Although trademarks consisting of single words or names are most commonly encountered, federal trademark protection has sometimes been extended to colors, pictures, label and package designs, slogans, sounds, arrangements of numbers and/or letters (e.g., “7-Eleven”), and shapes of goods or their containers (e.g., Coca-Cola bottles). Service marks resemble trademarks but identify and distinguish services. Certification marks certify the origin, materials, quality, method of manufacture, and other aspects of

vored products and services. For this reason, they also give sellers and manufacturers an incentive to innovate and strive for quality. However, both these ends would be defeated if competitors were free to appropriate each other’s trademarks. Thus, the federal Lanham Act protects trademark owners against certain uses of their marks by third parties.3 LO8-8

State what a trademark does and provide examples of potentially protectable trademarks.

In addition, the owner of a trademark may enjoy legal protection under common law trademark doctrines and state trademark statutes. 3

District court’s decision affirmed; defendants held entitled for protection of fair use defense.

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Part Two Crimes and Torts

goods and services. Here, the user of the mark and its owner are distinct parties. A retailer, for example, may sell products bearing the Good Housekeeping Seal of Approval. Collective marks are trademarks or service marks used by organizations to identify themselves as the source of goods or services. Trade union and trade association marks fall into this category. Although all four kinds of marks receive federal protection, this chapter focuses on trademarks and service marks, using the terms mark or trademark to refer to both. Distinctiveness Identify the key requirement for registration of a mark on the Principal Register (distinctiveness) and explain LO8-9 the role of secondary meaning when registration of a nondistinctive mark is sought.

Because their purpose is to help consumers identify products and services, trademarks must be distinctive to merit maximum Lanham Act protection. Marks fall into five general categories of distinctiveness (or nondistinctiveness): 1. Arbitrary or fanciful marks. These marks are the most distinctive—and the most likely to be protected—because they do not describe the qualities of the product or service they identify. The “Exxon” trademark is an example. 2. Suggestive marks. These marks convey the nature of a product or service only through imagination, thought, and perception. They do not actually describe the underlying product or service. The “Dietene” trademark for a dietary food supplement is an example. Although not as clearly distinctive as arbitrary or fanciful marks, suggestive marks are nonetheless classified as distinctive. Hence, they are good candidates for protection.

3. Descriptive marks. These marks directly describe the product or service they identify (e.g., “Realemon,” for bottled lemon juice). Descriptive marks are not protected unless they acquire secondary meaning. This occurs when their identification with a particular source of goods or services has become firmly established in the minds of a substantial number of buyers. “Realemon,” of course, now has secondary meaning. Among the factors considered in secondary-meaning determinations are the length of time the mark has been used, the volume of sales associated with that use, and the nature of the advertising employing the mark. When applied to a package delivery service, for instance, the term overnight is usually descriptive and thus not protectible. It may come to deserve trademark protection, however, through long use by a single firm that advertised it extensively and made many sales while doing so. As will be seen, the same approach is taken concerning deceptively misdescriptive and geographically descriptive marks. 4. Marks that are not inherently distinctive. Although these marks are not distinctive in the usual senses of arbitrary nature, fanciful quality, or suggestiveness, proof of secondary meaning effectively makes these marks distinctive. They are therefore protectible if secondary meaning exists. The Supreme Court has held that under appropriate circumstances, product color is a potentially protectible trademark of this type. 5. Generic terms. Generic terms (e.g., diamond or truck) simply refer to the general class of which the particular product or service is one example. Because any seller has the right to call a product or service by its common name, generic terms are ineligible for trademark protection.

CYBERLAW IN ACTION In the Digital Millennium Copyright Act of 1998 (DMCA), Congress addressed selected copyright issues as to which special rules seemed appropriate, in view of recent years’ technological advances and explosion in Internet usage. One such issue was how narrowly or broadly to define the class of parties potentially liable for copyright infringement in an Internet context. If, without Osborne’s consent, Jennings posts Osborne’s copyrighted material in an online context made available by Devaney (an Internet service provider), is only Jennings liable to Osborne, or is Devaney also liable? In the DMCA, Congress enacted “safe harbor” provisions designed to protect many service providers such as Devaney from

liability for the actions of direct infringers who posted or transmitted copyrighted material. The DMCA also addressed the actions of persons who seek to circumvent technological measures (e.g., encryption, passwordprotection measures, and the like) that control access to or copying of a copyrighted work. With certain narrowly defined exceptions of very limited applicability, Congress outlawed both (1) the circumvention of such technological measures and (2) the activity of trafficking in programs or other devices meant to accomplish such circumvention. In Universal City Studios, Inc. v. Corley, 273 F.3d 429 (2d Cir. 2001), the U.S. Court of Appeals for the Second Circuit rejected the arguments of an individual (Corley) who had been held liable to



Chapter Eight Intellectual Property and Unfair Competition

various movie studios for violating the antitrafficking provisions of the DMCA. Corley had written an article about the decryption program known as “DeCSS” and had posted the article on his website, along with a copy of the DeCSS program itself and links to other sites where DeCSS could be found. DeCSS had been developed by parties other than Corley as a means of decrypting the “CSS” encryption technology that movie studios place on copyrighted DVDs of their movies. If it is not circumvented, CSS prevents the copying of the movie that appears on the DVD. A federal district court, holding that Corley had violated the DMCA’s antitrafficking provisions, issued an injunction barring Corley from posting DeCSS on his website and from posting links to other sites where DeCSS could be found. On appeal, Corley argued that his publication of the DeCSS program’s codes was speech protected by the First Amendment and that the application of the DMCA to him was thus unconstitutional. The Second Circuit concluded that Corley was to some extent engaged in speech but that his actions also had a substantial nonspeech component. In any event, the Second Circuit reasoned, the DMCA’s antitrafficking provisions served a substantial government interest

Federal Registration Once the seller of a product or service uses a mark in commerce or forms a bona fide intention to do so very soon, she may apply to register the mark with the U.S. Patent and Trademark Office (PTO). The office reviews applications for distinctiveness. Its decision to deny or grant the application may be contested by the applicant or by a party who feels that he would be injured by registration of the mark. Such challenges may eventually reach the federal courts. Trademarks of sufficient distinctiveness are placed on the Principal Register of the Patent and Trademark Office. A mark’s inclusion in the Principal Register (1) is prima facie evidence of the mark’s ownership, validity, and registration (which is useful in trademark infringement suits); (2) gives nationwide constructive notice of the owner’s claim of ownership (thus eliminating the need to show that the defendant in an infringement suit had notice of the mark); (3) entitles the mark owner to assistance from the Bureau of Customs in stopping the importation of certain goods that, without the consent of the mark owner, bear a likeness of the mark; and (4) means that the mark will be incontestable after five years of registered status (as described later). Even though they are not distinctive, certain other marks may merit placement on the Principal Register if they have acquired secondary meaning. These include (1) marks that are not inherently distinctive (as discussed earlier), (2) descriptive marks (as discussed earlier), (3) some deceptively misdescriptive marks (such as “Dura-Skin,” for plastic gloves), (4) geographically descriptive marks (such as “Indiana-Made”), and (5) marks

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in protecting the rights of intellectual property owners and were content-neutral restrictions unrelated to the suppression of free expression. The court therefore held that the antitrafficking provisions did not violate the First Amendment. Some critics of the DMCA’s anticircumvention and antitrafficking provisions have asserted that those provisions may operate to restrict users’ ability to make fair use of copyrighted materials. Evidently attempting to convert this policy-based objection about what Congress enacted into a constitutional objection on which the court might be more inclined to rule, Corley argued that the fair use doctrine was required by the First Amendment and that the DMCA, insofar as it limited users’ ability to rely on the fair use doctrine, was unconstitutional. The Second Circuit called it “extravagant” to assert that the fair use doctrine was constitutionally required, for there was no substantial authority to support such a contention. Moreover, the court reasoned that even if Corley’s contention were not otherwise questionable, “[f]air use has never been held to be a guarantee of access to copyrighted material in order to copy it by the fair user’s preferred technique or in the format of the original.”

that are primarily a surname (because as a matter of general policy, persons who have a certain last name should be fairly free to use that name in connection with their businesses). Once a mark in one of these classifications achieves registered status, the mark’s owner obtains the legal benefits described in the previous paragraph. Regardless of their distinctiveness, however, some kinds of marks are denied placement on the Principal Register. These include marks that (1) consist of the flags or other insignia of governments; (2) consist of the name, portrait, or signature of a living person who has not given consent to the trademark use; (3) are immoral, deceptive, or scandalous; or (4) are likely to cause confusion because they resemble a mark previously registered or used in the United States. Until a key Supreme Court decision in 2017, the previous list of types of marks that may be denied placement on the Principal Register included another category: marks that are disparaging to individuals or groups (a denial basis commonly referred to as the “disparagement clause”). However, in Matal v. Tam, 137 S. Ct. 1744 (2017), the Supreme Court held that the disparagement clause violated the First Amendment’s freedom of speech guarantee. The case arose after the PTO used the disparagement clause as the reason to deny registered status to “The Slants,” the name of a band whose members were Asian Americans. The PTO noted that the name has been used as a derogatory term regarding Asian Americans and thus was disparaging. In holding the disparagement clause unconstitutional, the Supreme Court noted that the clause led to impermissible viewpoint

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discrimination in violation of the First Amendment. The Court also emphasized that the First Amendment’s protection extends to speech that many may find offensive. Although Matal v. Tam dealt only with the disparagement clause, the Court’s analysis could have significance if a First Amendment–based challenge were brought regarding another Lanham Act provision noted earlier: the provision allowing the PTO to deny registration to marks that are immoral or scandalous. As this book went to press, no such challenge had yet been brought. (Because Matal v. Tam is a major First Amendment case, an edited version of the decision is included in Chapter 3. You may wish to review that edited version.) Transfer of Rights Because of the purposes underlying trademark law, transferring trademark rights is more difficult than transferring copyright or patent interests. A trademark owner may license the use of the mark, but only if the owner reserves control over the nature and quality of the goods or services as to which the licensee will use the mark. An uncontrolled “naked license” would allow the sale of goods or services bearing the mark but lacking the qualities formerly associated with it, and could confuse purchasers. Trademark rights may also be assigned or sold, but only along with the sale of the goodwill of the business originally using the mark. Losing Federal Trademark Protection Federal registration of a trademark lasts for 10 years, with renewals for additional 10-year periods possible. However, trademark protection may be lost before the period expires. The government must cancel a registration six years after its date unless the registrant files with the Patent and Trademark Office, within the fifth and sixth years following the registration date, an affidavit detailing that the mark is in use or explaining its nonuse. Any person who believes that he has been or will be damaged by a mark’s registration may petition the PTO to cancel that registration. Normally, the petition must be filed within five years of the mark’s registration on the Principal Register because the mark becomes incontestable regarding goods or services with which it has continuously been used for five consecutive years after the registration. A mark’s incontestability means that the permissible grounds for canceling its registration are limited. Even an incontestable mark, however, may be canceled at any time if, among other things, it was obtained by fraud, has been abandoned, or has become the generic name for the goods or services it identifies. Abandonment may occur through an express statement or agreement to abandon, through the mark’s losing its significance as an indication

of origin, or through the owner’s failure to use it. A mark acquires a generic meaning when it comes to refer to a class of products or services rather than a particular source’s product or service. For example, this has happened to such once-protected marks as aspirin, escalator, and thermos. Loss of registered status because the mark is generic occurs only if the PTO or a court rules, in an appropriate legal proceeding, that the mark indeed has become generic. Another longstanding exception to the protections afforded by incontestability status has recently fallen by the wayside for First Amendment reasons. Earlier discussion noted that until the Supreme Court’s 2017 decision in Matal v. Tam, the PTO could refuse to register a trademark if the mark was disparaging to individuals or groups. That same ground had also been available to the PTO as a basis for cancelling the registration of a mark. However, Tam’s First Amendment–based nullification of the disparagement clause as a basis for denying registration in the first place logically means that the disparagement clause cannot be used as a basis for cancelling a registration after the fact. Tam was no doubt good news for the owner of the Washington Redskins football team, whose registration of the Redskins trademark was canceled by the PTO in 2014 after many years on the Principal Register. The cancellation decision was being appealed at the time Tam was handed down. After Tam, the Redskins mark will continue to hold registered status. Trademark Infringement LO8-10

Identify and apply the elements of trademark infringement.

A trademark is infringed when, without the owner’s consent, another party uses a substantially similar mark in connection with the sale of goods or services and this use is likely to cause confusion concerning their source or concerning whether there is an endorsement relationship or other affiliation between the mark’s owner and the other party. Most of the court’s attention in a trademark infringement case tends to go toward determining whether the requisite likelihood of confusion is present in the facts. Because the likelihood of confusion determination is critical to resolution of trademark infringement cases, courts have had plenty of occasions to make such determinations. In the process, they have identified lists of factors that are weighed and balanced as part of the likelihood of confusion inquiry. The Kibler case, which appears later in the chapter, outlines such a list of factors. Although the relative weight assigned to a particular factor may vary from one case to another because the likelihood of confusion determination



Chapter Eight Intellectual Property and Unfair Competition

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The Global Business Environment Piracy and other unauthorized uses of American goods or technology protected by U.S. patent, copyright, and trademark law have become a major problem of American businesses. For example, foreign jeans manufacturers may without authorization place the Levi’s label on their jeans, thereby damaging the business of Levi Strauss & Co. by depriving it of some of the jeans’ market and damaging the value of the Levi trademark, especially if the imported jeans are of inferior quality. This is an example of counterfeit goods—goods that copy or otherwise purport to be those of the trademark owner whose mark has been unlawfully used on the nongenuine goods. Counterfeit goods may also unlawfully appropriate patented technology or copyrighted material. Assume, for example, that a foreign music recording company pirates the latest Katy Perry album and works with another party to import thousands of copies of it into the United States without the copyright owner’s permission. American firms harmed by the importation of counterfeit goods may obtain injunctions and damages under the Tariff Act of 1930, the Lanham Act, the Copyright Act, and the patent statute. In addition, the Trademark Counterfeiting Act of 1984 establishes civil and criminal penalties for counterfeiting goods. It also allows an American firm to recover from a counterfeiter three times its damages or three times the counterfeiter’s profits (whichever is greater). Patent, copyright, and trademark piracy is increasing in many parts of the world, especially in developing nations. Some

is highly fact-specific, courts often assign fairly significant weight to such factors as the degree of similarity between the plaintiff’s mark and the defendant’s version and the degree of similarity (or dissimilarity) between the parties’ underlying products or services. The general assumption underlying those factors is this: the greater the degree of similarity, the greater the danger of consumer confusion. Yet courts look very closely at the context in which the defendant’s use of a substantially similar mark takes place. If, for instance, the defendant’s use involves poking fun at the plaintiff’s mark, the court could conclude that likelihood of confusion is lacking because reasonable consumers would not think the trademark owner would criticize or otherwise make fun of its own mark. A court so ruled in a case in which Jordache Inc., which used the Jordache name on its designer jeans, sued a company that began using the name Lardashe on its large-size designer jeans. The court held that even though both parties produced and sold jeans, the obvious parody present in the defendant’s choice of the Lardashe name would cause consumers to recognize that the defendant’s jeans were neither produced by Jordache nor licensed by that company. Hence, there was no likelihood of confusion.

developing nations believe that technology should be transferred freely to foster their economic growth. Consequently, they either encourage piracy or choose not to oppose it. Gray market goods are goods lawfully bearing trademarks or using patents and copyrighted material but entering the American market without authorization. For example, Parker Pen Co. may authorize a Japanese manufacturer to make and sell Parker pens only in Japan. When an American firm imports the Japanese-made Parker pens into the United States, the goods become gray market goods. While importing gray market goods may violate the contract between the American firm and its foreign licensee, it is not clear in what contexts it violates U.S. importation, trademark, patent, or copyright law. Some courts find a Lanham Act or Tariff Act violation, but other courts do not. The Trademark Counterfeiting Act of 1984 specifically excludes gray market goods from its coverage. The Copyright Act deals with gray market goods in a provision barring the “[i]mportation into the United States, without the authority of the owner of the copyright . . . of copies or phonorecords of a work that has been acquired outside the United States.” Whether the items may lawfully enter the United States depends, therefore, on whether the copyright owner has provided “authority” for this to occur. Note, too, that the first sale doctrine discussed earlier in the chapter may also have a role to play. See the Kirtsaeng case, which appears earlier.

A trademark owner who wins an infringement suit may obtain an injunction against uses of the mark that are likely to cause confusion. In addition, the owner may obtain money damages for provable injury resulting from the infringement, and sometimes the attributable profits realized by the infringing defendant. Trademark Dilution LO8-11 Identify and apply the elements of trademark dilution.

Although trademark infringement is the traditional legal theory employed when a mark owner seeks legal relief against one who used the mark without the owner’s consent, trademark dilution sometimes serves as an alternative to the standard claim of infringement. Roughly half the states have had laws recognizing the dilution doctrine for many years. Because of the geographic limitations inherent in state laws and because not all states have dilution statutes, trademark owners had long advocated enactment of a federal law

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recognizing dilution as a trademark rights theory. Congress finally obliged with the Federal Trademark Dilution Act of 1996 (FTDA), which was placed in the Lanham Act as § 43(c). However, a 2003 Supreme Court decision interpreting the FTDA made the statute less useful to trademark owners than it initially appeared to be. The Court concluded that in view of the FTDA’s wording, proof of a § 43(c) violation required a showing of actual dilution of the plaintiff’s mark rather than the likelihood of dilution required by state dilution laws. For trademark owners, the proof-of-actual-dilution requirement enhanced the difficulty of winning dilution cases under the federal statute. Congress responded to the 2003 Supreme Court decision by enacting the Trademark Dilution Revision Act of 2006 (TDRA), which amended § 43(c) to state explicitly that a showing of likelihood of dilution was sufficient. Under the TDRA, one who makes a commercial use of a “famous mark” without the mark owner’s consent faces liability if the use is “likely to cause dilution by blurring or dilution by tarnishment of the famous mark.” The TDRA thus makes clear that there are two types of dilution (to be explained below): “dilution by blurring” and “dilution by tarnishment.” In so providing, the TDRA responded to an expression of skepticism in the same 2003 Supreme Court decision over whether the tarnishment variety of dilution was contemplated by the federal law. Proof of a likelihood of either type of dilution satisfies the TDRA, assuming that the famous mark and commercial use elements are also met. Likelihood of confusion—the critical element in a trademark infringement case—need not be proven in a dilution case. Proof of competition between the plaintiff and the defendant is likewise unnecessary in a dilution case, as is proof of actual economic injury resulting from the defendant’s actions. According to the TDRA, a mark is “famous” if it is “widely recognized by the general consuming public.” (The Kibler case, which appears later, explores this requirement.) The TDRA goes on to define “dilution by blurring” as an “association arising from the similarity between a mark or trade name and a famous mark that impairs the distinctiveness of the famous mark.” Also recognized by the FTDA (the TDRA’s predecessor) and the patchwork quilt of state dilution laws, this type of dilution takes place when the defendant’s use of the plaintiff’s mark causes, or is likely to cause, the public to cease associating the mark solely with the plaintiff and instead to associate it with both the plaintiff and the defendant. When this occurs or appears likely to occur, the mark’s distinctiveness as a clear identifier of the plaintiff is in danger of being blurred or whittled away—in other words, diluted—even if the public recognizes that the plaintiff and defendant are not affiliated and that

they provide very different products or services. Consider a classic example: the dilution claim won by Polaroid (the camera company) against a small heating and air conditioning business whose chosen name, Polaraid, presented the danger of blurring the source-identification image conjured up by the Polaroid name. Clearly, however, dilution by blurring does not occur in every instance in which the plaintiff’s mark and the defendant’s version are quite similar, as Mead Data Central found out when it unsuccessfully sought to prove that its LEXIS mark (for legal research services) was diluted by Toyota’s use of LEXUS (for a luxury car model and division).  The TDRA defines “dilution by tarnishment,” the other type of dilution it recognizes, as an “association arising from the similarity between a mark or trade name and a famous mark that harms the reputation of the famous mark.” This form of tarnishment is also recognized in state dilution laws. Although courts do not agree completely on what is necessary for likely tarnishment of a mark, various courts have concluded that the defendant’s use of the plaintiff’s mark in an unwholesome context—normally one suggesting illicit sexual or drugrelated associations—may dilute a mark by tarnishing its reputation.  Presumably to guard against overuse of the dilution theory, the TDRA states that certain uses cannot constitute dilution by blurring or dilution by tarnishment. The TDRA lists noncommercial uses and uses amounting to “news reporting and news commentary” in the protected category. In addition, the TDRA’s exclusions from dilution liability apply to “[a]ny fair use” of a famous mark to identify or describe that mark or its owner, as opposed to a defendant’s use of a version of the plaintiff’s mark “as a designation of source for the [defendant’s] own goods or services.” These fair uses may include a defendant’s references to the plaintiff’s mark in the context of comparative advertising of the parties’ respective goods or services, as well as a defendant’s references to the plaintiff’s mark in the course of “identifying and parodying, criticizing, or commenting upon the famous mark owner or the goods or services of the mark owner.” When the mark owner makes out a TDRA-based dilution claim, the standard (and normally sole) remedy is an injunction against the defendant’s continued use of the diluting version of the plaintiff’s mark. The same is true of successful dilution cases brought under state laws. The TDRA allows the prospect of recovering damages and the defendant’s attributable profits only if the evidence reveals that the defendant willfully sought to harm the mark’s reputation or to trade on the recognition associated with the mark.



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Kibler v. Hall   843 F.3d 1068 (6th Cir. 2016) Disc jockey Lee Jason Kibler uses turntables and other performers’ vocals to produce music containing jazz and funk elements. Since 1999, he has performed and released several albums under the name “DJ Logic.” At the time of the litigation described here, however, he did not have a record deal. Kibler registered DJ LOGIC as a trademark in 2000, allowed the registration to lapse in 2003, and reregistered the name in 2013. He has also been known as simply “Logic.” Robert Bryson Hall II, a rapper, has performed under the name “Logic” since 2009. Three Oh One Productions and Visionary Music Group are companies owned by, or professionally connected with, Hall. He had a recording contract with UMG Recording d/b/a Def Jam Recordings (Def Jam) at times pertinent to the case described here. William Morris Endeavor Entertainment (WME) is Hall’s booking agent. In September 2012, Kibler’s attorney sent Visionary Music Group and WME an e-mail ordering them to stop using the name Logic and to recall any product or advertisement that did. The attorney maintained that such use infringed on Kibler’s DJ LOGIC mark. In January 2014, Kibler filed suit in the U.S. District Court for the Eastern District of Michigan against Hall and the firms noted above. Kibler alleged claims for trademark infringement and trademark dilution in violation of the federal Lanham Act. In March 2014, the defendants delayed Hall’s tour and first album release because of ongoing settlement negotiations that ultimately collapsed. Def Jam proceeded to release the album in October of that year. The album sold more than 170,000 copies. In May 2015, the defendants moved for summary judgment on each of Kibler’s claims. After a hearing, the district court granted the defendants’ motion. Cole, Chief Judge [Kibler’s appeal requires] us to answer two questions. First, [regarding the trademark infringement claim,] has Kibler provided evidence sufficient to find that relevant consumers are likely to confuse the sources of his and Hall’s products? Second, has Kibler provided evidence sufficient to find that Hall has diluted Kibler’s mark? Trademark Infringement This court considers whether trademark infringement has occurred using a two-step test. First, we determine whether plaintiff’s mark is protectable.  Then, we assess whether relevant consumers are likely to confuse the sources of the parties’ products. The relevant consumers are potential buyers of defendant’s products. Here, the parties agree Kibler’s mark is protectable. So we focus on the likelihood that potential buyers of rap would believe Kibler’s music is Hall’s, or vice-versa. In assessing the likelihood of confusion, we take into account the following eight Frisch factors: 1) strength of the plaintiff’s mark; 2) relatedness of the products; 3) similarity of the marks; 4) evidence of actual confusion; 5) parties’ marketing channels; 6) likely degree of purchaser care; 7) defendant’s intent in selecting the mark; and 8) probability that the product lines will expand. CFE Racing Products, Inc. v. BMF Wheels, Inc., 793 F.3d 571, 592 (6th Cir. 2015)  (citing  Frisch’s Restaurants, Inc. v. Shoney’s Inc., 759 F.2d 1261, 1264 (6th Cir. 1985)). Plaintiff need not establish each factor to prevail. Each case is unique, so not all of the factors will be helpful.  Further, there is no designated balancing formula for the factors. CFE Racing, 793 F.3d at 592. “The[ir] enumeration is meant ‘merely to indicate the need for weighted evaluation of the pertinent facts in arriving

at the legal conclusion of confusion.’”  Id. (quoting Frisch, 759 F.2d at 1264). 1. Strength of Plaintiff’s Mark The stronger a mark is, the greater the risk of confusion.  Homeowners Group, Inc. v. Home Marketing Specialists, Inc., 931 F.2d 1100, 1107 (6th Cir. 1991). A mark cannot be strong unless it is both conceptually and commercially strong.  Maker’s Mark Distillery, Inc. v. Diageo North America, Inc., 679 F.3d 410, 419 (6th Cir. 2012). And it cannot be conceptually strong unless it is inherently distinctive. Id. Arbitrary marks, which convey something unrelated to the product they announce, e.g., the “Apple” in “Apple computers,” are distinctive. Therma-Scan, Inc. v. Thermoscan, Inc., 295 F.3d 623, 631 (6th Cir. 2002). Descriptive marks, which describe the product they announce, are usually indistinctive. See, e.g., Therma-Scan, 295 F.3d at 632 (finding “Therma-scan,” which describes the services plaintiff performs, indistinctive, and hence conceptually weak). Further, courts presume that an incontestable mark is conceptually strong. Daddy’s Junky Music Stores, Inc. v. Big Daddy’s Family Music Center, 109 F.3d 275, 282 (6th Cir. 1997). A mark is incontestable when it has not been successfully challenged within five years of its registration.  Id. In this case, the district court found that DJ LOGIC is moderately strong conceptually. The court reasoned that while “DJ” describes Kibler’s craft, “LOGIC” is not even “suggestive of the characteristics of [his] music.” Defendants concede this. Kibler contends only that the court erred in not considering the mark’s incontestability. We need not address this argument because we agree with the district court’s assessment, which renders DJ LOGIC at least as conceptually strong as a finding of incontestability would.

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But  a mark can be conceptually strong without being commercially strong, and thus weak under Frisch. A mark’s commercial strength depends on public recognition, the extent to which people associate the mark with the product it announces. Maker’s Mark, 679 F.3d at 419. Survey evidence is not a prerequisite for establishing public recognition, but it is the most persuasive evidence of it. See, e.g., id. at 421. Proof of marketing is not a prerequisite either. Therma-Scan, 295 F.3d at 632. But plaintiffs lacking such proof must provide other evidence of “broad public recognition.” Id. Here, the district court concluded that DJ LOGIC is commercially weak. The court cited Kibler’s lack of survey or marketing evidence and limited commercial success.  [The court noted Kibler’s] sale of fewer than 300 albums [during the previous] three years and fewer than 60,000 albums [during the] past sixteen years, [his] current lack of a recording contract, and [his] inability ever to secure a recording contract with a major label. Kibler admits he offered no survey evidence, but . . . argues he provided marketing evidence. First is a sworn declaration that he advertises in print and online, including on MySpace, Twitter, and Facebook. Second are a 2006 Downbeat article featuring him, a 2001 New York Times review mentioning him, and a 1999 Gig article featuring him. Third is a sworn declaration that he has appeared on television shows such as The Tonight Show Starring Jimmy Fallon, The Today Show, and Good Morning America. Kibler also points to his tours and online music sales as proof of marketing. Additionally, Kibler insists he is commercially successful, noting that there is no fixed number of album sales establishing commercial success. Defendants . . . argue that Kibler’s failure to provide the number of his Facebook “likes” or Twitter followers creates an adverse inference, dismiss the publications as obscure and out-of-print, and question the number of people who have attended Kibler’s concerts. [Defendants] also highlight Kibler’s deposition testimony that he appeared on the television shows to support other, headlining artists. Promotion on platforms such as Twitter and Facebook not only constitutes marketing, but is among the most popular and effective advertising strategies today. And whether publicity like magazine interviews and television appearances constitutes marketing or a separate form of evidence, it speaks to commercial strength.  But  some  proof is not enough. Kibler must offer evidence that would permit a reasonable jury to determine that wide segments of the public recognize DJ LOGIC as an emblem of his music. This means “extensive” marketing and “widespread” publicity around the music and mark.  Maker’s Mark, 679 F.3d at 421. Kibler’s evidence . . . lacks the information jurors would need to find such awareness. For instance, how many and what kind of Twitter followers does Kibler have? A large number of

followers, or celebrities likely to re-tweet Kibler’s messages to their large number of followers, for example, would suggest that many types of people know his work and mark. We can say the same of the number and kind of Kibler’s Facebook fans, likes, posts, and re-posts. Similarly, Kibler fails to provide the circulations or target audiences of Downbeat and Gig, which appear to be niche publications. Further, the New York Times review focuses on two other artists, placing “DJ Logic” in a series of supporting musicians. This leaves a slim chance that readers noticed and recalled Kibler. Kibler has neither refuted nor explained his deposition testimony that he appeared on television shows to support other, headlining artists. For instance, he testified that Carly Simon, “the main act,” introduced “the guests she had playing with her” on the Fallon show. We do not know how many guests there were, if Simon introduced them individually, if she said anything other than their names, etc. Kibler did not need to address each of these considerations. But they indicate the sort of information a jury would need to assess the extent to which the public affiliates DJ LOGIC with Kibler’s music. The district court rightly found that Kibler has enjoyed limited commercial success and that this implies that DJ LOGIC is not broadly familiar. But the court’s analysis was incomplete. Album sales and even recording contracts are less critical markers of success than before because of widespread internet use. As a result, a plaintiff with low album sales or no representation could nevertheless show commercial success suggesting broad recognition of his mark using web-based indicators of popularity, e.g., YouTube views. Because Kibler has not done that, we have only his low album sales, current lack of a recording contract, and inability ever to secure a recording contract with a major label. Kibler declares that he has participated “in hundreds of live performances held in at least 46 states,” but he does not indicate the number of people who attended, the number of other artists involved, and whether he ever received top billing. Kibler’s silence on his popularity online and general statement about his performances do not allow for a finding that most people will be familiar with DJ LOGIC.  DJ LOGIC lacks commercial strength. Because the record reflects that DJ LOGIC is moderately strong conceptually, but weak commercially, the first Frisch factor favors defendants. 2. Relatedness of Products This court uses the following test to decide whether relatedness favors either party: 1) if the parties’ products  compete directly with each other, consumer confusion is likely if the parties’ marks are sufficiently similar; 2) if the products are somewhat related, but do not compete directly, the likelihood of confusion will depend on other factors; 3) if the products are completely unrelated, confusion is unlikely. Daddy’s, 109 F.3d at 282.



Chapter Eight Intellectual Property and Unfair Competition

Products belonging to the same industry are not necessarily related. To be related, they must be marketed and consumed in ways that lead buyers to believe they come from the same source. The district court found the relatedness factor neutral insofar as the parties’ products are somewhat related, but not directly competitive. The court reasoned that while both Kibler and Hall perform and sell music, only Hall uses his vocals. Kibler maintains that the factor favors him based on proof that he and Hall both sell hip-hop incorporating turntables and rap. Kibler refers to print and online media about Hall, much of which affiliates him with hip-hop and all of which describes him as a rapper. The district court correctly found this factor neutral because the record supports that the parties’ products are somewhat related, but not directly competitive. The most relevant evidence is a booking notice describing Hall as a “hot upcoming rapper” and two online ads featuring Hall holding a microphone. They indicate that while both are musicians and perhaps hip-hop artists, Hall markets himself as a rapper and Kibler a disc jockey. Incidental overlap of their customers [would] not sustain a finding of direct competition at trial. Accordingly, the factor is neutral. 3. Similarity of Marks The more similar the marks are, the more likely it is that relevant consumers will confuse their sources. We determine the similarity of marks by considering whether either mark would confuse a consumer who did not have both marks before her and had only a vague impression of the other mark. We consider the marks’ pronunciation, appearance, and verbal translation.  The antidissection rule requires us not to dwell on the prominent features of a mark and instead consider it as a whole. See Little Caesar Enterprises, Inc. v. Pizza Caesar, Inc., 834 F.2d 568, 571–72 (6th Cir. 1987) (finding differences in sound, appearance, and syllables distinguish “Little Caesar” from “Pizza Caesar USA” despite the prominent word they share). The district court concluded that this factor favors defendants based on the anti-dissection rule. The court acknowledged that both marks include the prominent word  “logic.”  Then it noted that the “‘DJ’ portion not only changes the look and sound of the mark but also describes or suggests certain characteristics of [Kibler’s] music.” The district court . . . correctly appl[ied] the anti-dissection rule [by] examining DJ LOGIC as a whole, including its appearance, sound, language, and impression. Kibler’s call [in his brief] for this court to “focus on the dominant features of each mark and disregard the non-dominant features” is precisely what the anti-dissection rule forbids. Thus, the anti-dissection rule requires the similarity of marks factor to favor defendants here. 4. Evidence of Actual Confusion Evidence of actual confusion is the strongest proof of likely confusion. Frisch, 759 F.2d at 1267. But the weight we give that

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evidence depends on the amount and type of confusion. On one end of the spectrum are persistent mistakes and confusion by actual customers. On the other are relatively few instances of confusion and inquiries rather than purchases. The analysis is, above all, contextual. In Therma-Scan, for example, the court found that six email inquiries implying that plaintiff manufactured the defendant’s products provided only weak support for the conclusion that relevant consumers were likely to confuse the two. 295 F.3d at 635–36. The court considered the number of emails against the [very large] scale of defendant’s operations. Id.   Kibler offers evidence of at most ten instances of actual confusion. These include tweets and webpages advertising a performance by “DJ Logic,” but meaning Hall; an email offering to book “DJ Logic,” but meaning Hall; and inquiries about whether Kibler would be performing somewhere advertising “logic” and referring to Hall. The district court concluded that the evidence of actual confusion favors Kibler only slightly. The court suggested that the ten instances paled in comparison to Hall’s 170,000 album sales and popularity on YouTube, Facebook, and Twitter. The court also indicated that computer rather than human error caused the confusion on the webpages. Because past confusion is the best proof of future confusion, any evidence at all favors the plaintiff. Kibler has offered some proof, but it is scant. If “Logic” really threatened to confuse consumers about the distinctions between Hall and Kibler, one would see much more than ten incidents throughout 170,000 album sales, 1.7 million album downloads, and 58 million YouTube views. The fact that none of the incidents were purchases would further prevent a jury from finding that this factor significantly helps Kibler. In sum, Kibler has not presented the quantity or type of proof that would tilt the actual confusion factor substantially in his favor. 5. Marketing Channels The marketing channels factor requires us to compare both how the parties market their products and their main customers. The more channels and buyers overlap, the greater the likelihood that relevant consumers will confuse the sources of the parties’ products. The reverse is true too. Here, the district court found the marketing channels factor favors neither party. Kibler maintains that he has offered proof that would allow a reasonable jury to find the factor favorable to him. This includes deposition testimony 1) that he advertises on a personal website, MySpace, Twitter, and Facebook; 2) that he sells his music on Amazon and iTunes; and 3) that the parties have played fifteen of the same venues. It also includes tweets promoting Hall’s album and performances and screenshots of Hall’s Facebook page. Defendants [highlight] Kibler’s deposition testimony that thousands of artists have played two of the fifteen venues and [note] that Hall has never appeared in Downbeat or Gig.

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Part Two Crimes and Torts

[Defendants also urge] us to discount the parties’ online advertising, reasoning that such a pervasive channel as the Internet cannot clarify the likelihood of confusion. The district court correctly concluded that this factor is neutral, but underestimated the impact of widespread Internet use. Kibler has shown that the parties market  their products on the same websites, Twitter and Facebook, and target the same customers, users of Amazon or iTunes. At first glance, this overlap is compelling. But  we must assess the likelihood of confusion in the real-life circumstances of the market. Most musical artists use those websites to advertise and sell their products today. At the same time, the popularity of these channels makes it that much less likely that consumers will confuse the sources of the parties’ products. There are just too many other contenders. For these reasons, shared use of the above websites does not help us determine the likelihood of confusion. Though evidence of the parties’ common venues comes closest, it would not permit a reasonable jury to find that Kibler’s and Hall’s customers substantially overlap. Kibler himself admitted that thousands of artists have played two of the fifteen venues. The more artists there are, the fewer the chances of any one attendee encountering both Kibler’s and Hall’s songs, let alone confusing their sources. Proof of the remaining venues carries minimal weight without information about their traditional line-ups or patrons, for example. The marketing channels factor is neutral because there is minimal evidence that the parties’ advertising methods or targeted customers substantially overlap beyond shared use of congested websites like Facebook and iTunes. 6. Likely Degree of Purchaser Care When consumers are more likely to exercise caution in purchasing items, they are less likely to confuse their origins. This happens when consumers have expertise in the items and when the items are particularly expensive. In this case, the district court found this factor unhelpful because the degree of care exercised by music consumers varies greatly by consumer and transaction. [T]he district court’s analysis was sound and the factor is insignificant here.  7. Intent in Selecting the Mark This court may infer a likelihood of confusion from evidence that defendant chose its mark to confuse consumers about the source of the parties’ products.  Therma-Scan, 295 F.3d at 638. The standard assumes that defendant itself believed that using the mark would divert business from plaintiff. Daddy’s, 109 F.3d at 286. Circumstantial evidence of intent is sufficient when direct evidence is unavailable (as it often is).  Therma-Scan, 295 F.3d at 638–39. And evidence that defendant knew of plaintiff’s

trademark while using its mark constitutes such circumstantial evidence. Daddy’s, 109 F.3d at 286–87. Having found no evidence of intent, the district court concluded that the factor is neutral in this case. Kibler asserts that two pieces of evidence create a triable issue. One is his sworn declaration that a Google or YouTube search for “logic music” or “logic musician” yielded DJ LOGIC and Kibler’s picture or music before Hall adopted LOGIC. The other is Hall’s deposition testimony that he ran Google, Facebook, and Twitter searches for “any other rappers” using LOGIC before adopting it. Hall testified that he ran the search “[t]o see if [any rapper] with this name was already at a level where it wouldn’t make sense for two people to coexist with the same name.” The district court properly found the factor neutral because the record prevents a reasonable jury from inferring intent. Here, we have no proof that Hall searched for “logic music” or “logic musician,” no reason to believe he had to, and thus no evidence he knew of DJ LOGIC before adopting LOGIC. Hall’s testimony shows, to the contrary, that he avoided choosing a mark that might lead consumers to confuse his product with that of another musician. The factor is therefore neutral. 8. Likelihood of Expansion A strong possibility that either party will expand its business to compete with the other’s increases the likelihood of consumers confusing the sources of the parties’ products. As with intent, a finding that neither party will expand its business is irrelevant in determining the likelihood of confusion.  The district court concluded that this factor is neutral after finding it “unlikely that the parties will expand their markets to put them in competition.” Kibler identifies book excerpts, press clippings, and deposition testimony describing his experimentation with different musical genres as proof he will expand his reach. He adds [in his brief that] there is “no evidence that [Hall] will not continue to expand his musical reach as well.” Kibler stresses that the parties’ mutual use of hip-hop predisposes them to expansion. The district court rightly concluded that this factor is neutral. All we can conclude is that Kibler offered no proof that the parties will expand their businesses. Kibler’s supposed evidence says nothing of the potential for competition with Hall, whether Kibler anticipates rapping or working closely with a rapper, for example. With no sign of any future overlap in the market, the parties’ mutual use of hip-hop is irrelevant. Thus, the factor is neutral. 9. Balance of Factors We note that evidence of actual confusion favors Kibler only marginally and that both the strength of plaintiff’s mark and similarity of the marks favor defendants. Though the Frisch inquiry is flexible and contextual, these are the “most important factors.” Maker’s Mark, 679 F.3d at 424. Further, the remaining factors are either



Chapter Eight Intellectual Property and Unfair Competition

neutral or insignificant here. Because no reasonable jury could find a likelihood of confusion based solely on a few instances of actual confusion, defendants are entitled to judgment as a matter of law on Kibler’s trademark infringement claim. Trademark Dilution Kibler also alleges trademark dilution in violation of the Lanham Act. The Act entitles “the owner of a famous mark that is distinctive” to an injunction against someone who “commences use of a mark . . . in commerce that is likely to cause dilution . . . of the famous mark” “any time after the owner’s mark has become famous.” 15 U.S.C. § 1125(c)(1). The Act specifies that a mark is famous when it is “widely recognized by the general consuming public of the United States as a designation of source of the goods or services of the mark’s owner.” § 1125(c)(2)(A). In evaluating whether a mark is sufficiently recognized, courts may consider the duration, extent, and reach of advertising and publicity around the mark; amount, volume, and extent of product sales; and actual recognition of the mark. Id. Courts have interpreted the Act to require the mark to be a “household name.” Coach Services, Inc. v. Triumph Learning LLC, 668 F.3d 1356, 1373 (Fed. Cir. 2012). That is, “when the general public encounters the mark in almost any context, it associates the term, at least initially, with the mark’s owner.” Id. See, e.g., Audi AG v. D’Amato, 469 F.3d 534, 547 (6th Cir. 2006) (finding AUDI marks [are] famous under Lanham Act because Audi had spent millions of dollars on them and they are known globally); Starbucks Corp. v. Wolfe’s Borough Coffee, Inc., 588 F.3d 97, 105 (2d Cir. 2009) (finding that STARBUCKS marks are famous under the Lanham Act);  Louis Vuitton Malletier S.A. v. Haute Diggity

Trade Secrets The law provides two partially overlapping means of protecting creative inventions. Owners of such inventions may go public and obtain monopoly patent rights. As an alternative, they may sometimes keep the invention secret and rely on trade secrets law to protect it. The policies underlying patent protection and trade secrets protection differ. The general aim of patent law is to encourage the creation and disclosure of inventions by granting the patentee a temporary monopoly in the patented invention in exchange for his making it public. Trade secrets, however, are nonpublic by definition. Although protecting trade secrets may stimulate creative activity, it also keeps the information from becoming public

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Dog, LLC, 507 F.3d 252, 257, 265 (4th Cir. 2007) (finding that LOUIS VUITTON marks are famous under the Lanham Act). It is difficult to establish fame under the Act sufficient to show trademark dilution. Coach, 668 F.3d at 1373. The district court concluded that summary judgment was appropriate because no reasonable jury could find DJ LOGIC is famous under the Lanham Act. The court cited its finding that Kibler failed to show the mark is commercially strong for trademark infringement purposes. Indeed, it is easier to show public recognition under Frisch than it is under the Lanham Act[’s dilution provision]. Kibler contends that the district court erred in discounting proof of his fame. He cites his sworn declaration describing his experience in the music industry and his deposition testimony that he was a guest contributor on a Grammy-winning album. Kibler’s evidence clearly falls short of the high threshold for fame under the Lanham Act. DJ LOGIC is simply in a different league from the marks that have met this threshold. Indeed, having failed to show that his mark is commercially strong for even trademark infringement purposes, Kibler cannot point to a triable issue here. Thus, we do not address Kibler’s remaining  arguments on his trademark dilution claim. Kibler has not provided evidence that would allow a reasonable jury to find relevant consumers are likely to confuse the sources of his and Hall’s products, or that Hall’s mark has diluted his. [Therefore, the district court did not err in granting summary judgment to defendants on Kibler’s trademark infringement and trademark dilution claims.] District Court’s grant of summary judgment for defendants affirmed.

knowledge. Thus, the main justification for trade secrets protection is simply to preserve certain standards of commercial morality. State law historically served as the primary source of legal protection for trade secrets and as the only source of civil liability for the violation of another party’s trade secret rights. Although a federal statute (the Economic Espionage Act of 1996) contemplated criminal liability in some instances of trade secret violations, federal law did not recognize a civil cause of action for misappropriation of trade secrets until very recently. That state of affairs changed with the enactment of a 2016 federal law, the Defend Trade Secrets Act (DTSA). The DTSA defines trade secrets and the elements of a misappropriation claim in ways that are very similar to state laws’ customary treatment of

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Part Two Crimes and Torts

The Global Business Environment An American firm may enter the world market by licensing its product or service to a foreign manufacturer. In exchange for granting a license to the foreign licensee, the American licensor will receive royalties from the sale of the licensed product or service. Usually, the licensed product or service or the name under which it is sold will be protected by American intellectual property law, such as patent, trade secret, copyright, or trademark law. Because American intellectual property law does not protect the property outside the boundaries of the United States, a licensor needs to take steps to ensure that its intellectual property will acquire protection in the foreign nation. Otherwise, the licensor risks that a competitor may appropriate the intellectual property without penalty. The World Trade Organization has attempted to increase the protection of intellectual property through passage of the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). Effective in 1995, TRIPS covers patents, trade secrets, copyrights, and trademarks. It sets out minimum standards of intellectual property protection to be provided by each member nation. Some signatory nations, such as the United States, provide greater protection of intellectual property.

There is no international copyright that automatically protects a copyrighted work everywhere in the world. Instead, copyright protection for a work must be secured under the laws of the individual nations in which protection is sought. International agreements, however, may smooth the way to copyright acquisition in many countries. The most notable is the Berne Convention, to which the United States and approximately 150 other nations subscribe. The Berne Convention guarantees that a work eligible for copyright in any signatory nation will be eligible for protection in all signatory nations. Although the Berne Convention does not completely standardize the copyright laws of the member nations, it does require each country’s copyright laws to contain certain minimum guarantees of rights. Another key aspect of the Berne Convention is its principle of national treatment, under which each signatory nation agrees to treat copyright owners from other subscribing countries according to the same rules it applies to copyright owners who are its own residents or citizens. Other international agreements to which the United States is a party operate in generally similar fashion. These include the Universal Copyright Convention and the World Intellectual Property Organization Copyright Treaty.

Patents and Trade Secrets A patent filing must be made in each nation in which protection is desired. It is not especially difficult for a firm to acquire parallel patents in each of the major countries maintaining a patent system because many countries (including the United States) are parties to the Paris Convention for the Protection of Industrial Property. This convention recognizes the date of the first filing in any nation as the filing date for all, but only if subsequent filings are in fact made within a year of the first filing. When technology is not patented, either because it is not patentable or because a firm makes a business decision not to patent it, a licensor may control its use abroad under trade secret law. For example, an American firm can license its manufacturing know-how to a foreign manufacturer for use in a defined territory in return for promises to pay royalties and to keep the trade secret confidential.

Trademarks The holder of an American trademark may license the use of its trademark in a foreign nation. For example, McDonald’s may license a French firm to use the McDonald’s name and golden arches at a restaurant on the Champs-Élysées, or the holder of the Calvin Klein trademark may license a South Korean firm to manufacture Calvin Klein jeans. An American trademark’s owner, when licensing its product or services abroad, runs the risk of experiencing unwanted and largely uncontrollable uses of its trademark in a foreign market unless it has acquired trademark rights in that nation. Trademark registrations normally must be made in each nation in which protection is desired. Parallel trademark registrations, however, may be made in compliance with the Paris Convention for the Protection of Industrial Property. Under the Paris Convention, the date of the first filing in any nation is the filing date for all nations, if the subsequent filings are made within six months of the first filing. The European Union allows a single filing to be effective in all EU nations. An agreement known as the Madrid Protocol also permits a firm to seek registration or a trademark in all its signatory nations simultaneously by filing an application for registration in any signatory nation and with the World Intellectual Property Organization (WIPO) in Geneva. The United States joined the Madrid Protocol in 2003.

Copyright An American firm may license a foreign manufacturer to produce literary, artistic, or musical materials for which the firm holds an American copyright. For example, a computer software development firm may grant a license to a foreign manufacturer of software, or the American owner of copyrights protecting cartoon characters from the television program The Simpsons may license a Chinese firm to manufacture Homer, Marge, and Bart dolls.



Chapter Eight Intellectual Property and Unfair Competition

such matters. Because the DTSA does not preempt state trade secrets law, state law remains an important player in the trade secrets realm. Those whose trade secret rights have arguably been violated are likely to have considerable freedom to decide whether to pursue litigation under the DTSA or, instead, under applicable state law. The following discussion focuses on key principles that typical state laws and the DTSA share.

Definition of a Trade Secret LO8-12

Explain what a trade secret is and what the trade secret owner must prove in order to win a misappropriation case.

A trade secret can be defined as any secret formula, pattern, process, program, device, method, technique, or compilation of information used in the owner’s business, if it gives its owner an advantage over competitors who do not know it or use it.4 Examples include chemical formulas, computer software, manufacturing processes, designs for machines, and certain detailed customer lists. To be protectible, a trade secret must usually have sufficient value or originality to provide an actual or potential competitive

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advantage. It need not possess the novelty required for patent protection, however. Courts examine various factors when determining whether a trade secret exists. As common sense suggests, a trade secret must actually be secret if it is to be legally protected. A substantial measure of secrecy is necessary, but it need not be absolute. Thus, information that becomes public knowledge or becomes generally known in the industry cannot be a trade secret. Similarly, information that is reasonably discoverable by proper means may not be protected. “Proper means” include independent invention of the secret, observation of a publicly displayed product, the owner’s advertising, published literature, product analysis, and reverse engineering (starting with a legitimately acquired product and working backward to discover how it was developed).

This definition comes mainly from Restatement (Third) of Unfair Competition § 39 (1995), with some additions from Uniform Trade Secrets Act § 1(4) (1985). Many states have adopted the Uniform Trade Secrets Act (UTSA) in some form. The discussion in this chapter is a composite of the Restatement’s and the UTSA’s rules. 4

CYBERLAW IN ACTION Trademark infringement principles sometimes govern conflicts between one party’s claim of trademark rights and another’s claim of rights over a World Wide Web domain name. Such disputes sometimes raise dilution issues as well. In a 1999 enactment, Congress paid special attention to the trademark rights–domain name rights conflict by enacting the Anticybersquatting Consumer Protection Act (ACPA). The ACPA authorizes a civil action in favor of a trademark owner against any person who, having a “bad faith intent to profit” from the owner’s mark, registers, sells, purchases, licenses, or otherwise uses a domain name that is identical or confusingly similar to the owner’s mark (or would dilute the mark, if it is famous). Among the factors listed in the ACPA as relevant to the existence of bad-faith intent to profit are a defendant’s intent to divert consumers from the mark owner’s online location to a site that could harm the mark’s goodwill and a defendant’s offer to sell the domain name to the mark owner without having used, or intended to use, the domain name in the offering of goods or services.

If the trademark owner wins a cybersquatting action, the court may order the forfeiture or cancellation of the domain name or may order that it be transferred to the mark owner. The successful trademark owner may also recover actual damages as well as the cybersquatter’s attributable profits. Borrowing the statutory damages concept from the Copyright Act, the ACPA provides that in lieu of actual damages plus profits, the trademark owner may elect to recover statutory damages falling within a range of $1,000 to $100,000 per domain name, “as the court considers just.” Many cases in which a trademark owner complains about another party’s registration of a domain name have been submitted to arbitration, rather than to a court, in recent years. When a party registers an Internet address with the Internet Corporation for Assigned Names and Numbers, the registrant must agree to submit to arbitration in the event that a trademark owner claims a right to the domain name. The World Intellectual Property Organization is a leading provider of arbitrators for this process.

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Part Two Crimes and Torts

In addition, a firm claiming a trade secret must usually show that it took reasonable measures to ensure secrecy. Examples include advising employees about the secret’s secrecy, limiting access to the secret on a need-to-know basis, requiring those given access to sign a nondisclosure agreement, disclosing the secret only on a confidential basis, and controlling access to an office or plant. Computer software licensing agreements commonly forbid the licensee to copy the program except for backup and archival purposes, require the licensee and its employees to sign confidentiality agreements, call for those employees to use the program only in the course of their jobs, and require the licensee to use the program only in a central processing unit. Because the owner must make only reasonable efforts to ensure secrecy, however, she need not adopt extreme measures to block every ingenious form of industrial espionage.

secrets by improper means and sell them to the firm’s competitors. If those competitors know or have reason to know that the spy obtained the secrets by improper means, they are liable for misappropriation along with the spy. 3. Breached a duty of confidentiality regarding the secret. If an employer owns a trade secret, for example, an employee is generally bound not to use or disclose it during his employment or thereafter.5 As indicated in the Coleman case, which follows shortly, this rule applies to a former employee of the trade secret owner regardless of whether that ex-employee agreed in a written contract to respect the employer’s trade secrets after the employment relationship ceased.

Remedies for misappropriation of a trade secret include damages, which may involve both the actual loss caused by the misappropriation and the defendant’s unjust enrichment. In some states, punitive damages are awarded for willful and Ownership and Transfer of Trade Secrets  malicious misappropriations. Also, an injunction may be isThe owner of a trade secret is usually the person who develsued against actual or threatened misappropriations. oped it or the business under whose auspices it was generated. Establishing the ownership of a trade secret can pose Noncompetition Agreements Once an employment relaproblems, however, when an employee develops a secret in tionship ends, the ex-employee is normally free to compete the course of her employment. In such cases, courts often with her former employer on the basis of general knowledge find the employer to be the owner if (1) the employee was and skills obtained and developed during the employment hired to do creative work related to the secret, (2) the emrelationship (as opposed to trade secrets learned during the ployee agreed not to divulge or use trade secrets, or (3) other relationship). However, employers fairly often attempt to employees contributed to the development of the secret. restrict such otherwise allowable postemployment relationEven when the employee owns the secret, the employer still ship competition by having their employees enter into a may obtain a royalty-free license to use it through the shop written noncompetition agreement in which the employees right doctrine discussed in the section on patents. agree not to compete with the employer (or accept employThe owner of a trade secret may transfer rights in the secret ment with a competitor of the employer) for some period of to third parties. This may occur by assignment (in which case time after the employment relationship ends. Often, these the owner loses title) or by license (in which case the owner noncompetition agreements go well beyond the clearly retains title but allows the transferee certain uses of the secret). important and legally recognized interest in preserving trade secrets. To the extent that they extend beyond trade Misappropriation of Trade Secrets secret protection and restrict postemployment competition more generally, such agreements are disfavored in the law because they may interfere unduly with individuals’ imporExplain what a trade secret is and what the trade secret LO8-12 tant interests in working and making a living. Accordingly, owner must prove in order to win a misappropriation case. courts tend to enforce noncompetition agreements that extend beyond trade secret protection only if their proviMisappropriation of a trade secret can occur in various ways, sions restricting competition are narrowly defined in terms most of which involve disclosure or use of the secret. For exof duration, geographic area, and relationship to legitimate ample, misappropriation liability occurs when the secret is interests of the employer. Noncompetition agreements that disclosed or used by one who did one of the following: strike the court as too broad may be ruled unenforceable. 1. Acquired it by improper means. Improper means include The Coleman case, which follows, addresses not only theft, trespass, wiretapping, spying, bugging, bribery, fraud, misappropriation of trade secret issues, but also issues reimpersonation, and eavesdropping. garding enforceability of noncompetition agreements. 2. Acquired it from a party who is known or should be 5 known to have obtained it by improper means. For examThis is an application of the agent’s duty of loyalty, which is discussed ple, a freelance industrial spy might obtain one firm’s trade in Chapter 35.



Chapter Eight Intellectual Property and Unfair Competition

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Coleman v. Retina Consultants, P.C.   687 S.E.2d 457 (Ga. 2009) Retina Consultants, P.C. does business under the name The Retina Eye Center (TREC) and will be referred to here as TREC. As its name indicates, TREC is a medical practice specializing in retina surgery. In 2000, TREC hired Brendan Coleman as a software engineer. Prior to his employment by TREC, Coleman wrote and marketed a medical billing program called Clinex. While employed by TREC, Coleman, with the assistance of the doctors who worked for TREC, modified the Clinex program to suit TREC’s specific business and developed an integrated retinal practice computer application called Clinex-RE. Clinex-RE is a software program that integrates electronic medical records and image storage with a billing software component. Clinex and Clinex-RE are different programs, and Clinex-RE works only in conjunction with Clinex. In order to develop Clinex-RE, Coleman incorporated into his Clinex program certain proprietary information and trade secrets of TREC. In 2003, Coleman and TREC entered into a Software Agreement that allocated the rights to Clinex and Clinex-RE between TREC and Coleman. Although the Software Agreement stated that Coleman owns Clinex and that TREC had only a nonexclusive license to use and sell Clinex, Paragraph 8 of the agreement provided that “Coleman will not distribute, vend or license to any ophthalmologist or optometrist the Clinex software or any computer application competitive with the Clinex-RE software without the written consent of TREC.” Prior to ending his employment relationship with TREC in 2008, Coleman developed encryption keys that were required for the installation of the Clinex-RE package (i.e., Clinex as integrated with Clinex-RE) on any computer in TREC’s office and that were necessary for the program to work properly. After the parties’ employment relationship ended, TREC sued Coleman in a Georgia court for breach of the Software Agreement and for misappropriation of trade secrets. TREC alleged—and the trial court later found—that, after his resignation, Coleman removed all applicable encryption keys and source and access codes along with any manual/installation instructions; attempted to distribute, vend, or license to other ophthalmologists the Clinex and Clinex-RE software; refused to disclose to TREC the passwords required to read and revise copies of the Clinex and Clinex-RE software; refused to provide copies to TREC of all documentation in his possession and control relating to the programming and use of the software; refused to return to TREC copies of the Clinex-RE software; and used or attempted to use TREC’s proprietary information and trade secrets to compete with TREC. The trial court issued an injunction in favor of TREC and against Coleman. The injunction purported to enforce the Software Agreement and in particular the noncompetition provision in its Paragraph 8. The injunction further prohibited Coleman from “continuing to retain and use any applicable encryption keys, access codes, source codes and the multiple copies of manual/installation instructions,” from “retaining any passwords required to read and to revise copies of the Clinex and Clinex-RE software,” and from “retaining copies of all documentation in his possession or control relating to the programming and use of the Clinex and Clinex-RE software.” Coleman appealed to the Supreme Court of Georgia.

Melton, Justice Coleman claims that the non-compete clause in [Paragraph 8 of] the Software Agreement is unenforceable as a matter of law. A contract “which may have the effect of or which is intended to have the effect of defeating or lessening competition, or encouraging a monopoly, [is] unlawful and void.” [Citation omitted.] However, “a restrictive covenant contained in an employment contract . . . will be upheld if the restraint imposed is not unreasonable, is founded on a valuable consideration, and is reasonably necessary to protect the interest of the party in whose favor it is imposed, and does not unduly prejudice the interests of the public.” [Citation omitted.] A useful tool in examining the reasonableness of a [noncompetition clause] consists of a “three-element test of duration, territorial coverage, and scope of activity.” [Citation omitted.] Even if only a portion of a non-compete clause in an employment contract would be unenforceable, the entire covenant must fail.

We agree with Coleman that the non-compete clause at issue is unenforceable as a matter of law. [Paragraph 8 of] [t]he Software Agreement states that “Coleman will not distribute, vend or license to any ophthalmologist or optometrist the Clinex software or any computer applications competitive with the Clinex-RE software without the written consent of TREC.” On its face, the agreement contains no time limitation, as the contract purports to limit Coleman’s actions in perpetuity. A noncompete clause, such as the one at issue here, is invalid where it “contain[s] no limitation regarding duration.” [Citation omitted.] Furthermore, “[t]he covenant which we are asked to consider in this case, as it is written, has no territorial limitation. The absence of such a limitation renders it void.” [Citation omitted.] Indeed, the non-compete clause here would prohibit Coleman from marketing Clinex and any other competitive software to any ophthalmologist or optometrist, regardless of whether or not they are or ever were customers of TREC and regardless of

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where they are located. Such a restrictive covenant is overbroad and unenforceable. For the foregoing reasons, we find that the non-compete clause of the Software Agreement is unreasonable and that the trial court therefore erred to the extent that the injunction enforces the clause against Coleman. Thus, the non-compete clause, in and of itself, cannot operate to prevent Coleman from marketing Clinex and Clinex-RE to ophthalmologists and optometrists. However, this does not end our inquiry. Even without an express restrictive covenant, TREC could still prohibit Coleman from marketing the Clinex-RE package, that is, Clinex as integrated with Clinex-RE. Indeed, [according to a Georgia statute], “[i]n no event shall a contract be required in order to maintain an action or to obtain injunctive relief for misappropriation of a trade secret.” See also Thomas v. Best Mfg. Corp., 218 S.E.2d 68 (Ga. 1975) (“Even without an express restrictive covenant, one of the implied terms of a contract of employment is that the employee will not disclose a trade secret learned during his employment, to a competitor of his former employer. It is not relevant whether or not a valid express written contract or restrictive covenant was entered into.”). The trial court found that the Clinex-RE package is a trade secret belonging to TREC. Paragraph (c) of the injunction [issued by the trial court] correctly prohibits Coleman “from using, communicating, revealing or otherwise making available confidential information and trade secrets belonging to [TREC].” Therefore, regardless of the fact that the non-compete clause in the Software Agreement is unenforceable, Coleman would nevertheless be prohibited from using the Clinex-RE package to compete with TREC to the extent that the Clinex-RE package contains TREC’s confidential information and trade secrets. Coleman would not, however, be restricted

from using and marketing his own version of Clinex, which is undisputably his own property, to the extent that it does not contain any of TREC’s confidential information or trade secrets. Coleman claims that the trial court erred by enjoining him from retaining copies of the Clinex program and accompanying software. Specifically, the Software Agreement states that “the Clinex software is valuable commercial property of Coleman,” and only requires Coleman to “disclose [to TREC] any passwords required to read and to revise . . . copies of the Clinex . . . software, and [to] provide copies of all documentation in his possession or control relating to the programming and use of the Clinex . . . software.” The injunction, on the other hand, purports to enjoin Coleman from “continuing to retain . . . any . . . applicable encryption keys, access codes, source codes and . . . copies of manual/installation instructions [for Clinex]” and further enjoins him “from retaining any passwords required to read and revise copies of the Clinex . . . software and from retaining copies of all documentation in his possession or control relating to the programming and use of the Clinex . . . software.” By prohibiting Coleman from retaining any and all information and documentation related to Clinex, the plain language of the injunction [erroneously] goes beyond the scope of that which is required of Coleman pursuant to the terms of the Software Agreement [and beyond what misappropriation of trade secrets principles permit. It is Clinex-RE that contains TREC’s trade secrets, not Clinex, which is Coleman’s property under the terms of the Software Agreement].

Commercial Torts

property rights in land, things, or intangibles or their quality. The property rights in question include legally protected property interests that can be sold; examples include leases, mineral rights, trademarks, copyrights, and corporate stock. Injurious falsehood also includes false statements that harm another’s economic interests even though they do not disparage property or property rights as such. For example, the seller of a bodybuilding program was held to have stated a valid claim for injurious falsehood against a book publisher regarding a false statement that the plaintiff’s program was isometric in nature. The harm to the plaintiff’s economic interest in the sale of its bodybuilding program stemmed from the juxtaposition of the untrue statement about the program with a statement concerning supposed dangers of isometric exercise programs.

In addition to the intentional torts discussed in Chapter 6, other intentional torts involve business or commercial competition. These torts may help promote innovation by protecting creative businesses against certain competitive abuses. Their main aim, however, is simply to uphold certain minimum standards of commercial morality.

Injurious Falsehood Injurious

falsehood also goes by names such as product disparagement, slander of title, and trade libel. This tort involves the publication of false statements that disparage another’s business, property, or title to property, and thus harm her economic interests. One common kind of injurious falsehood involves false statements that disparage either a person’s

Trial court’s judgment affirmed in part and reversed in part; terms of injunction to be modified accordingly.



Chapter Eight Intellectual Property and Unfair Competition

Elements and Damages LO8-13

List the elements that a plaintiff must prove in order to win an injurious falsehood case.

In injurious falsehood cases, the plaintiff must prove that the defendant made a false statement of the sort just described, and that the statement was communicated to a third party. The degree of fault required for liability is unclear. Sources often say that the standard is malice, but formulations of this differ. The Restatement requires either knowledge that the statement is false or reckless disregard as to its truth or falsity. There is usually no liability for false statements that are made negligently and in good faith. The plaintiff must also prove that the false statement played a substantial part in causing him to suffer special damages. These may include losses resulting from the diminished value of disparaged property; the expense of measures for counteracting the false statement (e.g., advertising or litigation expenses); losses resulting from the breach of an existing contract by a third party; and the loss of prospective business. In cases involving the loss of prospective business, the plaintiff is usually required to show that some specific person or persons refused to buy because of the disparagement. This rule is often relaxed, however, where these losses are difficult to prove. The special damages that the plaintiff is required to prove are his usual—and typically his only—remedy in injurious falsehood cases. Damages for personal injury or emotional distress, for instance, are generally not recoverable. However, punitive damages and injunctive relief are sometimes obtainable. Injurious Falsehood and Defamation Injurious falsehood may or may not overlap with the tort of defamation discussed in Chapter 6. Statements impugning a businessperson’s character or conduct are probably defamatory. If, on the other hand, the false statement is limited to the plaintiff’s business, property, or economic interests, his normal claim is for injurious falsehood. Both claims are possible when the injurious falsehood implies something about the plaintiff’s character and affects his overall reputation. An example would be a defendant’s false allegation that the plaintiff company knew the children’s products it sold contained dangerously high levels of lead. As in defamation cases, statements of pure opinion (as opposed to false statements of supposed fact) do not give rise to injurious falsehood liability. Defamation law’s absolute and conditional privileges generally apply in injurious falsehood cases.6 Certain other Chapter 6 discusses those privileges.

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privileges protect defendants who are sued for injurious falsehood. For example, a rival claimant may in good faith disparage another’s property rights by asserting his own competing rights. Similarly, one may make a good-faith allegation that a competitor is infringing one’s patent, copyright, or trademark. Finally, a person may sometimes make unfavorable comparisons between her product and that of a competitor. This privilege is generally limited to sales talk asserting the superiority of one’s own product and does not cover unfavorable statements about a competitor’s product.

Interference with Contractual Relations LO8-14

Explain the elements of interference with contractual relations.

In a lawsuit for intentional interference with contractual relations, one party to a contract claims that the defendant’s interference with the other party’s performance of the contract wrongly caused the plaintiff to lose the benefit of that performance. One can interfere with the performance of a contract by causing a party to repudiate it or by wholly or partly preventing that party’s performance. The means of interference can range from mere persuasion to threatened or actual violence. The agreement whose performance is impeded, however, must be an existing contract. This includes contracts that are voidable, unenforceable, or subject to contract defenses but not void bargains, contracts that are illegal on public policy grounds, or contracts to marry. Finally, the defendant must have intended to cause the breach; there is usually no liability for negligent contract interferences. Even if the plaintiff proves these threshold requirements, the defendant is liable only if his behavior was improper. Despite the flexible, case-by-case nature of such determinations, a few generalizations about improper interference are possible. 1. If the contract’s performance was blocked by such clearly improper means as threats of physical violence, misrepresentations, defamatory statements, bribery, harassment, or bad-faith civil or criminal actions, the defendant usually is liable. Liability is also likely where the interference was motivated solely by malice, spite, or a simple desire to meddle. 2. If his means and motives are legitimate, a defendant generally escapes liability when his contract interference is in the public interest—for example, when he informs an airport that an air traffic controller habitually uses hallucinogenic drugs. The same is true when the defendant acts

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to protect a person for whose welfare she is responsible—for example, when a mother induces a private school to discharge a diseased student who could infect her children. 3. A contract interference resulting from the defendant’s good-faith effort to protect her own existing legal or economic interests usually does not create liability so long as appropriate means are used. For example, a landowner can probably induce his tenant to breach a sublease to a party whose business detracts from the land’s value. However, business parties generally cannot interfere with existing contract rights merely to further some prospective competitive advantage. For example, a seller cannot entice its competitors’ customers to break existing contracts with those competitors. 4. Finally, defendants are sometimes less likely to be held liable when the contracts they allegedly interfered with were terminable at will. The reason is that in such cases, the plaintiff had only a desire or hope that the contract would continue but not an enforceable expectation in that regard. Accordingly, those who hire away their competitors’ at-will employees may have a credible argument for avoiding liability, though the cases are highly fact-specific and the argument is not a guaranteed winner. The basic measure of damages for intentional interference with contractual relations is the value of the lost contract performance. Some courts also award compensatory damages reasonably linked to the interference (including emotional distress and damage to reputation). Sometimes the plaintiff may obtain an injunction prohibiting further interferences.

The Lewis-Gale Medical Center case, which follows shortly, discusses issues arising in interference with contractual relations cases, including the improper behavior element and the effect when the contract interfered with was terminable at will.

Interference with Prospective Advantage  The rules and remedies for intentional inter-

ference with prospective advantage parallel those for interference with contractual relations. The main difference is that the former tort involves interferences with prospective relations rather than existing contracts. The protected future relations are mainly potential contractual relations of a business or commercial sort. Liability for interference with such relations requires intent; negligence does not suffice. The “improper interference” factors weighed in interference-with-contract cases generally apply to interference with prospective advantage as well. One difference, however, is that interference with prospective advantage can be justified if (1) the plaintiff and the defendant are in competition for the prospective relation with which the defendant interferes; (2) the defendant’s purpose is at least partly competitive; (3) the defendant does not use such improper means as physical threats, misrepresentations, and bad-faith lawsuits; and (4) the defendant’s behavior does not create an unlawful restraint of trade under the antitrust laws or other regulations. Thus, a competitor ordinarily can win customers by offering lower prices and attract suppliers by offering higher prices. Unless this is otherwise illegal, he can also refuse to deal with suppliers or buyers who also deal with his competitors.

Lewis-Gale Medical Center, LLC v. Alldredge    710 S.E.2d 716 (Va. 2011)

Southwest Emergency Physicians Inc. (SWEP) and Lewis-Gale Medical Center entered into a 2005 contract under which SWEP’s physician-employees exclusively staffed Lewis-Gale’s Emergency Department. Dr. Karen Alldredge, an emergency room physician, was under contract with SWEP from 2005 until the termination of her employment in 2008. Her contract provided for a 12-month term of employment with SWEP and included an automatic renewal provision. However, the contract further provided that it could be terminated by either party without cause, subject to a 90-day written notice of the intent to do so. During her time as a SWEP employee, Dr. Alldredge worked in the Lewis-Gale emergency room. In 2008, Dr. Alldredge attended an informal dinner with some of the emergency room nursing staff who were employees of LewisGale. During the dinner, these nurses discussed and signed a letter addressed to the Lewis-Gale administration voicing certain workrelated concerns. Dr. Alldredge was the only physician present. She did not sign the letter and later explained to one of the nurses that she did not sign the letter because it related to “a nursing issue, not a physician issue.” Dr. Alldredge subsequently conceded that she did not sign the letter because she also knew that SWEP did not want its physicians involving themselves in Lewis-Gale’s personnel issues. Candi Carroll, Lewis-Gale’s chief nursing officer, received a copy of the letter. Carroll subsequently became aware of Dr. Alldredge’s involvement with the signatories to the letter. By e-mail, Carroll contacted Dr. Robert Dowling, SWEP’s president, who also served as medical director for the emergency department at Lewis-Gale. Carroll informed him of her belief that Dr. Alldredge had



Chapter Eight Intellectual Property and Unfair Competition

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supported the staff members who had sent the letter. She inquired “what the plan of [SWEP] is to deal with Doctor Alldredge.” Carroll and Dr. Dowling exchanged several e-mails addressing Carroll’s concerns. Carroll also advised her superiors of the situation. After learning that Dr. Alldredge had attended the dinner referred to above, Charlotte Tyson, chief operating officer of Lewis-Gale, was concerned that Dr. Alldredge had become involved in the hospital’s personnel matters. Tyson contacted Dr. Jeffrey Preuss, another SWEP physician. He later testified in the litigation referred to below that Tyson had “brought to [SWEP] the fact that there was a perceived issue with Doctor Alldredge’s behavior and had asked that [SWEP] do something to take care of that issue, resolve it one way or another.” Later in 2008, at SWEP’s request, Tyson and Carroll met with members of SWEP’s executive board. During the meeting, Tyson described Dr. Alldredge’s behavior as that of an “organizational terrorist,” and told SWEP’s executive board that when a business has someone like Dr. Alldredge, “they had to go.” Although the representatives of SWEP repeatedly asked Tyson how Lewis-Gale wanted the situation addressed, Tyson later maintained that she never expressly told SWEP that Lewis-Gale’s administration wanted Dr. Alldredge’s employment to be terminated. Nonetheless, shortly after the meeting Dr. Dowling informed Tyson in an e-mail that he planned to recommend the termination of Dr. Alldredge’s employment at an upcoming meeting of the SWEP board. The minutes of SWEP’s board meeting cited additional concerns about Dr. Alldredge’s “treatment of other partners and group members” and “her behavior over the years.” The board was of the opinion that “the situation had come to a crisis point” and that Dr. Alldredge “was not likely to improve her behavior long-term.” Nonetheless, the principal concern cited by the board was that not terminating Dr. Alldredge’s employment could jeopardize SWEP’s contract with Lewis-Gale. Dr. Alldredge, who was present for part of the meeting, defended herself and expressed frustration and sadness at being called an “organizational terrorist.” SWEP terminated Dr. Alldredge’s employment in accordance with the provision of her contract by providing her with a 90-day notice period. Dr. Alldredge then sued Lewis-Gale in a Virginia court, alleging tortious interference with her contract of employment with SWEP. The case eventually proceeded to a jury trial. At the close of Dr. Alldredge’s evidence, Lewis-Gale sought a directed verdict in its favor. The trial court, however, submitted the case to the jury and instructed it that Dr. Alldredge had the burden of proving that Lewis-Gale “use[d] improper methods to interfere with the contractual relationship or expectancy” between Dr. Alldredge and SWEP. The jury returned a verdict for Dr. Alldredge, awarding her $900,000 in compensatory damages. Lewis-Gale appealed to the Supreme Court of Virginia.

Koontz, Senior Justice The dispositive issue we consider is whether Dr. Alldredge presented sufficient evidence to permit the jury to find that LewisGale employed improper methods to induce SWEP to terminate her employment. Intentional interference with performance of a contract by a third party is a permissible cause of action in Virginia. “The elements required for a prima facie showing of the tort are: (i) the existence of a valid contractual relationship or business expectancy; (ii) knowledge of the relationship or expectancy on the part of the interferor; (iii) intentional interference inducing or causing a breach or termination of the relationship or expectancy; and (iv) resultant damage to the party whose relationship or expectancy has been disrupted.” [Citation omitted.] “Additionally, when a contract is terminable at will, a plaintiff, in order to present a prima facie case of tortious interference, must allege and prove not only an intentional interference that caused the termination of the at-will contract, but also that the defendant employed improper methods.” Dunn, McCormack & MacPherson v. Connolly, 708 S.E.2d 867 (Va. 2011). An employment contract is terminable at will if the plain terms of the contract provide that the employer may terminate

the contract prior to the designated period of time of the employment without being required to establish a just cause for doing so. Although such a contract may place conditions of notice and timing of the termination, when the employer complies with these conditions the termination does not constitute a breach of the employment contract. In the present case, regardless of any expectancy that Dr. Alldredge may have had with regard to her continued employment by SWEP, because her contract provided for termination by SWEP after giving 90 days notice, Dr. Alldredge’s contract was for employment at will. Accordingly, Dr. Alldredge was required to prove not only that Lewis-Gale intentionally interfered with her contract relationship with SWEP, but also that in doing so LewisGale employed “improper methods.” The thrust of Lewis-Gale’s assertions is that when Dr. Alldredge’s evidence adduced at trial is viewed in its totality, it was insufficient as a matter of law to permit the jury to find that Lewis-Gale’s dealings with SWEP with regard to its employment of Dr. Alldredge constituted improper methods that would sustain her cause of action for interference with her at-will employment contract. Thus, Lewis-Gale contends that the court erred in . . . submitting the case to the jury. We agree.

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Our recent decision in Dunn, McCormack & MacPherson reiterated the contours of what constitutes the types of “improper methods” that a third party may not undertake when it intends for those actions to result in the termination of an at-will contract between others. Quoting from [an earlier case], we said: Methods of interference considered improper are those means that are illegal or independently tortious, such as violations of statutes, regulations, or recognized common-law rules. Improper methods may include violence, threats or intimidation, bribery, unfounded litigation, fraud, misrepresentation or deceit, defamation, duress, undue influence, misuse of inside or confidential information, or breach of a fiduciary relationship. . . . Methods also may be improper because they violate an established standard of a trade or profession, or involve unethical conduct [even if not otherwise tortious]. Sharp dealing, overreaching, or unfair competition may also constitute improper methods. We declined, however, to expand the parameters of “improper methods” to include “actions solely motivated by spite, ill will and malice” toward the plaintiff [even though some states have done so]. Dr. Alldredge did not allege or present any evidence tending to prove that Lewis-Gale’s actions were illegal or independently tortious. Nor was there any fiduciary duty owed to Dr. Alldredge that Lewis-Gale could have violated. Dr. Alldredge did not assert that Lewis-Gale’s motivation in seeking to have SWEP terminate her employment involved a desire to gain some competitive advantage, violated an established standard of the dealings between hospitals and their independent medical contractors, or involved unethical conduct in the form of sharp dealing, overreaching, or unfair competition. Rather, Dr. Alldredge maintains that Lewis-Gale’s actions were improper in that it used intimidation, duress, and undue influence based upon Lewis-Gale’s ability to bring “financial ruin” on SWEP by canceling its contract to provide emergency room services to Lewis-Gale, which was SWEP’s principal source of revenue. However, while the evidence supported the inference that SWEP was concerned about the continuation of its contract with Lewis-Gale, the at-will contract between Lewis-Gale and SWEP allowed termination of the contract upon due notice and without cause at any time. This status required that SWEP be continually sensitive to the possibility of termination for any reason or no reason, regardless of any specific action or comment made by Lewis-Gale officers or personnel. Thus, the inherent intimidation or duress experienced as a result of the very nature of this at-will contract cannot rise to the level of improper methods necessary to establish a cause of action for tortious interference with contract expectancy. Furthermore, in this case neither Dr. Alldredge’s allegations nor her evidence demonstrated a specific threat or other action by Lewis-Gale that it was going to cancel its contract with SWEP if SWEP did not terminate Dr. Alldredge’s employment.

We also reject Dr. Alldredge’s allegations that Tyson’s statements, such as her use of the term “organizational terrorist” to describe Dr. Alldredge, were independently tortious and therefore rose to improper methods. These statements were certainly unwise, unprofessional hyperbole, and may even indicate a personal animus toward Dr. Alldredge. In the context of Tyson’s discussions with SWEP, however, the statements did not rise to the level of fraud, misrepresentation, deceit, or defamation that could constitute improper methods of interference with the contract between Dr. Alldredge and SWEP. We disagree with Dr. Alldredge that the actions of LewisGale’s administrators, particularly Tyson, which Lewis-Gale’s counsel concedes were “unsavory,” “careless,” and “harsh,” rose to the level of the “improper methods” required to prove LewisGale’s actions exceeded that permissible in normal business relations in order to give rise to a cause of action in tort. In [an earlier case,] we noted that where the defendant has its own contractual or commercial relationship with the other party to the plaintiff’s contract, a balance must “be struck between the social desirability of protecting the business relationship [of the plaintiff and the other party], on one hand, and the interferor’s freedom of action [with the other party] on the other.” [W]e addressed this observation to the availability of an affirmative defense of privilege or justification, but we are of the opinion that it applies with equal force to determining what the law will deem to be an improper method by the interferor when there is an existing commercial relationship between it and the other party to the contract with the plaintiff. Under Virginia law, a threat to perform an act one is legally entitled to perform is not a wrongful act. As we have previously observed, “the law will not provide relief to every disgruntled player in the rough-and-tumble world comprising the competitive marketplace.” [Citation omitted.] The fact that Virginia recognizes the existence of the tort of intentional interference with a contract does not mean that every contract relationship which is terminated or disrupted through the interference of a third party promoting its own interests will result in tort liability for that party. Rather, the law provides a remedy in tort only where the plaintiff can prove that the third party’s actions were illegal or fell so far outside the accepted practice of that “rough-and-tumble world” as to constitute improper methods. In sum, Lewis-Gale’s actions in this case involving at-will contracts did not rise as a matter of law to the level of the “improper methods” required for Dr. Alldredge to prove that Lewis-Gale’s purposeful interference in her contract relationship with SWEP was tortious. Accordingly, we hold that the circuit court erred in not [granting a directed verdict] to Lewis-Gale. Trial court’s judgment in favor of Alldredge reversed.



Chapter Eight Intellectual Property and Unfair Competition

Lanham Act § 43(a) LO8-15

Identify key issues on which courts focus in false advertising cases brought under Lanham Act § 43(a).

Section 43(a) of the Lanham Act basically creates a federal law of unfair competition. Section 43(a) is not a consumer remedy; it is normally available only to commercial parties, which usually are the defendant’s competitors. The section creates civil liability for a wide range of false, misleading, confusing, or deceptive representations made in connection with goods or services. Section 43(a)’s many applications include:

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in jugs that are similar in size, shape, and color to a wellknown competitor’s jugs may face § 43(a) liability. 3. Claims for infringement of both registered and unregistered trademarks. 4. Commercial appropriation of name or likeness claims and right of publicity claims (discussed in Chapter 6).

1. Tort claims for “palming off” or “passing off.” This tort involves false representations that are likely to induce third parties to believe that the defendant’s goods or services are those of the plaintiff. Such representations include imitations of the plaintiff’s trademarks, trade names, packages, labels, containers, employee uniforms, and place of business.

5. False advertising claims. This important application of § 43(a) includes ads that misrepresent the nature, qualities, or characteristics of either the advertiser’s products and services or a competitor’s products and services. Section 43(a) applies to ads that are likely to mislead buyers even if they are not clearly false on their face, and to ads with certain deceptive omissions. Ordinary consumers are not regarded as appropriate plaintiffs in false advertising cases under § 43(a) (though they sometimes may sue under state laws dealing with deceptive trade practices). Rather, an appropriate plaintiff in a § 43(a) case has a commercial interest that goes beyond the interest a consumer typically has. This generally means that the plaintiff will be a competitor, either direct or indirect, of the defendant. 

2. Trade dress infringement claims. These claims resemble passing-off claims. A product’s trade dress is its overall appearance and sales image. Section 43(a) prohibits a party from passing off its goods or services as those of a competitor by employing a substantially similar trade dress that is likely to confuse consumers as to the source of its products or services. For example, a competitor that sells antifreeze

The POM Wonderful case, which follows, illustrates the types of allegations that may violate § 43(a) of the Lanham Act if they are proven. In POM Wonderful, the Supreme Court also addresses the interaction between § 43(a) and regulatory authority granted to the Food and Drug Administration under the federal Food, Drug, and Cosmetic Act.

POM Wonderful LLC v. Coca-Cola Co.   134 S. Ct. 2228 (2014) POM Wonderful LLC (POM) produces, markets, and sells, under its POM Wonderful brand, a variety of pomegranate products, including a pomegranate-blueberry juice blend. POM competes in the pomegranate-blueberry juice market with CocaCola Co. Using its Minute Maid brand, Coca-Cola created and sold a juice blend containing 99.4 percent apple and grape juices, 0.3 percent pomegranate juice, 0.2 percent blueberry juice, and 0.1 percent raspberry juice. Despite the small amount of pomegranate and blueberry juices in the blend, the front label of the  Coca-Cola  product displayed the words “pomegranate blueberry” in all capital letters, on two separate lines. Below those words,  Coca-Cola  placed the phrase “flavored blend of 5 juices” in much smaller type. Below that phrase, in still smaller type, were the words “from concentrate with added ingredients and other natural flavors.” The product’s front label also displayed a vignette of blueberries, grapes, and raspberries in front of a halved pomegranate and a halved apple.  Claiming that Coca-Cola’s label deceived consumers and thereby harmed POM as a competitor, POM sued Coca-Cola under § 43(a) of the federal Lanham Act. POM alleged that the name, label, marketing, and advertising of Coca-Cola’s juice blend would mislead consumers into believing that the product consisted predominantly of pomegranate and blueberry juice when it, in fact, consisted predominantly of less-expensive apple and grape juices. That confusion, POM complained, caused it to lose sales and made its sought-after remedies of damages and injunctive relief appropriate. A federal district court rejected POM’s Lanham Act claim and granted summary judgment to Coca-Cola after concluding that Congress had entrusted matters of food and beverage labeling, including misleading labeling, to the Food and Drug Administration (FDA) under the federal Food, Drug, and Cosmetic Act (FDCA). Therefore, the district court reasoned, the plaintiff’s

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Part Two Crimes and Torts

§ 43(a) cause of action was precluded. POM appealed to the U.S. Court of Appeals for the Ninth Circuit, which affirmed the district court’s grant of summary judgment to Coca-Cola. The U.S. Supreme Court granted POM’s petition for certiorari. (Further discussion of § 43(a) of the Lanham Act, the FDCA, and relevant FDA regulations will appear in the following edited version of the Supreme Court’s decision.) Kennedy, Justice This case concerns the intersection and complementarity of . . . two federal laws[, the Lanham Act and the FDCA]. A proper beginning point is a description of the statutes. Congress enacted the Lanham Act nearly seven decades ago [and included a provision that makes the statute’s purposes clear.] Section 45 provides: The intent of this chapter is to regulate commerce within the control of Congress by making actionable the deceptive and misleading use of marks in such commerce; to protect registered marks used in such commerce from interference by State, or territorial legislation; to protect persons engaged in such commerce against unfair competition; [and] to prevent fraud and deception in such commerce by the use of reproductions, copies, counterfeits, or colorable imitations of registered marks. . . . The Lanham Act’s trademark provisions are the primary means of achieving these ends. But the Act also creates a federal remedy that goes beyond trademark protection. The broader remedy is at issue here. [Section 43(a) of the] Lanham Act creates a cause of action for unfair competition through misleading advertising or labeling. Though in the end consumers also benefit from the Act’s proper enforcement, the cause of action is for competitors, not consumers. The petitioner here (POM) asserts injury as a competitor. The cause of action [created in § 43(a)] imposes civil liability on any person who “uses in commerce any word, term, name, symbol, or device, or any combination thereof, or any false designation of origin, false or misleading description of fact, or false or misleading representation of fact, which . . . in commercial advertising or promotion, misrepresents the nature, characteristics, qualities, or geographic origin of his or her or another person’s goods, services, or commercial activities.” The private remedy may be invoked only by those who “allege an injury to a commercial interest in reputation or sales. A consumer who is hoodwinked into purchasing a disappointing product may well have an injury-in-fact cognizable [on other legal grounds], but he cannot invoke the protection of the Lanham Act.” Lexmark International v. Static Control Components, 134 S. Ct. 1377 (2014). POM’s cause of action [under § 43(a)] would be straightforward enough but for  Coca-Cola’s contention that a separate federal statutory regime, the FDCA, allows it to use the label in question and in fact precludes the Lanham Act claim. So the FDCA is the second statute to be discussed. The FDCA statutory regime is designed primarily to protect the health and safety of the public at large. The FDCA prohibits the

misbranding of food and drink. 21 U.S.C. §§ 321(f), 331. A food or drink is deemed misbranded if, inter alia, “its labeling is false or misleading,”  § 343(a), information required to appear on its label “is not prominently placed thereon,”  § 343(f), or the label does not bear “the common or usual name of the food, if any there be.”  § 343(i). To implement these provisions, the Food and Drug Administration (FDA) promulgated regulations regarding food and beverage labeling, including the labeling of mixes of different types of juice into one juice blend. See 21 CFR § 102.33 (2013). One provision of those regulations is particularly relevant to this case: If a juice blend does not name all the juices it contains and mentions only juices that are not predominant in the blend, then it must either declare the percentage content of the named juice or “[i]ndicate that the named juice is present as a flavor or flavoring,” e.g., “raspberry and cranberry flavored juice drink.” § 102.33(d). The Government represents that the FDA does not preapprove juice labels under these regulations. That contrasts with the FDA’s regulation of other types of labels, such as drug labels, and is consistent with the less extensive role the FDA plays in the regulation of food than in the regulation of drugs. Unlike the Lanham Act, which relies in substantial part for its enforcement on private suits brought by injured competitors,  the FDCA and its regulations provide the United States with nearly exclusive enforcement authority, including the authority to seek criminal sanctions in some circumstances. 21 U.S.C. §§ 333(a), 337. Private parties may not bring enforcement suits.  § 337. Also unlike the Lanham Act, the FDCA contains a provision pre-empting certain state laws on misbranding. That provision forecloses a “State or political subdivision of a State” from establishing requirements that are of the type but “not identical to” the requirements in some of the misbranding provisions of the FDCA. 21 U.S.C. § 343-1(a). It does not address, or refer to, other federal statutes or the preclusion thereof. [In the case before us, the district court] granted summary judgment to Coca-Cola on POM’s Lanham Act claim, ruling that the FDCA and its regulations preclude challenges to  the name and label of Coca-Cola’s juice blend. The district court reasoned that in the juice blend regulations, the “FDA has directly spoken on the issues that form the basis of POM’s Lanham Act claim against the naming and labeling” of Coca-Cola’s product, but has not prohibited any, and indeed expressly has permitted some, aspects of Coca-Cola’s label. The Court of Appeals for the Ninth Circuit affirmed, [reasoning] that Congress decided “to entrust matters of juice beverage labeling to the FDA”; [that] the FDA



Chapter Eight Intellectual Property and Unfair Competition

has promulgated “comprehensive regulation of that labeling”; and [that] the FDA “apparently” has not imposed the requirements on Coca-Cola’s label that are sought by POM. [The Ninth Circuit further noted that] “for a court to act when the FDA has not— despite regulating extensively in this area—would risk undercutting the  FDA’s expert judgments and authority.” For these reasons, and “[o]ut of respect for the statutory and regulatory scheme,” the Court of Appeals barred POM’s Lanham Act claim. This Court granted certiorari to consider whether a private party may bring a Lanham Act claim challenging a food label that is regulated by the FDCA.  The answer to that question is based on the following premises. First, this is not a pre-emption case. In pre-emption cases, the question is whether state law is pre-empted by a federal statute, or in some instances, a federal agency action. This case, however, concerns the alleged preclusion of a cause of action under one federal statute by the provisions of another federal statute. So the state-federal balance does not frame the inquiry. Second, this is a statutory interpretation case and the Court relies on traditional rules of statutory interpretation. That does not change because the case involves multiple federal statutes. Nor does it change because an agency is involved. Analysis of the statutory text, aided by established principles of interpretation, controls. Beginning with the text of the two statutes, it must be observed that  neither the Lanham Act nor the FDCA, in express terms, forbids or limits Lanham Act claims challenging labels that are regulated by the FDCA. By its terms, § 43(a) of the Lanham Act subjects to suit any person who “misrepresents the nature, characteristics, qualities, or geographic origin” of goods or services. This comprehensive imposition of liability extends, by its own terms, to misrepresentations on labels, including food and beverage labels. No other provision in the Lanham Act limits that understanding or purports to govern the relevant interaction between the Lanham Act and the FDCA. And the FDCA, by its terms, does not preclude Lanham Act suits. In consequence, food and beverage labels regulated by the FDCA are not, under the terms of either statute, off limits to Lanham Act claims [such as POM’s]. This absence is of special significance because the Lanham Act and the FDCA have coexisted since the passage of the Lanham Act in 1946. If Congress had concluded, in light of experience, that Lanham Act suits could interfere with the FDCA, it might well have enacted a provision addressing the issue during these 70 years. Congress enacted amendments to the FDCA and the Lanham Act, including an amendment that added to the FDCA an express pre-emption provision with respect to state laws addressing food and beverage misbranding. Yet Congress did not enact a provision addressing the preclusion of other federal laws that might bear on food and beverage labeling. This is powerful evidence that Congress did not intend FDA oversight to be the exclusive means of ensuring proper food and beverage labeling.

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Perhaps the closest the statutes come to addressing the preclusion of the Lanham Act claim at issue here is the pre-emption provision added to the FDCA in 1990. But, far from expressly precluding suits arising under other federal laws, the provision if anything suggests that Lanham Act suits are not precluded. This pre-emption provision forbids a “State or political subdivision of a State” from imposing requirements that are of the type but “not identical to” corresponding FDCA requirements for food and beverage labeling. It is significant that . . . the provision does not refer to requirements imposed by other sources of law, such as federal statutes. Pre-emption of some state requirements does not suggest an intent to preclude federal claims. The structures of the FDCA and the Lanham Act reinforce the conclusion drawn from the text.  When two statutes complement each other, it would show disregard for the congressional design to hold that Congress nonetheless intended one federal statute to preclude the operation of the other. The Lanham Act and the FDCA complement each other in major respects, for each has its own scope and purpose. Although both statutes touch on food and beverage labeling, the Lanham Act protects commercial interests against unfair competition, while the FDCA protects public health and safety. The two statutes complement each other with respect to remedies in a more fundamental respect. Enforcement of the FDCA and the detailed prescriptions of its implementing regulations is largely committed to the FDA. The FDA, however, does not have the same perspective or expertise in assessing market dynamics that day-to-day competitors possess. Competitors who manufacture or distribute products have detailed knowledge regarding how consumers rely upon certain sales and marketing strategies. Their awareness of unfair competition practices may be far more immediate and accurate than that of agency rulemakers and regulators. Lanham Act suits draw upon this market expertise by empowering private parties to sue competitors to protect their interests on a case-by-case basis. Allowing Lanham Act suits takes advantage of synergies among multiple methods of regulation. This is quite consistent with the congressional design to enact two different statutes, each with its own mechanisms to enhance the protection of competitors and consumers. A holding that the FDCA precludes Lanham Act claims challenging food and beverage labels would not only ignore the distinct functional aspects of the FDCA and the Lanham Act but also would lead to a result that Congress likely did not intend. Unlike other types of labels regulated by the FDA, such as drug labels, it would appear the FDA does not preapprove food and beverage labels under its regulations and instead relies on enforcement actions, warning letters, and other measures. Because the FDA acknowledges that it does not necessarily pursue enforcement measures regarding all objectionable labels,  if Lanham Act claims were to be precluded then commercial interests—and

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Part Two Crimes and Torts

indirectly the public—could be left with less effective protection in the food and beverage labeling realm than in other, less regulated industries. It is unlikely that Congress intended the FDCA’s protection of health and safety to result in less policing of misleading food and beverage labels than in competitive markets for other products. The [lower courts’] ruling that POM’s Lanham Act cause of action is precluded by the FDCA was incorrect. There is no statutory text or established interpretive principle to support the contention that the FDCA precludes Lanham Act suits like the one brought

by POM in this case. Nothing in the text, history, or structure of the FDCA or the Lanham Act shows the congressional purpose or design to forbid these suits. Quite to the contrary, the FDCA and the Lanham Act complement each other in the federal regulation of misleading food and beverage labels. Competitors, in their own interest, may bring Lanham Act claims like POM’s that challenge food and beverage labels that are regulated by the FDCA.

Problems and Problem Cases

dangling prominently over images of confections—a large chocolate fudge brownie topped with ice cream, a tray of donuts, and a tray of apple danish pastries—with a grassy field and Niagara Falls in the background. The images of the legs were placed side by side, each pair pointing vertically downward. Koons drew the images in Niagara from fashion magazines and advertisements. One of the pairs of legs in the painting was adapted from a copyrighted photograph taken by Andrea Blanch, an accomplished professional fashion and portrait photographer. The Blanch photograph used by Koons in Niagara was titled Silk Sandals. It appeared in the August 2000 issue of Allure magazine. While working on Niagara and other paintings, Koons saw Silk Sandals in Allure. In an affidavit submitted in the litigation referred to below, Koons stated that “certain physical features of the legs [in the photograph] represented for me a particular type of woman frequently presented in advertising.” He considered this typicality to further his purpose of commenting on the “commercial images . . . in our consumer culture.” Koons scanned the image of Silk Sandals into his computer and incorporated a version of the scanned image into Niagara. He omitted certain aspects of the scanned image from his painting and modified certain other aspects of the image, such as by making the woman’s legs angle downward rather than upward (the opposite of how they had appeared in Blanch’s photograph). Koons did not seek permission from Blanch before using her photograph. He later earned approximately $125,000 from financial exploitation of Niagara. When Blanch sued Koons for copyright infringement, what defense would Koons have attempted to establish? Did Koons succeed with that defense? 3. Monsanto Co. invented a genetic modification that enables soybean plants to survive exposure to glyphosate,

1. In car engines without computer-controlled throttles, the accelerator pedal interacts with the throttle via a cable or other mechanical link. The traditional mechanical design of an accelerator pedal permitted the pedal to be pushed down or released, but the position in the footwell area of the car could not be adjusted by sliding the pedal forward or back. As a result, a driver who wished to be closer to or farther from the pedal had to reposition himself in the driver’s seat or move the seat in some way. These were imperfect solutions for drivers of smaller stature who had cars with deep footwells. Inventors therefore designed pedals that could be adjusted to change their location in the footwell. Patents were issued for some of these inventions, which relied on a mechanical link. Steven Engelgau later invented an adjustable pedal with an electronic sensor mounted on a fixed pivot point. He received a patent on his invention. Engelgau’s invention was the first adjustable pedal to employ an electronic sensor on a fixed pivot point. Of course, electronic sensors and computerized systems are used in various ways elsewhere in vehicles. Engelgau granted Teleflex Inc. an exclusive license to exercise his rights under the patent. Later, when Teleflex sued another party for alleged infringement of the patent, the defendant argued that the patent was invalid—and therefore should not have been issued—because Engelgau’s invention was obvious. Was the defendant correct in this argument? Was Engelgau’s invention obvious even though no other inventor in the field had utilized an electronic sensor mounted on a fixed pivot point? 2. Visual artist Jeff Koons created a painting called Niagara. The painting consisted of fragmentary images collaged against the backdrop of a landscape. It depicted four pairs of women’s feet and lower legs

Ninth Circuit’s judgment reversed; case remanded for further proceedings.



Chapter Eight Intellectual Property and Unfair Competition

the active ingredient in many herbicides (including Monsanto’s own Roundup product). Monsanto markets soybean seed containing this altered genetic material as Roundup Ready seed. Farmers planting that seed can use a glyphosate-based herbicide to kill weeds without damaging their crops. Two patents issued to Monsanto cover various aspects of its Roundup Ready technology, including a seed incorporating the genetic alteration. Monsanto sells, and allows other companies to sell, Roundup Ready soybean seeds to growers who assent to a special licensing agreement. That agreement permits a grower to plant the purchased seeds in one—and only one—season. The grower can then consume the resulting crop or sell it as a commodity, usually to a grain elevator or agricultural processor. Under the agreement, the farmer may not save any of the harvested soybeans for replanting, nor may he supply them to anyone else for that purpose. These restrictions reflect the ease of producing new generations of Roundup Ready seed. Because glyphosate resistance comes from the seed’s genetic material, that trait is passed on from the planted seed to the harvested soybeans. A single Roundup Ready seed can grow a plant containing dozens of genetically identical beans, each of which, if replanted, can grow another such plant—and so on. The agreement’s terms thus prevent the farmer from producing his own Roundup Ready seeds from season to season, forcing him instead to buy from Monsanto each season.  Vernon Bowman is an Indiana farmer. Each year, he purchased Roundup Ready seed from a company affiliated with Monsanto for his first crop of the season. In accordance with the agreement just described, he used all of that seed for planting and sold his entire crop to a grain elevator (which typically would resell it to an agricultural processor for human or animal consumption). For his second crop of each season, Bowman devised a different approach. Because he thought such late-season planting risky and because Monsanto charges a premium price for Roundup Ready seed, he went to a grain elevator, purchased commodity soybeans intended for human or animal consumption, and planted them in his fields. Those soybeans came from prior harvests of other local farmers. Because most of those farmers also used Roundup Ready seed, Bowman could anticipate that many of the soybeans he purchased from the grain elevator would contain Monsanto’s patented technology. After he applied a glyphosate-based herbicide to his fields, a significant proportion of the new plants survived the treatment and produced a new crop of soybeans with the Roundup Ready trait. Bowman saved seed from that crop to use in his late-season planting the next year. He continued this pattern for

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the next several years—­planting saved seed from the year before, spraying his fields with glyphosate to kill weeds, and yielding a new crop of glyphosate-resistant—that is, Roundup Ready—soybeans.  After discovering this practice, Monsanto sued Bowman for infringing its patents on Roundup Ready seed. Bowman raised patent exhaustion as a defense, arguing that Monsanto could not control his use of the soybeans because they were the subject of a prior authorized sale (from local farmers to the grain elevator). The federal district court rejected Bowman’s argument and awarded damages of $84,456 to Monsanto. The U.S. Court of Appeals for the Federal Circuit affirmed. The U.S. Supreme Court agreed to decide the case. How did the Supreme Court rule? Did the patent exhaustion defense apply here to protect Bowman against liability? 4. Qualitex Co. produces pads that dry-cleaning firms use on their presses. Since the 1950s, Qualitex has colored its press pads a shade of green-gold. In 1989, Jabcobson Products Co. began producing press pads for sale to drycleaning firms. Jacobson colored its pads a green-gold resembling the shade used by Qualitex. Later in 1989, the U.S. Patent and Trademark Office granted Qualitex a trademark registration for the green-gold color (as used on press pads). Qualitex then added a trademark infringement claim to an unfair competition lawsuit it had previously filed against Jacobson. Qualitex won the case, but the Ninth Circuit Court of Appeals set aside the judgment on the trademark infringement claim. In the Ninth Circuit’s view, the Lanham Act did not allow any party to have color alone registered as a trademark. The Supreme Court granted certiorari. How did the Supreme Court rule on the question whether color is a registrable trademark? 5. Starbucks Corp., a company primarily engaged in the sale of coffee products, was founded in Seattle in 1971. Starbucks has grown to more than 8,700 retail locations in the United States, Canada, and foreign countries and territories. In addition to operating its retail stores, Starbucks supplies its coffees to hundreds of restaurants, supermarkets, airlines, sport and entertainment venues, motion picture theaters, hotels, and cruise ship lines. Starbucks prominently displays its federally registered “Starbucks” marks (the “Starbucks Marks”) in all of its commercial activities and spends large sums of money on advertising and promotional activities that feature the Starbucks Marks. Those marks include the “Starbucks” name and the company’s logo, which is circular and contains a graphic mermaid-like siren and the phrase

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Part Two Crimes and Torts

“Starbucks Coffee.” Starbucks has approximately 60 U.S. trademark registrations and trademark registrations in 130 countries. The company devotes substantial effort to policing the marketplace for possible violations of its trademark rights.  Wolfe’s Borough Coffee Inc., which does business under the Black Bear name (and which will be referred to here by that name), also sells coffee products. Black Bear, whose principal place of business is New Hampshire, is a small, family-run business that produces and sells roasted coffee beans and related goods via mail order and Internet order as well as at a limited number of New England supermarkets. In addition, Black Bear sold coffee products from a single retail outlet. In April 1997, Black Bear began selling a “dark roasted blend” of coffee called “Charbucks Blend” and later “Mister Charbucks” (together, the “Charbucks Marks”). Charbucks Blend was sold in a packaging that showed a picture of a black bear above the following large-print words: “BLACK BEAR MICRO ROASTERY.” The package informed consumers that the coffee was roasted and “Air Quenched” in New Hampshire and stated, in a fairly large font, that “You wanted it dark . . . You’ve got it dark!” Mister Charbucks was sold in a packaging that showed a picture of a man walking above the large font “Mister Charbucks.” The package also informed consumers that the coffee was roasted in New Hampshire by “The Black Bear Micro Roastery” and that the coffee was “ROASTED TO THE EXTREME . . . FOR THOSE WHO LIKE THE EXTREME.”  Not long after Black Bear made its first sale of Charbucks Blend, Starbucks demanded that Black Bear cease use of the Charbucks Marks. When Black Bear did not comply with this demand, Starbucks sued Black Bear in a federal district court. Starbucks alleged that Black Bear should be held liable for trademark infringement and trademark dilution under federal law. Did Black Bear commit trademark infringement? What about trademark dilution? 6. North Atlantic Instruments Inc. manufactured electronic equipment used on ships, tanks, and aircraft. In August 1994, North Atlantic acquired Transmagnetics Inc. (TMI), which designed, manufactured, and sold customized electronic devices to a limited number of engineers in the aerospace and high-tech industries. At the time North Atlantic acquired TMI, Fred Haber was a one-third owner of TMI, as well as its president and head of sales. This position allowed Haber to develop extensive client contacts. North Atlantic conditioned its agreement to acquire TMI on Haber’s continuing to work for North Atlantic in a role similar to the role he had played at TMI.

   The specialized nature of TMI’s business made the identity of the relatively small number of engineers who required its products especially crucial to its business success. Even in companies employing thousands of engineers, a very small number of those engineers—sometimes only two—might need the technology produced by TMI. The identity and needs of that small number of engineers (i.e., TMI’s client contacts) would have been very difficult for any company to derive on its own. TMI’s list of client contacts was among the intangible assets for which North Atlantic paid when it acquired TMI. North Atlantic retained Haber as president of its new TMI division. An employment agreement between North Atlantic and Haber ran until July 31, 1997. Its terms obligated Haber not to disclose North Atlantic’s customer lists, trade secrets, or other confidential information, either during his employment by North Atlantic or after that employment ceased. As president of the TMI division, Haber had access through desktop and laptop computers to information about North Atlantic’s technology and customer bases, including lists of clients and information about their individual product needs and purchases.  In July 1997, Haber left North Atlantic to join Apex Signal Corp., which manufactured products targeted toward the same niche market as North Atlantic’s TMI division. According to North Atlantic, Apex began targeting North Atlantic’s customer base, with Haber allegedly asking clients he had dealt with at North Atlantic and TMI to do business with Apex. North Atlantic also contended that Haber had taken its confidential client information with him when he joined Apex. North Atlantic sued Haber and Apex for misappropriation of trade secrets and requested a preliminary injunction. The federal district court later preliminarily enjoined Haber and Apex from using the individual client contacts Haber had developed at North Atlantic and TMI. Haber and Apex appealed. Was the court correct in issuing the preliminary injunction? 7. Two persons who worked together to develop a business method applied for a patent. The invention for which they sought a patent explained how buyers and sellers of commodities in the energy market could protect, or hedge, against the risk of price changes. The key claims were claims 1 and 4. Claim 1 described a series of steps that amounted to instructions on how to hedge risk. Claim 4 put the concept articulated in claim 1 into a simple mathematical formula.   The remaining claims explained how claims 1 and 4 could be applied to allow energy suppliers and consumers to minimize the risks resulting from



Chapter Eight Intellectual Property and Unfair Competition

fluctuations in market demand for energy. Some of those claims also suggested familiar statistical approaches to determine the inputs to use in claim 4’s equation. Are business methods potentially patentable? Should a patent be awarded for this particular claimed invention? 8. Louis Vuitton Malletier (Vuitton) is a well-known manufacturer of luxury luggage, leather goods, handbags, and accessories. Vuitton has a number of trademarks that it regularly uses in connection with its products. Among them are the LOUIS VUITTON name and the LV mark. The company’s products are expensively priced and sold in department stores and boutique stores. Vuitton filed a trademark infringement and trademark dilution lawsuit against Haute Diggity Dog LLC, a firm that produced and sold, primarily through pet stores, inexpensive dog chew toys under the Chewy Vuitton brand name and various other brand names consisting of humorous versions of other companies’ actual trademarks. The dog chew toys had the Chewy Vuitton name on them, along with a CV mark. Should Vuitton win its trademark infringement claim? What about its trademark dilution claim? 9. Carey Station Village Inc. (referred to below as the developer) purchased real estate near a Georgia lake in 1987. The developer planned to create a large residential subdivision known as Carey Station Village. Although the developer continued to own a number of the lots in the subdivision, it relinquished control of the subdivision to Carey Station Village Homeowners Association, Inc. (referred to below as the association) in 1994. In 1999, the developer began to sell off some of the lots whose ownership it had retained. These lots had been improved with double-wide, modular homes. The developer provided owner financing for a number of the purchases. Within the first three months of advertising the lots for sale, the developer had sold more than one-half of the lots. Later, however, the developer was required to foreclose on 16 of the 21 parcels of property it had sold.  The association brought suit against the developer in 2001 to recover dues and assessments it claimed were owed by the developer in regard to the developer’s remaining lots. The developer and the association had been involved in an earlier lawsuit that resulted in a settlement in which the developer forgave a promissory note from the association, and in exchange, the association released the developer from any liability for association dues or assessments through the year 1999. The developer paid all dues and assessments owing in 2000 but did not make any payments during the subsequent years.

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   The developer filed a counterclaim asserting that the association committed the tort of interference with contractual relations. According to the developer, actions by the association caused a number of purchasers of the developer’s lots to default on their promissory notes. In addition, the developer contended that the association’s actions adversely affected the developer’s ability to sell its remaining lots at market value. The developer sought to recover damages resulting from the foreclosures referred to above, as well as damages allegedly incurred when the developer’s remaining 27 lots were sold at a price below market value.  The case was tried to a jury in a Georgia court. The trial judge denied the association’s motion for a directed verdict on the developer’s interference with contractual relations counterclaim. The jury found in favor of the association on its claim for unpaid dues and assessments and awarded it $40,527.09. The jury also found in favor of the developer on its counterclaim and awarded it $211,250. The trial judge entered a judgment in favor of the developer in the amount of $170,722.91, the net amount once the damages awarded to the association were offset against the greater amount of damages awarded to the developer. The association appealed. Should the association have been held liable on the developer’s counterclaim? 10. Google Inc. operates a search engine that accesses many thousands of websites and indexes them in a database stored on Google’s computers. Google generates revenue through an advertising program associated with its search engine. The search results that Google provides through its Google Image Search are provided in the form of small images called “thumbnails.” The thumbnails are stored on Google’s servers. Perfect 10 Inc., which markets and sells copyrighted images of nude models, operates a subscription website. For a fee, Perfect 10 subscribers can access a password-protected section of Perfect’s 10 website. There, these subscribers have access to the photos Perfect 10 makes available. Perfect 10 has also done a limited amount of licensing of reduced-sized images of its copyrighted images for downloading and use on cell phones. Some of Perfect 10’s copyrighted images ended up appearing in thumbnail-sized form in Google search results (probably because the Perfect 10 photos had been posted by others without Perfect 10’s permission on websites that the Google search engine then picked up). Because Perfect 10 did not consent to Google’s display of the thumbnail images, Perfect 10 sued Google for copyright infringement. What defense

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should Google attempt to invoke? Should Google succeed with that defense? 11. In the late 1980s, SEB S.A., a French firm, invented a “cool-touch” deep fryer—a home-use appliance with external surfaces that remain cool during the frying process. SEB obtained a U.S. patent for its design in 1991. SEB later began manufacturing the cool-touch fryer and selling it in the United States. Presumably because it was superior to other products in the American market at the time, SEB’s fryer was a commercial success.  In 1997, Sunbeam Products Inc., a competitor of SEB, asked Pentalpha Enterprises Ltd. to supply it with deep fryers meeting certain specifications. Pentalpha, a Hong Kong maker of home appliances, is a wholly owned subsidiary of Global-Tech Appliances Inc. In order to develop a deep fryer for Sunbeam, Pentalpha purchased an SEB fryer in Hong Kong and copied all but its cosmetic features. Because the SEB fryer bought in Hong Kong was made for sale in a foreign market, it bore no U.S. patent markings. After copying SEB’s design, Pentalpha retained an attorney to conduct a right-to-use study. However, Pentalpha did not tell the attorney that its design was copied directly from SEB’s.  The attorney failed to locate SEB’s patent. In August 1997, he issued an opinion letter stating that Pentalpha’s deep fryer did not infringe any of the patents he had found. Pentalpha then started selling its deep fryers to Sunbeam, which resold them in the United States under its trademarks. By obtaining its product from a manufacturer with lower production costs, Sunbeam was able to undercut SEB in the U.S. market. After SEB’s customers started defecting to Sunbeam, SEB sued Sunbeam for patent infringement in March 1998. Sunbeam notified Pentalpha of the lawsuit the following month. Nevertheless, Pentalpha went on to sell deep fryers to Fingerhut Corp. and Montgomery Ward & Co., both of which resold them in the United States under their respective trademarks.  SEB settled the lawsuit with Sunbeam and then sued Pentalpha and Global-Tech on the theory that they had violated the Patent Act by actively inducing Sunbeam, Fingerhut, and Montgomery Ward to sell or to offer to sell the defendants’ deep fryers in violation of SEB’s patent rights. Are the defendants liable for inducing patent infringement? For purposes of that possible basis of liability, does it matter whether the defendants knew of SEB’s patent?

12. Aereo Inc. sells a service that allows its paying subscribers to watch television programs over the Internet at about the same time as the programs are broadcast over the air. Most of these programs are copyrighted works. Aereo neither owns the copyrights in those works nor holds a relevant license from the copyright owners.  When an Aereo subscriber wants to watch a show that is currently airing, he selects the show from a menu on Aereo’s website. Aereo’s system, which consists of thousands of dime-sized antennas and other equipment housed in a centralized warehouse, responds roughly as follows: A server tunes an antenna to the broadcast carrying the selected show. Each antenna is dedicated to the use of a single subscriber. A transcoder translates the signals received by the antenna into data that can be transmitted over the Internet. A server saves the data in a subscriber-specific folder on Aereo’s hard drive and, once several seconds of programming have been saved, begins streaming the show to the subscriber’s screen (personal computer, tablet, smartphone, Internet-connected television, or other Internet-connected device). The streaming continues, a few seconds behind the over-the-air broadcast, until the subscriber has received the entire show. The data that Aereo’s system streams to each subscriber are the data from that subscriber’s own personal copy, made from the broadcast signals received by the particular antenna allotted to him. Aereo’s system does not transmit data saved in one subscriber’s folder to any other subscriber. When two subscribers wish to watch the same program, Aereo’s system activates two separate antennas and saves two separate copies of the program in two separate folders. It then streams the show to the subscribers through two separate transmissions—each from the subscriber’s personal copy.  Various television producers, marketers, distributors, and broadcasters that own the copyrights in programs that Aereo streams sued Aereo for copyright infringement. They sought a preliminary injunction, arguing that Aereo was infringing their right to perform their copyrighted works publicly. A federal district court denied the preliminary injunction, and the U.S. Court of Appeals for the Second Circuit affirmed. The U.S. Supreme Court granted the copyright owners’ petition for a writ of certiorari. How did the Supreme Court rule? Did Aereo’s actions amount to performances of the copyrighted works?

ee Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Th t Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part One Part Th t Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three P ee Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Th t Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Th t Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Th t Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three Part Three P

Part Three

Chapter 9

Introduction to Contracts

Contracts

Chapter 10

The Agreement: Offer

Chapter 11

The Agreement: Acceptance

Chapter 12

Consideration

Chapter 13

Reality of Consent

Chapter 14

Capacity to Contract

Chapter 15

Illegality

Chapter 16

Writing

Chapter 17

Rights of Third Parties

Chapter 18

Performance and Remedies

Pixtal/AGE Fotostock

CHAPTER 9

Introduction to Contracts

T

he 2019 catalog that Gigantic State University (GSU) sent to prospective students described a merit-based scholarship called the “Eagle Scholarship.” The catalog stated that GSU offers the Eagle Scholarship to all incoming students who are in the top 10 percent of their high school classes and have SAT scores of 1350 or above. Paul, a prospective student, read the 2019 catalog that GSU sent to him. Money was tight for Paul, so he paid particular attention to the part of the catalog that described financial aid. He read about the Eagle Scholarship and realized that he qualified for it. Paul picked GSU over other schools in large part because of the Eagle Scholarship. He applied to GSU and GSU admitted him. Before his freshman orientation, Paul called GSU and checked to be sure that he met the requirements of the Eagle Scholarship. A GSU representative informed him that he did. When Paul arrived at GSU for freshman orientation, however, he received a copy of the 2020 catalog and learned that the qualifications for the Eagle Scholarship had changed and that he no longer qualified. • Was there a contract between GSU and Paul for the Eagle Scholarship? • If so, what kind of contract was it? • What body of legal rules would apply to the contract? • If it wasn’t a contract, is there any other basis for a legal obligation on the part of GSU? • Would it be ethical for GSU not to honor its promise to Paul?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 9-1 Explain what a contract is and why contracts are useful. 9-2 Define the terms used to describe contracts and apply those terms to actual contracts. 9-3 Distinguish the applicability of the common law of contracts and Article 2 of the Uniform

The Nature of Contracts LO9-1 Explain what a contract is and why contracts are useful.

The law of contracts deals with the enforcement of promises. It is important to realize from the outset of your study of contracts that not every promise is legally enforceable.

Commercial Code and identify which one governs a given contract. 9-4 Identify the circumstances under which quasicontract or promissory estoppel can afford a remedy even though no contract exists.

(If every promise were enforceable, this chapter could end here!) We have all made and broken promises without fear of being sued. If you promise to take a friend out to dinner and then fail to do so, you would be shocked to be sued for breach of contract. What separates such promises from legally enforceable contracts? The law of contracts sorts out what promises are enforceable, to what extent, and how they will be enforced.

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Part Three Contracts

A contract is a legally enforceable promise or set of promises. In other words, when promises have the status of contract, the contracting party harmed by a breach of the contract is entitled to obtain legal remedies against the breaching party.

The Functions of Contracts Contracts

give us the ability to enter into agreements with others with confidence that we may call on the law—not merely the good faith of the other party—to make sure that those agreements will be honored. Within limitations that you will study later, contracting lets us create a type of private law—the terms of the agreements we make—that governs our dealings with others. Contracts facilitate the planning that is necessary in a modern, industrialized society. Who would invest in a business if she could not rely on the fact that the builders and suppliers of the facilities and equipment, the suppliers of the raw materials necessary to manufacture products, and the customers who agree to purchase those products would all honor their commitments? How could we make loans, sell goods on credit, or rent property unless loan agreements, conditional sales agreements, and leases were backed by the force of the law? Contract, then, is necessary to the world as we know it. Like that world, its particulars tend to change over time, while its general characteristics remain largely stable.

The Evolution of Contract Law The idea of

contract is ancient. Thousands of years ago, Egyptians and Mesopotamians recognized devices resembling contracts; by the 15th century, the common law courts of England had developed a variety of theories to justify enforcing certain promises. Contract law did not, however, assume major importance in our legal system until the 19th century, when the Industrial Revolution created the necessity for greater private planning and certainty in commercial transactions. The central principle of contract law that emerged from this period was freedom of contract. Freedom of contract is the idea that contracts should be enforced because they are the products of the free wills of their creators, who should, within broad limits, be free to determine the extent of their obligations. The proper role of the courts in such a system of contract was to enforce these freely made bargains but otherwise to adopt a hands-off stance. The freedom to make good deals carried with it the risk of making bad deals. As long as a person voluntarily entered a contract, it would generally be enforced against him, even if the result was grossly unfair. And because equal bargaining power tended to be assumed, the courts were usually unwilling to hear defenses based on unequal bargaining power. This judicial

posture allowed the courts to create a pure contract law consisting of precise, clear, and technical rules that were capable of general, almost mechanical, application. Such a law of contract met the needs of the marketplace by affording the predictable and consistent results necessary to facilitate private planning. The emergence of large business organizations after the Civil War produced obvious disparities of bargaining power in many contract situations, however. These large organizations found it more efficient to standardize their numerous transactions by employing standard form contracts, which also could be used to exploit their greater bargaining power by dictating the terms of their agreements. Contract law evolved to reflect these changes in social reality. During the 20th century, there was a dramatic increase in government regulation of private contractual relationships. Think of all the statutes governing the terms of what were once purely private contractual relationships. Legislatures commonly dictate many of the basic terms of insurance contracts. Employment contracts are governed by a host of laws concerning maximum hours worked, minimum wages paid, employer liability for on-the-job injuries, unemployment compensation, and retirement benefits. The purpose of much of this regulation has been to protect persons who lack sufficient bargaining power to protect themselves. Courts also became increasingly concerned with creating contract rules that produce fair results. The precise, technical rules that characterized traditional common law gave way to permit some broader, imprecise standards such as good faith, injustice, reasonableness, and unconscionability. Despite the increased attention to fairness in contract law, the agreement between the parties is still the heart of every contract.

The Methods of Contracting Many students

reading about contract law for the first time may have the idea that contracts must be in writing to be enforceable. Generally speaking, that is not true. There are some situations in which the law requires certain kinds of contracts to be evidenced by a writing to be enforced. The most common examples of those situations are covered in Chapter 16. Unless the law specifically requires a certain kind of contract to be in writing, an oral contract that can be proven is as legally enforceable as a written one. (Of course, having a written contract may often be desirable even when a writing is not mandatory.) Contracts can be and are made in many ways. When most of us imagine a contract, we envision two parties bargaining for a deal, drafting a contract on paper, and signing it or shaking hands. Some contracts are negotiated and formed in that way. Far more common today, both online



Chapter Nine Introduction to Contracts

and offline, is the use of standardized form contracts. Such contracts are preprinted by one party and presented to the other party for signing. In most situations, the party who drafts and presents the standardized contract is the one with greater bargaining power and/or sophistication in the transaction. Frequently, the terms of standardized contracts are nonnegotiable. Such contracts have the advantage of providing an efficient method of standardizing common transactions. On the other hand, they present the dangers that the party who signs the contract will not know what he is agreeing to and that the party who drafts and presents the contract will take advantage of her bargaining power to include terms that are oppressive or abnormal in that kind of transaction.

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Basic Elements of a Contract LO9-1 Explain what a contract is and why contracts are useful.

Over the years, the law has developed a number of requirements that a set of promises must meet before they are treated as a contract. To qualify as a contract, a set of promises must be based on a voluntary agreement, which is made up of an offer and an acceptance of that offer. In addition, there usually must be consideration to support each party’s promise. The contract must be between parties who have capacity to contract, and the objective and performance of the contract must be legal. (See Figure 9.1.) Each of the

Figure 9.1 Getting to Contract Negotiation

Agreement? (offer and acceptance)

No

Yes

Voluntary?

No

Yes

Consideration?

No

Yes

Capacity?

No

Yes

Legality?

Yes Writing required?

Contract!

No

No contract!

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elements of a contract will be discussed individually in subsequent chapters. The elements of a contract can be found in all kinds of settings, from commercial dealings between strangers to agreements between family members to repeated interactions

between businesses. In determining whether a contract exists, courts scrutinize the parties’ communications and conduct in light of the context in which the parties interacted and their prior dealings. This process is illustrated by Trapani Construction Co. v. Elliot Group, Inc., which follows.

Trapani Construction Co. v. Elliot Group, Inc.   64 N.E.3d 132 (Ill. App. Ct. 2016) Trapani Construction Co. is a general contractor that had worked with the Elliot Group on a number of occasions. Over the years, Trapani had done more than $18 million in business with Elliot. Typically, Trapani would provide Elliot with a “contract” document, which called for signature but was never signed. In July 2007, Trapani and Elliot were engaged in planning for a project known as the “Arlington Market Site Work.” It included the project at issue in this case as well as a separate building project on the same site. Consistent with their past practices, Trapani sent Elliot a draft contract document describing the services it would perform on the Arlington Market Site. It listed Elliot as the project owner. Through the first couple of weeks of July 2007, the parties engaged in a backand-forth discussion about the terms of the project, both in person and by written correspondence. During that process, Trapani actually began work on the project and requested the first payment from Elliot. Although Elliot never signed the draft contract document, it made payments to Trapani in the amount of $2,042,846.50. Those payments were made in response to requests prepared by a Trapani employee. The president of Elliot would “meticulously review” the requests and often require changes to them before paying. In addition, Trapani hired subcontractors for work on the project, obtained insurance (which named Elliot as an additional insured party), and sent to Elliot 16 change orders for the work. Elliot was aware of each. Upon completing the project, Trapani claimed that Elliot still owed Trapani a balance of $257,764.70. Elliot refused to pay it. Trapani sued Elliot claiming, among other things, a breach of contract. The trial court found in favor of Trapani. Elliot appealed, claiming that it never accepted Trapani’s offer to provide construction services and that the unsigned draft contract document required signature to be enforceable. Reyes, Justice Defendant asserts there was no contract implied in fact between plaintiff and defendant because (1) defendant never accepted plaintiff’s offer, (2) no consideration was provided to defendant, and (3) there was no meeting of the minds or mutual assent. Even in the absence of an express contract, an implied contract can be created as a result of the parties’ actions. In Illinois, two types of implied contracts are recognized, those implied in fact and those implied in law. Contracts implied in law are “equitable in nature, predicated on the fundamental principle that no one should unjustly enrich himself at another’s expense.” In re Estate of Milborn, 461 N.E.2d 1075 (Ill. App. Ct. 1984). Contracts implied in fact, as aforementioned, arise from a promissory expression that may be inferred from the facts and circumstances that demonstrate the parties’ intent to be bound. Thus, “[t]he only difference between an express contract and an implied contract in the proper sense is, that in the former the parties arrive at an agreement by words, either verbal or written, while in the latter the agreement is arrived at by a consideration of their acts and conduct.” Litow v. Aurora Beacon News, 209 N.E.2d 668 (Ill. App. Ct. 1965). A contract implied in fact, which applies here, is a true contract. The elements of a contract are an offer, acceptance, and

consideration. Thus, a contract implied in fact contains all of the elements of a contract, including a meeting of the minds. Generally, for a contract to be valid, an acceptance must be objectively manifested; if it is not, there is no meeting of the minds. Acceptance of a contract implied in fact, however, can be proven by circumstances demonstrating that the parties intended to contract and by the general course of dealing between the parties. Similarly, mutual intent to contract can be established by the ordinary course of dealing and the common understanding of persons. Based on our review of the record, we conclude the trial court’s finding that a contract implied in fact existed between the parties was not against the manifest weight of the evidence for the following reasons. In the instant case, plaintiff was paid in excess of $18 million by defendant for its work on other construction projects that was performed under similar circumstances, i.e., under unsigned draft contracts. Plaintiff was also paid in full by defendant for its work on another building that was part of this particular project, also under an unsigned draft contract. For the work at issue, plaintiff submitted a proposal to defendant and performed pursuant to the terms and specifications in the draft contract dated July 5, 2007. To obtain payment for the work at issue, plaintiff submitted payment requests to defendant which



Chapter Nine Introduction to Contracts

defendant “meticulously review[ed]” before paying $2,041,846.50 to plaintiff in accordance with the draft contract. Further, defendant approved 16 written contract change orders that allowed plaintiff to continue to work on the project. In addition to these facts, defendant never corrected the subcontracts, certificates of insurance, change orders, weekly construction progress reports, contract activity reports, and documents for payment requests sent by plaintiff that identified defendant as the project owner. Moreover, defendant did not reject plaintiff’s work or instruct plaintiff to cease work at any time. In light of this evidence, we find the circumstances and behaviors of the parties demonstrated a general course of dealing and a mutual intent to contract. Accordingly, we find there is ample evidence to support the trial court’s ruling that a contract implied in fact existed between the parties.  *** Defendant [also] contends the draft contract dated July 5, 2007, “required acceptance by signature.” Plaintiff . . . argues

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the draft contract did not require a signature to establish defendant’s acceptance. Plaintiff also claims plaintiff’s performance pursuant to the requirements of the draft contract, the progress payments made to plaintiff, and defendant’s “conduct and silence” established that defendant had properly accepted plaintiff’s offer. . . . [T]he circumstances and behaviors of the parties demonstrated a general course of dealing and a mutual intent to contract. We thus conclude the trial court’s finding that a contract implied in fact existed between the parties was not against the manifest weight of the evidence. *** For the reasons stated above, we affirm the judgment of the circuit court of Cook County. Affirmed.

CYBERLAW IN ACTION Standardized contracts are common online as well as in the physical world. You have probably entered into online standardized contracts when you downloaded software from the Internet, joined an online service, initialized an e-mail account, or purchased goods online. The terms of standardized contracts online are sometimes presented in a manner that requires the viewer to click on an icon indicating agreement before he can proceed in the program. Standardized online contracts presented in this way are often called clickwrap contracts. Sometimes the terms of such contracts are included as a hyperlink on a page, and rather than requiring the user to click an icon, the indication of

Basic Contract Concepts and Types LO9-2

Define the terms used to describe contracts and apply those terms to actual contracts.

Bilateral and Unilateral Contracts Con-

tracts traditionally have been classified as unilateral or bilateral, depending upon whether one party has made a promise or both parties have done so. In unilateral contracts, only one party makes a promise in exchange for something specific. For example, Perks Café issues “frequent buyer” cards to its customers, and stamps the cards

agreement is purportedly the use of the product or service. These types of standardized agreements are called browse-wrap contracts. In the past, though, consumers often purchased mass-marketed software in the form of a package of CD-ROM discs, which were typically bundled in a sealed package with a notice that stated that the consumer was agreeing to the terms of a proposed standardized license agreement when he or she broke the seal on the packaging. These are called shrinkwrap contracts or shrinkwrap licenses, a name that refers to that practice of using shrinkwrapped packaging. The enforceability of clickwraps, browsewraps, and shrinkwraps, which has been a controversial topic, depends in large part on concepts addressed in Chapters 10 and 11.

each time a customer buys a cup of coffee. Perks promises to give any customer a free cup of coffee if the customer buys 10 cups of coffee and has his “frequent buyer” card stamped 10 times. In this case, Perks has made an offer for a unilateral contract, a contract that will be created with a customer only if and when the customer buys 10 cups of coffee and has his card stamped 10 times. In a bilateral contract, by contrast, both parties exchange promises and the contract is formed as soon as the promises are exchanged. For example, if Perks Café promises to pay Willowtown Mall $1,000 a month if Willowtown Mall will promise to lease a kiosk in the mall to Perks for the holiday season, Perks has made an offer for a bilateral contract because it is offering a promise in exchange for a promise. If Willowtown Mall makes the requested promise, a

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bilateral contract is formed at that point—even before the parties begin performing any of the acts that they have promised to do.

Valid, Unenforceable, Voidable, and Void Contracts A valid contract is one that meets all of the

legal requirements for a binding contract. Contracts must be valid to be enforceable in court. Some otherwise valid contracts, though, are not enforceable. An unenforceable contract is one that meets the basic legal requirements for a contract but may not be enforceable because of some other legal rule. You will learn about an example of this in Chapter 16, which discusses the statute of frauds, a rule that requires certain kinds of contracts to be evidenced by a writing. If a contract is one of those for which the statute of frauds requires a writing, but no writing is made, the contract is said to be unenforceable. Another example of an unenforceable contract is an otherwise valid contract whose enforcement is barred by the applicable contract statute of limitations. Voidable contracts are those in which harmed parties have the legal right to cancel their obligations under the contract. For example, a contract that is induced by fraud or duress is voidable (cancelable) at the election of the victimized party. Other situations in which contracts are voidable are discussed in Chapters 13 and 14. The important feature of a voidable contract is that the injured party has the right to cancel the contract if he chooses. That right belongs only to the harmed party, and if he does not cancel the contract, it can be enforced by either party. Void contracts are agreements that create no legal obligations and for which no remedy will be given. Contracts to commit crimes, such as “hit” contracts, are classic examples of void contracts. Illegal contracts are discussed in Chapter 15.

Express and Implied Contracts In

an express contract, the parties have directly stated the terms of their contract orally or in writing at the time the contract was formed. However, as you read in the Trapani Construction case earlier in this chapter, the ­mutual agreement necessary to create a contract may also be demonstrated by the conduct of the parties. When the surrounding facts and circumstances indicate that an agreement has in fact been reached, an implied contract (also called a contract implied in fact) has been created. If you are rushed to the emergency room for medical treatment following an accident, for example, you and the hospital do not ordinarily expressly state the terms of your agreement in advance, although it is clear that you do, in fact, have an agreement. A court would infer a promise by the hospital that its medical personnel will use reasonable care and skill in treating you and a return promise on your part to pay a reasonable fee for the treatment you receive. For further discussion of implied contracts, see PWS Environmental v. All Clear, which appears later in the chapter.

Executed and Executory Contracts A

contract is executed when all of the parties have fully performed their contractual duties. It is executory until such duties have been fully performed. Any contract may be described using one or more of the above terms. For example, Eurocars Inc. orders five new Mercedes-Maybach S 650 Sedans from MercedesBenz. Mercedes-Benz sends Eurocars its standard acknowledgment form accepting the order. The parties have a valid, express, bilateral contract that will be executory until Mercedes-Benz delivers the cars and Eurocars pays for them.

CYBERLAW IN ACTION Currently, many courts are using the Uniform Commercial Code in cases involving disputes over software and other information contracts. However, the UCC was designed to deal with sales of goods and may not sufficiently address the concerns that parties have when making contracts to create or distribute information. During the 1990s, contract scholars, representatives of the affected information industries, consumer groups, and others worked as a drafting committee of the National Conference of Commissioners on Uniform State Laws to draft a uniform law

that would be tailored to “information contracts.” Internet access contracts and software licenses are two familiar examples of information contracts. These efforts resulted in a proposed statute called the Uniform Computer Information Transactions Act, or UCITA. Several UCITA positions—notably those dealing with shrinkwrap and clickwrap licenses—have been quite controversial. Only two states—Virginia and Maryland—have adopted UCITA, albeit with some modifications. Meanwhile, other states—including Iowa, North Carolina, West Virginia, and Vermont—have passed anti-UCITA legislation.



Chapter Nine Introduction to Contracts

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Sources of Law Governing Contracts

financing transactions in goods, a separate UCC article, Article 2A, was developed to govern the lease of goods. Roughly one-third of the states have adopted Article 2A.

Two bodies of law—Article 2 of the Uniform Commercial Code and the common law of contracts—govern contracts today. The Uniform Commercial Code, or UCC, is statutory law in every state. The common law of contracts is court-made law that, like all court-made law, is in a constant state of evolution. Determining what body of law applies to a contract problem is a very important first step in analyzing that problem.

Application of Article 2 Article

Distinguish the applicability of the common law of contracts LO9-3 and Article 2 of the Uniform Commercial Code and identify which one governs a given contract.

The Uniform Commercial Code: Origin and Purposes The UCC was created by the American

Law Institute and the National Conference of Commissioners on Uniform State Laws. All of the states have adopted it except Louisiana, which has adopted only part of the UCC. The drafters of the UCC had several purposes in mind, the most obvious of which was to establish a uniform set of rules to govern commercial transactions, which are often conducted across state lines.1 In addition to promoting uniformity, the drafters of the UCC sought to create a body of rules that would realistically and fairly solve the common problems occurring in everyday commercial transactions. Finally, the drafters tried to formulate rules that would promote fair dealing and higher standards in the marketplace. The UCC contains nine articles, most of which are discussed in detail in Parts 4, 6, and 7 of this book. The most important UCC article for our present purposes is Article 2, which deals with the sale of goods. The UCC has changed and is in the process of continuing to change in response to changes in technology and business transactions. In some instances, the creation of new bodies of uniform law have been thought necessary to govern transactions that are similar to but different in significant ways from the sale of goods. For example, as leasing became a more common way of executing and

Despite the UCC’s almost national adoption, however, complete uniformity has not been achieved. Many states have varied or amended the UCC’s language in specific instances, and some UCC provisions were drafted in alternative ways, giving the states more than one version of particular UCC provisions to choose from. Also, the various state courts have reached different conclusions about the meaning of particular UCC sections. 1

2 expressly applies only to contracts for the sale of goods [2–102] (the numbers in brackets refer to specific UCC sections). The essence of the definition of goods in the UCC [1–105] is that goods are tangible, movable personal property. So, contracts for the sale of such items as motor vehicles, books, appliances, and clothing are covered by Article 2.

Application of the Common Law of Contracts Article 2 of the UCC applies to con-

tracts for the sale of goods, but it does not apply to contracts for the sale of real estate or intangibles such as stocks and bonds because those kinds of property do not constitute goods. Article 2 also does not apply to service contracts. Contracts for the sale of real estate, services, and intangibles are governed by the common law of contracts.

Law Governing “Hybrid” Contracts Many

contracts involve a hybrid of both goods and nongoods. As indicated in Grimes v. Young Life, Inc., which follows, courts normally determine whether Article 2 applies to such a contract by asking which aspect—in Grimes, goods or services—predominates in the contract. For example, is the major purpose or thrust of the agreement the rendering of a service, or is it the sale of goods, with any services involved being merely incidental to that sale? This means that contracts calling for services that involve significant elements of personal skill or judgment in addition to goods probably are not governed by Article 2.

Relationship of the UCC and the Common Law of Contracts Two important qualifications

must be made concerning the application of UCC contract principles. First, the UCC does not change all of the traditional contract rules. Where no specific UCC rule exists, traditional contract law rules apply to contracts for the sale of goods (see Figure 9.2). Second, and ultimately far more important, courts have demonstrated a significant tendency to apply UCC contract concepts by analogy to some contracts that are not technically covered by Article 2. For example, the UCC concepts of good faith dealing and unconscionability have enjoyed wide application in cases that are technically outside the scope of Article 2. Thus, the UCC is an important influence in shaping the evolution of contract law in general.

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Part Three Contracts

Figure 9.2 When the Uniform Commercial Code Applies No

Common law applies.

Unless

Code provision applied by analogy.

Sale of goods? No Yes

Code applies.

Code rule on point?

Use the relevant common law rule.

Yes Special rule for merchants?

Grimes v. Young Life, Inc.   2017 WL 5634239 (D.S.C. 2017) In July 2015, Olivia Grimes died when she fell from a three-person giant swing at the Carolina Point camp facility owned by Young Life. Phillip Wade Grimes, as personal representative of Olivia’s estate, sued Young Life, as well as Inner Quest, the company that provided the materials and built the giant swing for Young Life. Inner Quest filed a crossclaim against Young Life, arguing that Young Life should indemnify it against any judgment. Young Life and Inner Quest entered a contract for the construction of the swing, which included an indemnification clause. Whether that indemnification clause would apply and what effect it would have on the relationship between Young Life and Inner Quest depended on whether the common law or the state UCC applied to it. Inner Quest and Young Life each filed motions for summary judgment on Inner Quest’s crossclaim for indemnity. To determine the merits of the motions, the court had to determine what law applied to the hybrid contract between the parties for the construction of the swing.

Henry M. Herlong Jr., Senior United States District Judge [T]he parties disagree about whether the indemnity clause is enforceable. Young Life argues that the purpose of the contract was as a services contract primarily for the design and construction of the swing and, therefore, common law [applies]. . . . In contrast, Inner Quest argues that the contract was primarily for the sale of goods delivered in South Carolina and, therefore, the South Carolina Uniform Commercial Code’s (“UCC”) [applies]. . . . Thus, as an initial matter the court must consider whether the contract at issue is predominately a contract for services or the sale of goods to determine whether the UCC or South Carolina common law applies in this case. Where a contract is for the mixed sale of goods and services, South Carolina courts apply the predominant factor test to determine whether the UCC applies. Factors that the court may consider in determining whether a contract is for services or the sale of goods include “(1) the language of the contract, (2) the nature of the business of the supplier, and (3) the intrinsic worth of the materials involved.” Coakley & Williams, Inc. v. Shatterproof Glass Corp., 706 F.2d 456, 460 (4th Cir. 1983).

Contracts which contain language primarily associated with the sale of goods, such as “buyer,” “seller,” “terms of sale,” “customer,” and “sales representative,” are evidence that a contract is for the sale of goods. However, the court should consider the terminology in the context of the contract as a whole, rather than narrowly focusing on individual words. Additionally, the court may consider whether the contract was for a fixed price, the time and detail used to describe the goods and services to be provided, and the variety of services to be offered in the contract. In the instant case, the contract is predominately for construction services. The contract does not use terms such as sale, buyer, or seller, but instead uses “project,” “construction,” “client,” and “installation” to describe the work to be done. Similarly, the contract provides only a summary list of materials to be provided, while providing in-depth descriptions of the services offered and provided. Additionally, while the contract contains a single price, the price is listed as an estimate and provides for possible adjustments based upon the cost of obtaining necessary parts for the swing. As a result, the terms of the contract reveal that the primary purpose of



Chapter Nine Introduction to Contracts

the contract was for construction services, rather than the sale of goods. This finding is also supported by the nature of Inner Quest’s business. Inner Quest’s corporate representative stated that Inner Quest has two divisions: “[o]ne is responsible for design, installation, training [and] inspection . . . services vended to owners and operators of challenge courses,” and “the other division is a programming division where we market and operate adventure-based challenge courses . . . on contract for schools and other businesses. . . .” By its own admission, Inner Quest’s primary business focus is to provide services related to the design, construction, and operation of challenge courses, rather than to sell equipment. Lastly, the intrinsic value of the materials does not demonstrate that the contract is for the sale of goods. Both parties submit conflicting figures about the value of materials. Young Life argues that the cost of the swing’s materials is no more than $12,000.00 of the approximately $36,000.00 total price. In contrast, Inner Quest argues that an additional $11,900.00 in costs

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should be factored in to account for the cost of the support poles and swing bar which support the swing. However, the cost of the support poles is composed of “both pole cost and installation.” Because Inner Quest has not provided any further breakdown of the component and labor costs for the support poles and swing bar, the court can only speculate as to the intrinsic value of these components. Based on the foregoing, the contract in dispute is primarily for a services contract with the incidental sale of goods necessary only for the performance of those services. As a result, the UCC is not applicable to this case. *** It is therefore ORDERED that Young Life’s motion for summary judgment . . . is granted. It is further ORDERED Inner Quest’s motion for summary judgment . . . is denied.

The Global Business Environment Dealing with Contract Disputes in International Transactions The United Nations Convention on Contracts for the International Sale of Goods, or CISG, is an international body of contract rules that harmonizes contract principles from many legal systems. Approximately 80 countries, including the United States and Canada, have adopted the CISG to date. The CISG is intended to provide a uniform code for international commercial contracts in much the same way as the UCC provides uniformity for transactions among contracting parties in different states in the United States. Like the UCC, though, the CISG does not have provisions to cover every contract problem that might occur. It applies to sales of goods, not services. Unlike the UCC, however, it applies only to commercial parties (whereas the UCC applies to such parties and to consumers). When there is a contract for the sale of goods between commercial parties whose relevant places of business are located in two different countries that have agreed to the CISG, the CISG applies by default unless the parties have opted out

Basic Differences in the Nature of Article 2 and the Common Law of Contracts Many

of the provisions of Article 2 differ from traditional common law rules in important ways. The UCC is more concerned with rewarding people’s legitimate expectations

of the CISG in their contract. Because the CISG emphasizes freedom of contract, it does permit the parties to agree to exclude or vary any of the CISG rules or to opt out of the CISG completely by stating in their contract that some other body of law (such as the UCC) will apply to their contract. Companies entering international transactions often protect themselves from disputes over what body of laws applies to their disputes by including a choice of law clause in their contracts. This is a provision stating the parties’ agreement that a particular country or state’s law will apply to their contract. (Of course, choice of law clauses are used extensively in domestic transactions as well.) In addition, it is very common for parties in international transactions to include an arbitration clause in their contracts, providing that future disputes between them will be resolved by arbitration.2 Using arbitration gives the parties a relatively speedy and affordable dispute resolution process. An added benefit is that there are several international treaties that will enforce arbitration awards. Arbitration is discussed in more detail in Chapter 2.

2

than with technical rules, so it is generally more flexible than the common law of contracts. A court that applies the UCC is more likely to find that the parties had a contract than is a court that applies the common law of contracts [2–204]. In some cases, the UCC gives less

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Part Three Contracts

LOG ON For links to almost everything you might ever want to know about the CISG, visit the Pace Law Albert H. Kritzer CISG Database, hosted by the Institute of International Commerical Law in the Elizabeth Haub School of Law at Pace University, www.iicl.law.pace.edu/cisg/cisg.

weight to technical requirements such as consideration [2–205 and 2–209]. The drafters of the UCC sought to create practical rules to deal with what people actually do in today’s marketplace. We live in the day of the form contract, so some of the UCC’s rules try to deal fairly with that fact [2–205, 2–207, 2–209(2), and 2–302]. The words reasonable, commercially reasonable, and seasonably (within a reasonable time) are found throughout the UCC. This reasonableness standard is different from the hypothetical reasonable person standard in tort law. A court that tries to decide what is reasonable under the UCC is more likely to be concerned with what people really do in the marketplace than with what a hypothetical reasonable person would do. The drafters of the UCC also wanted to promote fair dealing and higher standards in the marketplace, so they imposed a duty of good faith [1–203] in the performance and enforcement of every contract under the UCC. Good faith means “honesty in fact,” which is required of all parties to sales contracts [1–201(19)]. In addition, merchants are required to observe “reasonable commercial standards of fair dealing” [2–103(1)(b)]. The parties cannot alter this duty of good faith by agreement [1–102(3)]. Finally, the UCC expressly recognizes the concept of an unconscionable contract, one that is grossly unfair or one-sided, and it gives the courts broad discretionary powers to deal fairly with such contracts [2–302].3 The UCC also recognizes that buyers tend to place more reliance on professional sellers and that professionals are generally more knowledgeable and better able to protect themselves than nonprofessionals. So, the UCC distinguishes between merchants and nonmerchants by holding merchants to a higher standard in some cases [2–201(2), 2–205, and 2–207(2)]. The UCC defines the term merchant [2–104(1)] on a case-by-case basis. Contracting parties who regularly deal in the kind of goods being sold in a contract, who hold themselves out to have some special knowledge about goods being sold in a contact, or who have employed an agent in the sale of goods by contract who fits either of the preceding two descriptions are merchants for the purposes of the contract in question. So, if you buy a used car Chapter 15 discusses unconscionability in detail.

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from a used-car dealer, the dealer is a merchant for the purposes of your contract. But if you buy a refrigerator from a used-car dealer, the dealer is not a merchant.

Influence of Restatement (Second) of Contracts In 1932, the American Law Institute pub-

lished the first Restatement of Contracts,4 an attempt to codify and systematize the soundest principles of contract law gleaned from thousands of often-conflicting judicial decisions. As the product of a private organization, the Restatement did not have the force of law, but as the considered judgment of some of the leading scholars of the legal profession, it was highly influential in shaping the evolution of contract law. The Restatement (Second) of Contracts, issued in 1979, is an attempt to reflect the significant changes that have occurred in contract law in the years following the birth of the first Restatement. The Restatement (Second) reflects the “shift from rules to standards” in modern contract law—the shift from precise, technical rules to broader, discretionary principles that produce just results.5 In fact, many Restatement (Second) provisions are virtually identical to their UCC analogues. For example, the Restatement (Second) has explicitly embraced the UCC concepts of good faith6 and unconscionability.7 The Restatement (Second) does not have the force of law. Nonetheless, it can be and has been influential in shaping the evolution of contract law because courts have the option of adopting a Restatement (Second) approach to the contract issues presented in the cases that come before them. Particular approaches suggested by the Restatement (Second) will be mentioned in some of the following chapters. Identify the circumstances under which quasi-contract or

LO9-4 promissory estoppel can afford a remedy even though no

contract exists.

“Noncontract” Obligations Before we proceed to the following chapters’ discussion of the individual elements of contract law, there is one more group of introductory concepts to be considered. Although contract obligations normally require mutual agreement and an exchange of value, there are some circumstances in which the law enforces an obligation to pay for certain losses or benefits even in the absence of mutual agreement See Chapter 1 for a general discussion of the Restatement phenomenon. Richard E. Speidel, “Restatement Second: Omitted Terms and Contract Method,” 67 Cornell L. Rev. 785, 786 (1982). 6 Restatement (Second) of Contracts § 205 (1981). 7 Restatement (Second) of Contracts § 208 (1981). 4 5



Chapter Nine Introduction to Contracts

and exchange of value. We will refer to these circumstances as “noncontract” obligations because they impose the duty on a person to pay for a loss or benefit despite the absence of the requirements for formation of a contract. These noncontract doctrines give a person who cannot establish the existence of a contract a chance to obtain compensation.

Quasi-Contract Requiring all the elements of a bind-

ing contract before a contractual obligation is imposed can cause injustice in some cases. One person may have provided goods or services to another person who benefited from them but has no contractual obligation to pay for them because no facts exist that would justify a court in implying a promise to pay for them. Such a situation can also arise in cases where the parties contemplated entering into a binding contract, but some legal defense prevents the enforcement of the agreement. Consider the following examples: 1. Jones paints Smith’s house by mistake, thinking it belongs to Reed. Smith knows that Jones is painting his house but does not inform him of his error. There are no facts from which a court can infer that Jones and Smith have a contract because the parties have had no prior discussions or dealings. 2. Thomas Products fraudulently induces Perkins to buy a household products franchise by grossly misstating the average revenues of its franchisees. Perkins discovers the misrepresentation after he has resold some products that he has received but before he has paid Thomas for them. Perkins elects to rescind (cancel) the franchise contract on the basis of the fraud. In the preceding examples, both Smith and Perkins have good defenses to contract liability; however, enabling Smith to get a free paint job and Perkins to avoid paying for the goods he resold would unjustly enrich them at the expense of Jones and Thomas. To deal with such cases and to prevent such unjust enrichment, the courts imply as a matter of law a promise by the benefited party to pay the reasonable value of the benefits he received. This idea is called quasi-contract (also called unjust enrichment or contract implied in law) because it represents an obligation imposed by law to avoid injustice, not a contractual obligation created by voluntary consent. Quasi-contract liability has been imposed in situations too numerous and varied to detail. In general, however, quasi-contract liability is imposed when one party confers a benefit on another who knowingly accepts it and retains it under circumstances that make it unjust to do so without paying for it. So, if Jones painted Smith’s house while Smith was away on vacation, Smith would probably not be liable for the reasonable value of the paint

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job because he did not knowingly accept it and because he has no way to return it to Jones. In PWS Environmental v. All Clear, which follows, the court considers whether an implied contract existed and, if not, whether the plaintiff can invoke unjust enrichment principles. In addition, the case touches on promissory estoppel, another noncontract doctrine to be discussed later in the chapter.

Promissory Estoppel Identify the circumstances under which quasi-contract or

LO9-4 promissory estoppel can afford a remedy even though no

contract exists.

Another very important idea that courts have developed to deal with the unfairness that would sometimes result from the strict application of traditional contract principles is the doctrine of promissory estoppel. In certain situations, one person might rely on a promise made by another even though the promise and the relevant circumstances are not sufficient to justify the conclusion that a contract exists. To allow the person who made such a promise (the promisor) to argue that no contract was created could sometimes work an injustice on the person who relied on the promise (the promisee). For example, in Ricketts v. Scothorn, a grandfather’s promise to pay his granddaughter interest on a demand note he gave her so that she would not have to work was enforced against him after she had quit her job in reliance on his promise.8 The Nebraska Supreme Court acknowledged that such promises were traditionally unenforceable because they were gratuitous and not supported by any consideration, but held that the granddaughter’s reliance prevented her grandfather from raising his lack of consideration defense. In the early decades of this century, many courts began to extend similar protection to relying promisees. They said that persons who made promises that produced such reliance were estopped, or equitably prevented, from raising any defense they had to the enforcement of their promise. Out of such cases grew the doctrine of promissory estoppel. Section 90 of the Restatement (Second) of Contracts states: A promise which the promisor should reasonably expect to induce action or forbearance on the part 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. 57 Neb. 51, 77 N.W. 365 (1898).

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Part Three Contracts

PWS Environmental, Inc. v. All Clear Restoration and Remediation, LLC    2018 WL 3139736 (M.D. Fla. 2018)

On September 16, 2017, All Clear Restoration and Remediation, LLC (All Clear) contacted PWS Environmental, Inc. (PWS) asking if PWS was available to provide pressure washing services to several condominium properties in the wake of Hurricane Irma, which struck west central and southwestern Florida the previous week. At the time PWS was performing pressure washing services in Texas as part of the Hurricane Harvey clean-up but decided to decline additional jobs in Texas in favor of moving the equipment to Florida for the business opportunities presented by All Clear there. On September 18, 2017, PWS e-mailed a proposal to All Clear to provide services to 14 residential properties for whom All Clear was acting as agent in the Hurricane Irma clean up process. The e-mail asked All Clear to sign and return the proposal or acknowledge it by a return e-mail, which a representative of All Clear did, stating, “Thanks. I am fine with attachment. Please proceed.” Through the rest of September and October, PWS worked on pressure washing the condominiums and sent invoices to All Clear seeking payment for that work. All Clear failed to pay for any of the work. While PWS sued All Clear for breach of the contract it claims the parties entered, it also sued the condominium associations that owned the properties PWS power washed (the “condo defendants”) for breach of implied contract (i.e., quasi-contract), seeking damages for the value of the work it performed. The condo defendants moved to dismiss PWS’s claims against them.

A claim for breach of a contract implied in law is also known as “unjust enrichment” [or “quasi-contract.”] “In Florida, a claim for unjust enrichment is an equitable claim based on a legal fiction which implies a contract as a matter of law even though the parties to such an implied contract never indicated by deed or word that an agreement existed between them.” 14th & Heinberg, LLC v. Terhaar & Cronley Gen. Contractors, Inc., 43 So. 3d 877, 880 (Fla. Ct. App. 2010). . . . A claim of unjust enrichment requires PWS to show by at least a preponderance of the evidence that: (1) PWS conferred a direct benefit on the condo defendants, (2) the condo defendants had knowledge of the benefit, (3) the condo defendants accepted or retained the conferred benefit, and (4) the benefit was conferred under circumstances which make it inequitable for the condo defendants to retain the benefit without paying its fair value. Unjust enrichment “acknowledges an obligation which is imposed by law regardless of the intent of the parties.” Circle Fin. Co. v. Peacock, 399 So. 2d 81, 84 (Fla. Ct. App. 1981). A plaintiff must directly confer the benefit upon defendant. Peoples Nat’l Bank of Commerce v. First Union Nat’l Bank of Fla., 667 So. 2d 876, 879 (Fla. Ct. App. 1996). . . .

PWS has plausibly alleged the elements of an unjust enrichment claim in order to avoid dismissal. PWS alleges that it directly conferred the benefit of its pressure washing services on each of the condominiums. PWS serviced each of the condominiums for multiple days at a time, while regularly communicating with the condo defendants’ agent, All Clear, about the progress. Plaintiff does not specifically allege that the condo defendants had knowledge of the benefit, but plaintiff does state that All Clear, as the condo defendants’ agent, had knowledge of the benefit. In Florida, an agent may bind his or her principal based on real or actual authority. . . . The Court accepts at this stage in the proceedings the allegations that the condo defendants had knowledge of the benefit through its agent, as well as a reasonable inference that the condo defendants could have had personal knowledge based on the allegations that the pressure washing often went on for days at each property. Finally, the condo defendants, by the very nature of the services conferred upon them, retained the pressure washing benefits. These circumstances could result in inequity if the condominiums were able to retain these benefits without conferring just compensation upon PWS. . . . For the foregoing reasons, the condo defendants’ Motion to Dismiss is denied.

Thus, the elements of promissory estoppel are a promise that the promisor should foresee is likely to induce reliance, reliance on the promise by the promisee, and injustice as a result of that reliance. (See Figure 9.3.) If the plaintiff accomplishes the difficult task of establishing each of these elements, the

plaintiff will obtain appropriate legal relief despite the lack of an enforceable contract. Thomas v. Archer, which follows, provides an example of promissory estoppel’s operation. When you consider the elements noted above, it becomes obvious that promissory estoppel is fundamentally

John E. Steele, Senior United States District Judge



Chapter Nine Introduction to Contracts

Figure 9.3 Contract and Noncontract Theories of Recovery Theory

Key Concept

Remedy

Contract

Voluntary agreement

Enforce promise

Quasi-contract

Unjust enrichment

Reasonable  value of services

Promissory estoppel

Foreseeable reliance

Enforce promise  or recover reliance losses

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different from traditional contract principles. Contract is traditionally thought of as protecting agreements or bargains. Promissory estoppel, on the other hand, protects reliance. Early promissory estoppel cases applied the doctrine only to gift promises such as the one made by the grandfather in the earlier example. As subsequent chapters demonstrate, however, promissory estoppel is now used by courts, in appropriate cases, to prevent offerors from revoking their offers, to enforce indefinite promises, and to enforce oral promises that would ordinarily have to be in writing.

Thomas v. Archer   384 P.3d 791 (Alaska 2016) Rachel Thomas was admitted to the emergency room at Ketchikan General Hospital in Alaska in October 2008 for pregnancy-related complications. Her attending physician, Sarah B. Archer, determined that Rachel was at risk of premature delivery and needed an immediate transfer via medivac to a medical facility better equipped to handle her condition. Due to weather conditions in Anchorage, Alaska, which made transfer to a hospital there untenable, Archer recommended transferring Rachel to Swedish Medical Center in Seattle. Rachel and her husband, Steven, informed Dr. Archer that they needed preauthorization from the Ketchikan Indian Corporation Tribal Health Clinic (KIC) and the Alaska Native Medical Center (ANMC) in order to be insured for treatment outside of ANMC’s Anchorage facilities. According to the Thomases, Dr. Archer told them that she would contact KIC, that they should not worry, that everything would be taken care of, and that if KIC failed to cover the costs of the medivac, “we” will. The Thomases understood “we” to mean the hospital. While the hospital was arranging Rachel’s transfer, Steven signed a form titled “Acknowledgment of Financial Responsibility,” which noted that the medivac by Guardian Flight could be very costly. While the form named KIC as the “Payment Source,” Steven’s signature indicated that he agreed to be personally responsible for any unpaid charges from the flight and to “save and hold the hospital harmless therefrom.” The Thomases eventually received bills totaling more than $23,000 from Swedish Medical Center and more than $69,000 by Guardian Flight. When they sought payment from KIC and ANMC under their insurance plan, they were denied for several reasons, the most relevant being that the Thomases failed to request preauthorization within 72 hours of beginning treatment or of Rachel’s admission to Swedish Medical Center. While the Thomases admitted that arranging preauthorization was ultimately their responsibility, they claimed that they boarded the medivac flight based on Dr. Archer’s representation that someone else would arrange for the preauthorization requirements. Although Dr. Archer ultimately did write to KIC and ANMC to explain her decision to have Rachel transported to Seattle, she did not do so until more than six months later. When the hospital and Dr. Archer would not pay the balances for which the Thomases were billed, the Thomases sued under a number of theories, including promissory estoppel. That claim was based on Dr. Archer’s alleged promise to contact KIC and ANMC to ensure coverage of the expenses related to Rachel’s transfer to Swedish Medical Center and treatment there. The trial court granted summary judgment to the hospital and Dr. Archer. The Thomases appealed. Maassen, Justice The Thomases argue . . . that the superior court erred by rejecting promissory estoppel as a basis for enforcement of Dr. Archer’s alleged promise to the Thomases. * * * 

C. It Was Error To Grant Summary Judgment On The Thomases’ Promissory Estoppel Claim. The Thomases . . . argue that the superior court erred when it re- jected their claim that “[i]f the parties did not create a binding con- tract, their agreement is nevertheless enforceable by the ­doctrine of promissory estoppel.” They argue that Dr. Archer’s alleged

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Part Three Contracts

promise induced them to leave the hospital immediately without their insurer’s preauthorization, that this was a foreseeable response to the promise, that because they left the hospital without preauthorization they incurred substantial medical expenses, and that the interest of justice is served by enforcing Dr. Archer’s promise. They argue that, at a minimum, a jury should have decided this claim. “The doctrine of promissory estoppel allows the enforcement of contract-like promises despite a technical defect or defense that would otherwise make the promise unenforceable.” [Kiernan v. Creech, 268 P.3d 312, 315 (Alaska 2012).] Promissory estoppel has these elements: “1) [t]he action induced amounts to a substantial change of position; 2) it was either actually foreseen or reasonably foreseeable by the promisor; 3) an actual promise was made and itself induced the action or forbearance in reliance thereon; and 4) enforcement is necessary in the interest of justice.” [Simpson v. Murkowski, 129 P.3d 435, 440 (Alaska 2006) (quoting Zeman v. Lufthansa German Airlines, 699 P.2d 1274, 1284 (Alaska 1985)).] The superior court, relying primarily on Sea Hawk Seafoods, Inc. v. City of Valdez, [282 P.3d 359 (Alaska 2012),] held that Dr. Archer’s “alleged promise [was] not ‘definitive,’ ‘clear,’ or ‘precise’ ” enough to constitute an “actual promise.” The court discussed what it perceived to be “the lack of clarity in the alleged oral promises and the lack of unequivocal acceptance,” noting “[Steven’s] signature on the Acknowledgment of Financial Responsibility and [Rachel’s] deposition testimony that . . . she would have taken the flight to Swedish even if it was not covered.” The court concluded that even if all other elements of promissory estoppel were met, the Thomases “fail to show a substantial change in position” because of Rachel’s testimony that she “would have gone to Swedish even if she knew the [medivac] would not be covered.” We conclude that there are genuine issues of material fact about whether the elements of the doctrine were met. It was therefore error to grant summary judgment on the Thomases’ promissory estoppel claim. 1. Whether there was a substantial change of position “Whether particular actions represent substantial changes [in position] is a question of all the circumstances and is not determinable by reference to a set formula.” [Zeman, 699 P.2d at 1284 (citing 1A A. Corbin, Corbin on Contracts § 200, at 216 (1963)).] Courts tend to “look for evidence of actual and substantial economic loss.” [Id.] In deciding that the “substantial change in position” element was not met, the superior court relied on the Thomases’ concession that they would have followed Dr. Archer’s advice regardless of whether they had insurance coverage. Rachel testified at her deposition that “[a]t this point, [she] would have gone anywhere to save [her unborn] son’s life.” She continued:

“I mean, had [Dr. Archer] said you need to go to Anchorage, I would have gone to Anchorage. She said, you need to go to Seattle, so I am going to Seattle.” When asked whether she would have agreed to be transported to Seattle “if [she] felt that it would have saved [her] son’s life” even if there was no insurance coverage for it, she responded, “Again, my concern was not billing at that time. It was immediate health.” This testimony, the superior court concluded, demonstrated that the Thomases did not substantially change their position based on Dr. Archer’s alleged promise. But while there is no dispute that the Thomases would have flown to Seattle regardless of insurance coverage, questions of fact remain because of their assertions that they would have called their insurance providers for preauthorization had they not believed that Dr. Archer was going to do so. A reasonable person could conclude that the Thomases substantially changed their position in reliance upon Dr. Archer’s alleged promise by failing to do what they otherwise would have done. 2. Whether the change in position was foreseeable  “According to Corbin on Contracts, ‘[f]oreseeability of reliance raises a question of fact for court and jury.’ ” Simpson, 129 P.3d at 441 (alteration in original) (quoting Corbin on Contracts, at 216). The superior court did not address the foreseeability prong in its order on summary judgment, nor does the hospital address it on appeal, focusing its analysis instead on the elements of changed position and actual promise. We conclude that a reasonable person, when viewing the circumstances of Dr. Archer’s alleged promise—including that it was made by a treating physician in the context of a medical emergency—could find it was reasonably foreseeable that the Thomases would rely on the promise and not seek preauthorization themselves. 3. Whether there was an actual promise  The superior court’s rejection of the Thomases’ promissory estoppel claim rested primarily on its conclusion that there was no “actual promise” on which the Thomases were entitled to rely. “When a promissory estoppel claim is made in conjunction with a breach of contract claim, the ‘actual promise’ element of promissory estoppel is ‘analytically identical to’ the ‘“acceptance” required for a contract.’ ” [Valdez Fisheries Dev. Ass’n v. Alyeska Pipeline Serv. Co., 45 P.3d 657, 668 (Alaska 2002) (quoting Brady v. State, 965 P.2d 1, 11 (Alaska 1998)).] “Were it otherwise, promissory estoppel . . . would become a device by which parties could be held to contracts they did not accept.” [Id.] “An ‘actual promise’ is one that is ‘definitive, . . . very clear, . . . and must use precise language.’ ” [Safar v. Wells Fargo Bank, N.A., 254 P.3d 1112, 1119 (Alaska 2011) (alterations in original) (quoting Alaska Trademark Shellfish, LLC v. State, Dep’t of Fish & Game, 172 P.3d 764, 767 (Alaska 2007)).] “[A] promise . . .



Chapter Nine Introduction to Contracts

must ‘manifest an unequivocal intent to be bound.’ ” [Id. (quoting Alaska Trademark Shellfish, 172 P.3d at 767).] The superior court, in deciding that there was no actual promise, relied on Sea Hawk Seafoods, Inc. v. City of Valdez, in which we reversed the trial court’s denial of summary judgment to Valdez on Sea Hawk’s promissory estoppel claim. Valdez had made oral promises to Sea Hawk that it would submit a grant application for funds, which it would then turn over to Sea Hawk to pay for the conversion of one of Sea Hawk’s processing facilities. Valdez confirmed these promises in a letter, indicating that it was in the process of finalizing the application but that a number of issues remained to be resolved before it would accept the grant. After the grant application was tentatively approved, Valdez sent Sea Hawk another letter reiterating that it would not accept the grant until it had reached an agreement with Sea Hawk. The parties could not agree and Valdez did not accept the grant, prompting Sea Hawk’s suit. The superior court in this case noted our holding in Sea Hawk that Valdez’s “alleged oral promises were not sufficiently ‘definitive,’ ‘clear,’ and ‘precise’ to constitute an actual promise, particularly when considered in conjunction with [Valdez’s] letter.” [282 P.3d at 367.] The court reasoned that because “[t]he language of [Valdez’s] alleged promises [in Sea Hawk] . . . was more certain than in the present case,” Dr. Archer’s alleged promises could not be considered precise enough to constitute an actual promise. We do not consider Sea Hawk controlling. Valdez’s oral offer in Sea Hawk identified “three conditions prior to submitting the Sea Hawk grant application,” and its later confirming letter again noted those “conditions, informing Sea Hawk these issues would need to be resolved before Valdez accepted the grant funds, and stating the parties would need to enter [into] an agreement once the State decided whether to award Valdez the grant.” [Id. at 366.] We therefore held that “even assuming [Valdez] made such promises, [it] alerted [Sea Hawk] that

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Valdez would not accept the grant unconditionally and then specifically outlined those conditions in the [confirming] letter.” [Id. at 366–67 (emphasis added).] The promises in that case instead “demonstrate[d] [that] Valdez contemplated entering into a future agreement with Sea Hawk addressing various issues.” [Id.at 365.] The alleged promise at issue in this case, unlike the promises in Sea Hawk, was not expressly conditional. As the Thomases describe Dr. Archer’s promise, it gave no indication that it depended on the outcome of future negotiations. The alleged promise defined Dr. Archer’s role—she would contact the insurers if the Thomases boarded the medivac plane immediately—and it defined the Thomases’ role—they would board the plane without taking time to contact their insurers. Because the evidence could support a conclusion that the Thomases unequivocally accepted a clear offer, a reasonable person could conclude that there was an “actual promise.” 4. Whether enforcement of the promise is necessary in the interest of justice  “The fourth requirement, that enforcement is necessary in the interest of justice, presents fact questions that ordinarily should not be decided on summary judgment.” Reeves v. Alyeska Pipeline Serv. Co., 926 P.2d 1130, 1142 (Alaska 1996) (citing State v. First Nat’l Bank of Ketchikan, 629 P.2d 78, 82 n.4 (Alaska 1981)). This is a fact-intensive analysis in which reasonable people could reach different conclusions. Because the Thomases identified issues of fact that precluded summary judgment, it was error to grant the hospital’s motion on the Thomases’ promissory estoppel claim. Conclusion  We REVERSE the superior court’s grant of summary judgment on the Thomases’ promissory estoppel claim and REMAND for further proceedings consistent with this opinion.

Ethics and Compliance in Action The idea that contracts should be enforced because they are voluntary agreements can obviously be justified on ethical grounds. But what about quasi-contracts and promissory estoppel? What ethical justifications can you give for departing from the notion of voluntary agreement in quasi-contract and promissory estoppel cases?

From a compliance point of view, what sorts of controls and practices should an organization have in place to ensure that it only makes contractual commitments it intends to enter and does not end up committed by noncontract obligations like quasi-contract or promissory estoppel?

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Part Three Contracts

Problems and Problem Cases 1. Clarence Jackson went to the Snack Plus convenience store in Hamden, Connecticut, and bought a Connecticut Lotto “Quick Pick” ticket for the drawing of October 13, 1995. On the back of the ticket were various provisions, including the admonition that “Prize must be claimed within one year from the drawing date. Determination of winners subject to DOSR rules and regulations.” It also stated instructions for claiming the prize by presentment to any online agent or to “Lottery Claims” in Newington, Connecticut. The drawing was held on October 13, and the winning six-number combination was announced. One of the six-number combinations on Jackson’s Lotto ticket matched the six-number combination drawn in the October 13 drawing, for a prize of $5.8 million. Jackson learned of the match only 15 minutes before the one-year deadline. Instead of claiming his prize online, Jackson waited several more days until after the Columbus Day holiday to present his ticket in person at the Lottery Claims Center because he was under the impression that it had to be presented there. The Connecticut Lottery Corporation (CLC) denied Jackson’s claim because the oneyear presentment period had elapsed. Did contract law give Jackson the right to claim the prize under these circumstances? 2. Donald Lambert and Don Barron were friends. They had a longstanding professional relationship based on their service together on the Louisiana State Board of Licensed Contractors. Lambert was a specialist in resolving construction disputes. Barron was a commercial construction contractor, whose business was experiencing difficulty in part due to five projects that were mired in various kinds of difficulty. Lambert became concerned about his friend when he heard about Barron’s struggles and witnessed Barron’s depressed mental state. As a result, Lambert flew to Barron’s hometown to meet with Barron. Prior to the flight, one of Barron’s employees sent Lambert copies of various contracts and correspondence related to the troubled projects. After the visit, as Lambert prepared to board his flight back home, he claimed that he and Barron contracted for Lambert to provide consulting services for Barron, at his customary rate of $3,100 per month for the minimum term of one year. Then, after a year passed, Lambert billed Barron for $34,000 on the alleged oral contract. Barron professed to be shocked by the bill and disclaimed any contract for extended

consulting services. Rather, his business paid the first monthly invoice of $3,100, assuming that was the fee for the one-time visit and document review services. Barron claimed that Lambert had done no additional work throughout the year, and he denied ever agreeing to any additional work. The record showed that their only contact throughout the year had been initiated by Lambert. Nonetheless, Lambert sued Barron for breach of contract. Did he win? 3. Stephen Gall and his family became ill after drinking contaminated water supplied to their home by the McKeesport Municipal Water Authority. They filed suit against the utility, arguing, among other things, that the utility had breached the UCC implied warranty of merchantability when it sold them contaminated water. Arguing that water was not “goods” and that the UCC therefore should not apply, the utility moved to dismiss the Galls’ complaint. How did the court rule? 4. Piece of America (POA) hired Gray Loon Marketing to design and publish its website. Gray Loon finished the site in December 2003 at a final cost of about $8,500. Once the website was running to POA’s satisfaction, it paid Gray Loon in full during the first quarter of 2004. In April 2004, POA requested that Gray Loon make several changes, some of which required major programming work. Gray Loon immediately began the requested alterations. Gray Loon subsequently sent POA a bill for $5,224.50. POA’s representative stated he did not have any issues with the invoice, but POA needed time to obtain additional funds. During this period, Gray Loon was also charging POA $75 a month for hosting the site. Once Gray Loon published the modified website, it remained available from July to September 2004. Gray Loon filed suit against POA and its principals for nonpayment. Did the UCC apply to this contract? 5. LandTech Co. entered an “Outsourcing Agreement” with Ohio Fresh Eggs, LLC, and Trillium Farm Holdings, LLC, pursuant to which LandTech would obtain the right to remove chicken manure from the egg-laying facilities Ohio Fresh and Trillium operated in Hardin County, Ohio. LandTech sought to act as a “manure broker,” removing the manure produced at the Hardin County facilities and selling it for use as fertilizer. The relationship broke down before any manure changed hands. LandTech sued. At trial, the parties argued whether the Agreement stated a specific quantity of manure that Ohio Fresh and Trillium were obligated to provide to LandTech. The nature of the quantity term



Chapter Nine Introduction to Contracts

was vital to determine whether the parties were subject to a contractual obligation or they had just entered an “agreement to make an agreement.” And that, in turn, depended on which of the UCC or the common law of contracts applied to this situation. Applying the predominant purpose or factor test, does the UCC or the common law apply? 6. Over the course of six years, David Hix, on behalf of his company HAD Enterprises, repeatedly asked Wanda Galloway, who owned the property adjacent to Hix’s, to allow him to fill in the pond on her property and to regrade her property to avoid flooding and mosquito problems that plagued both properties. Galloway finally agreed to let Hix do the work on her land. Hix claimed that, in exchange for his labor, he requested to be allowed to use the improved land for parking, either for himself or for HAD Enterprises. Galloway recalled no such agreement. After roughly two years of extensive work by Hix on both his and Galloway’s land (during which time Galloway apparently expressed concern several times to Hix about the unexpectedly large scope of the work he was doing), Galloway instructed Hix to stop. Even after all that time, the pond was only partially filled. Nonetheless, Hix submitted to Galloway a bill totaling $14,972 for the work he had done to her land. Galloway refused to pay, saying she had never agreed to pay Hix anything for the work and had agreed to allow him to commence the work only because it seemed so important to him. Hix sued Galloway for the cost of his work on the land. If he claims Galloway has breached a contract between them, will he succeed on that theory? Even if there is no contract between the two, could he recover under the doctrine of quasi-contract? 7. On March 21, 2003, Robert Palese bought five Delaware State Lottery tickets from a Delaware liquor store. To select his numbers for the game, Palese used a “play slip” that contained five game panels. Each panel had a selection grid bearing numbers 1 through 38. Palese chose six numbers from each grid by manually filling in the grids. After purchasing the tickets, Palese placed them in his pants pocket and returned home. Several days later, he learned that someone had won the March 21 lottery but that the winner had not yet come forward. Palese searched for his tickets to see whether he had chosen the winning numbers, but he was unable to find the tickets. Eventually, he remembered that he had done laundry the same evening he

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purchased the tickets. He then concluded that the tickets, which had been left in his pants pocket, had probably been destroyed in the wash. Although the tickets were gone, Palese still had the play slip he used when he purchased the tickets. He checked the numbers on the play slip and discovered that the numbers he selected on the play slip’s fifth game panel were the winning numbers for the March 21 lottery. Reasoning that the play slip should be sufficient to satisfy the state’s Lottery Office that he had selected the winning numbers, Palese informed the office of his predicament. The Lottery Office ultimately took the position that the state’s lottery regulations and any contract arising from the purchase of the ticket required that the winning ticket itself be produced in order for the winner to claim the jackpot. Therefore, the Lottery Office denied Palese’s claim and transferred the jackpot to the state’s General Fund. Palese then sued the Lottery Office on a quasi-contract (unjust enrichment) theory. Did Palese win the case and collect the jackpot amount? 8. In 1994, Schumacher and his wife along with their two daughters moved to Finland, Minnesota, to operate a bar and restaurant called the Trestle Inn, which was owned by his parents. Schumacher claimed that his parents induced him to leave his previous job and to make the move by orally agreeing to (1) provide him a job managing the inn for life and (2) leave the business and a large parcel of land to him when his first parent died. Schumacher was given free reign in managing the inn and was allowed to retain all profits of the business, but he was not given any salary or wage. While he was operating the inn, Schumacher used his own funds to build a home for his family on his parents’ land, install a well, buy equipment for the business, and develop various marketing tools for the business. In 1998, Schumacher suspected that his parents were about to sell the inn and the adjoining property. He brought suit for a restraining order to prevent them from doing so, claiming breach of contract and unjust enrichment, among other claims. In October 1998, the parents notified Schumacher that his employment at the inn and his right to possess the adjoining property were terminated. The parents moved for summary judgment. The trial court held that Schumacher’s oral contract claim was invalid because the contract needed to be in writing under applicable Minnesota law. However, did Schumacher have a valid claim for unjust enrichment?

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Part Three Contracts

9. In 2006, Claudia Aceves obtained from her bank a loan in the amount of $845,000 to buy a house. The loan had an initial interest rate of 6.35 percent. After two years, the rate became adjustable and increased significantly. She could no longer afford the monthly payments on the loan. In March 2008, she received a notice that the bank was going to foreclose on her house. She filed for bankruptcy protection, which posed an automatic stay (i.e., “froze”) on the foreclosure proceedings. Aceves contacted the bank and was told that once her loan was out of bankruptcy, the bank “would work with her on a mortgage reinstatement and loan modification.” Relying on this representation, Aceves decided to forgo a legal process in the bankruptcy court that would have allowed her to reinstate the loan and repay the past due portion over time, while retaining her home. At the same time, the bank requested the bankruptcy court to remove the stay, so it could proceed with the foreclosure. Aceves did not object to that request, assuming that she and the bank were going to resolve things outside the court. The bank, however, scheduled Aceves’s home for public auction before the end of 2008 without allowing Aceves to discuss reinstatement and modification of the loan. When a “negotiator” for the bank did finally contact her on the day before the public auction was scheduled, he told her that

the new balance on the loan was nearly $1 million, that the new monthly payment would be nearly twice what it was before she declared bankruptcy, and that she needed to send a $6,500 deposit immediately to avoid the sale. When the negotiator refused to put any of those terms in writing, Aceves rejected the offer. Her house was sold the next day to the bank, which served her a three-day notice to vacate and instituted eviction proceedings against her. Aceves filed suit against the bank, claiming that to her detriment she relied on the promise by the bank that it would work with her. Did she succeed? 10. The Weitz Company, a general contractor, received an invitation to bid on a planned nursing facility. H & S Plumbing and Heating submitted a bid to Weitz for the plumbing work, as well as the heating, ventilation, and air conditioning parts of the job. Weitz’s bid to the project owner incorporated the amount of H & S’s bid. Because the bid was speculative, there was no contract formed between Weitz and H & S at that point. After the owner awarded the project to Weitz, H & S refused to honor its bid. Weitz completed the project with different subcontractors at greater expense. Does Weitz have any recourse against H & S to recover the lower profit margin that resulted from H & S’s refusal to honor its bid?

CHAPTER 10

The Agreement: Offer

O

n March 4, 2004, the “The Buzz” section of Louisville Scene, an online service of the Louisville CourierJournal, ran the following report: How much would you pay for Hollywood hunk George Clooney to wash your car in a toga?

The star of such films as “Ocean’s Eleven” and “The Perfect Storm” is hoping to raise money for father Nick Clooney’s congressional campaign. According to the New York Post, Clooney, 42, made the oddball offer in a handwritten appeal to potential donors, who were invited to a fund-raiser at his home in Studio City, Calif.

The letter begins: “OK, this is a little tricky. I’ll start with a warning: I’m asking for money so you might want to stop reading and pretend you never got this letter. My father, Nick, is running for the U.S. House of Representatives in Kentucky’s 4th District. He’s the Democratic candidate . . . There’s a limit to what anyone can donate to a campaign. If I was allowed, I’d pay for the whole thing (and cover a few Father’s Days), but I can’t. So I’m writing you in hopes of scaring up some cash for his Congressional bid. “If you can’t or don’t want to, I understand. However, if you can . . . I’m having a cocktail party at my house on Saturday March 6, at 7 P.M. It’s a benefit so there will be entertainment, hors d’oeurves and booze. And I’ll wash your car every week till it’s paid off and Armor-all the tires . . . in a toga. Hope to see you there, George.” The former “ER” hunk notes the minimum contribution is $500 and the maximum $4,000. And who wouldn’t pay top dollar to have him rub his hands all over your car?

• Is Clooney’s handwritten note an offer that could bind him to wash cars (in a toga) if accepted? • One can imagine, if Clooney were asked whether he intended to be making a formal offer to contract, he would likely respond something to the effect, “I certainly did not mean to commit myself to toga-clad car washing. I was joking!” What legal significance does this subjective intent have on whether the letter constitutes an offer to contract? • How would the determination of whether Clooney was joking be made as a legal matter? Is it relevant to whether the letter is an offer? • Assuming for the sake of argument that it is not a joke, is the letter specific enough to be an offer?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 10-1 Explain the elements of an offer under both the Uniform Commercial Code (UCC) and common law. 10-2 Determine whether a given proposal is likely to be considered to be an offer.

10-3 Distinguish advertisements that are considered to be offers from those that are merely invitations to negotiate. 10-4 Describe the circumstances that terminate an offer and determine whether a given offer remains “on the table.”

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Part Three Contracts

THE CONCEPT OF MUTUAL agreement lies at the heart of traditional contract law. Courts faced with deciding whether two or more persons entered into a contract look first for an agreement between the parties. Because the formation of an agreement is normally a two-step process by which one party makes a proposal and the other responds to the proposal, it is customary to analyze the agreement in two parts: offer and acceptance. This chapter, which concerns itself with the offer, and the next chapter, which covers acceptance, focus on the tools used by courts to determine whether the parties have reached the kind of agreement that becomes the foundation of a contract.

intent to enter the contract upon acceptance. It signifies that the offeror is not joking, haggling, or equivocating. It makes sense that intent on the part of the offeror would be required for an offer—otherwise, an unwilling person might wrongly be bound to a contract. But what is meant by intent? Should courts try to divine what the offeror was actually thinking at the time by searching the offeror’s mind (that is, determine subjective intent)? Or should the offeror’s intent be judged by the impression that the offeror has given to the rest of the world through the offeror’s words and acts, as well as the circumstances under which those words and acts occurred (that is, determine objective intent)?

Requirements for an Offer

The Objective Standard of Intent Early American courts took a subjective approach to contract formation, asking whether there was truly a “meeting of the minds” between the parties. This subjective standard, however, created uncertainty in the enforcement of contracts because it left every contract vulnerable to disputes about actual intent. The desire to meet the needs of the marketplace by affording predictable and consistent results in contracts cases dictated a shift toward an objective theory of contracts. By the middle of the 19th century, the objective approach to contract formation, which judges agreement by looking at the parties’ outward manifestations of intent, was firmly established in American law. Judge Learned Hand once described the effect of the objective contract theory as follows:

LO10-1

Explain the elements of an offer under both the Uniform Commercial Code (UCC) and common law.

An offer is the critically important first step in the contract formation process. An offer says, in effect, “This is it—if you agree to these terms, we have a contract.” The person who makes an offer (the offeror) gives the person to whom the offer is made (the offeree) the power to bind the offeror to a contract simply by accepting the offer. Not every proposal qualifies as an offer. Some proposals are vague, for example, or made in jest, or thrown out merely as a way of opening negotiations. To distinguish an offer, courts look for three requirements. First, they look for some objective indication of a present intent to contract on the part of the offeror. Second, they look for specificity, or definiteness, in the terms of the alleged offer. Third, they look to see whether the alleged offer has been communicated to the offeree. Chapter 9 discussed the fact that contracts for the sale of goods are governed by Article 2 of the Uniform Commercial Code (UCC) whereas contracts for services, real estate, and intangibles are generally governed by the common law of contracts. Common law and UCC standards for contract formation have a great deal in common, but they also differ somewhat. This chapter will point out those areas in which an offer for the sale of goods would be treated somewhat differently from an offer for services, real estate, and intangibles.

Intent to Contract Determine whether a given proposal is likely to be LO10-2 considered to be an offer.

For a proposal to be considered an offer, the offeror must indicate present intent to contract. Present intent means the

A contract has, strictly speaking, nothing to do with the personal, or individual, intent of the parties. A contract is an obligation attached by the mere force of law to certain acts of the parties, usually words, which ordinarily accompany and represent a known intent. If however, it were proved by 20 bishops that either party when he used the words intended something else than the usual meaning which the law imposes on them, he would still be held, unless there were mutual mistake or something else of that sort.1

Following the objective theory of contracts, then, an offeror’s intent will be judged by an objective standard—that is, what the offeror’s words, acts, and the circumstances signify about the offeror’s intent. If a reasonable person familiar with all the circumstances would be justified in believing that the offeror intended to contract, a court would find that the intent requirement of an offer was satisfied even if the offeror claims not to have intended to contract.

Definiteness of Terms If

Smith says to Ford, “I’d like to buy your house,” and Ford responds, “You’ve got a deal,” has a contract been formed? An obvious problem here is lack of specificity. A proposal that fails to state Hotchkiss v. National City Bank, 200 F. 287, 293 (S.D.N.Y. 1911).

1



Chapter Ten The Agreement: Offer

specifically what the offeror is willing to do and what the offeror asks in return for performance is unlikely to be considered an offer. One reason for the requirement of definiteness is that definiteness and specificity in an offer tend to indicate an intent to contract, whereas indefiniteness and lack of specificity tend to indicate that the parties are still negotiating and have not yet reached agreement. In the conversation between Smith and Ford, Smith’s statement that he’d like to buy Ford’s house is merely an invitation to offer or an invitation to negotiate. It indicates a willingness to contract in the future if the parties can reach agreement on mutually acceptable terms, but not a present intent to contract. If, however, Smith sends Ford a detailed and specific written document stating all of the material terms and conditions on which he is willing to buy the house and Ford writes back agreeing to Smith’s terms, the parties’ intent to contract would be objectively indicated and a contract probably would be created. A second reason definiteness is important is that courts need to know the terms on which the parties agreed in order to determine if a breach of contract has occurred and calculate a remedy if it has. Keep in mind that the offer often contains all the terms of the parties’ contract. This is so because all that an offeree is allowed to do in most cases is to accept or reject the terms of the offer. If an agreement is too indefinite, a court would not have a basis for giving a remedy if one of the parties alleged that the “contract” was breached.

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Definiteness Standards under the Common Law  Classical contract law took the position that courts are contract enforcers, not contract makers. The prospect of enforcing an agreement in which the parties had omitted terms or left terms open for later agreement was unthinkable to courts that took a traditional, hands-off approach to contracts. Traditionally, contract law required a relatively high standard of definiteness for offers, requiring that all the essential terms of a proposed contract be stated in the offer. The traditional insistence on definiteness can serve useful ends. It can prevent a person from being held to an agreement when none was reached or from being bound by a contract term to which that person never assented. Often, however, it can operate to frustrate the expectations of parties who intend to contract but, for whatever reason, fail to procure an agreement that specifies all the terms of the contract. The definiteness standard, like much of contract law, is constantly evolving. The trend of modern contract law is to tolerate a lower degree of specificity in agreements than classical contract law would have tolerated, although it is still unlikely that an agreement that leaves open important aspects of a transaction will be enforced. The following Domingo v. Mitchell case discusses the elements of an offer, including the objective standard of intent and the requirement of definiteness.   It is an example of the modern contract law to allow for some particularly important terms, like price, to be implied when the circumstances warrant.  

Domingo v. Mitchell   257 S.W.3d 34 (Tex. Ct. App. 2008) Coworkers Betty Domingo and Brenda Mitchell often played the Texas Lottery together. Their arrangement included an agreement to pool their money to purchase tickets and split their winnings equally. From time to time, Mitchell would purchase the lottery tickets prior to getting Domingo’s money, and Domingo would promptly reimburse Mitchell, win or lose. On March 9, 2006, Cindy Skidmore sent an e-mail to Mitchell asking if Mitchell was interested in joining a lottery group. Skidmore had formed LGroup, a Texas Limited Partnership, for the purpose of pooling money to play the lottery. On March 23, she sent a followup e-mail to members of the group, including Mitchell, notifying them of a meeting the next week at a local restaurant, during which members would pay their share into the pool and select numbers for the April 2006 lottery drawings. The e-mail also provided, “[i]f there is someone else you want to invite (& you feel pretty sure they won’t drop out) let me know.” Mitchell did not ask Skidmore if Domingo could participate in the April 2006 drawings. According to Domingo, sometime after the March 23 e-mail, Mitchell invited her to participate in the LGroup for April 2006, specifically to play Lotto Texas and Mega Millions. When Domingo asked how much her contribution would have to be, Mitchell offered to cover for her and be reimbursed at a later time. On March 30, Mitchell and other members of the group met at a restaurant to pay their share for the April 2006 tickets and contribute their numbers. Domingo was not present at this meeting. Mitchell paid her $17 contribution, but she did not contribute for Domingo’s share. According to Mitchell’s deposition testimony, she did not have enough money to cover Domingo’s payment.  On April 29, 2006, one of the tickets purchased by LGroup was a winner in the amount of $20,925,315.23. Domingo was excluded from any share of the winnings. As a result, she sued Mitchell for breach of contract. Mitchell filed a motion for summary judgment, alleging among other things, that she had never made a valid offer to Domingo, so they could not have entered into a contractual relationship. The trial court granted summary judgment for Mitchell, and Domingo appealed.

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Part Three Contracts

Pirtle, Justice The threshold question is whether Mitchell and Domingo entered into a contract. . . . In determining the existence of an oral contract, courts look at the communications between the parties and the acts and circumstances surrounding those communications. . . . To determine whether there was an offer and acceptance, and therefore a “meeting of the minds,” courts use an objective standard, considering what the parties did and said, not their subjective states of mind. . . .  To prove that an offer was made, a party must show (1) the offeror intended to make an offer, (2) the terms of the offer were clear and definite, and (3) the offeror communicated the essential terms of the offer to the offeree. . . . Mitchell alleges she did not make an offer to Domingo, but if she did, some of the material terms of the offer were lacking, making the contract invalid. She argues that price had not been agreed to and that Domingo failed to submit numbers for the drawings, which was an essential element of the agreement. In response, Domingo asserts that a reasonable price can be implied. She also asserts that submitting numbers was not an essential term of the agreement. We agree with Domingo. When all other elements of a contract have been met, a court may imply a reasonable price. According to Domingo’s affidavit, she was an experienced lottery player and estimated that playing Lotto Texas and Mega Millions for the month of April 2006 would have cost approximately $20 to $25. According to the evidence, Mega Millions was played every Tuesday and Friday and Lotto Texas was played every Wednesday and Saturday. Looking at a calendar for April 2006 at $1 per ticket, there were eight drawings for Mega Millions and nine drawings for Lotto Texas, for a total cost of $17 per participant. Thus, a reasonable price could have been implied. Whether a term forms an essential element of a contract depends primarily upon the intent of the parties. The question

Definiteness Standards under the UCC The UCC, with its increased emphasis on furthering people’s justifiable expectations and its encouragement of a hands-on approach by the courts, often creates contractual liability in situations where no contract would have resulted at common law. Perhaps no part of the UCC better illustrates this basic difference between the UCC and classical common law than does the basic UCC section on contract formation [2-204]. This section says that sales contracts under Article 2 can be created “in any manner sufficient to show agreement, including conduct which recognizes the existence of a contract” [2-204(1)]. So, if the parties are acting as though they have a contract by delivering or accepting goods or payment, for

is whether the parties regarded the term as a vitally important ingredient of their bargain. Mitchell contends that submitting numbers was an essential term of the agreement and that without Domingo complying, there was no valid contract. However, the evidence suggests that submitting numbers for the April drawings was not an essential element of the contract. Copies of e-mails established that different numbers were selected on the day after the LGroup met for dinner to decide on a price and submit numbers. Members of the LGroup were also notified by e-mail and given a deadline of noon on April 1st in which to pick different numbers. Thus, any numbers submitted at the meeting on March 30th were an uncertainty as they were subject to being changed and thus, could not have been regarded by the parties as an essential element of the contract. According to Domingo, she and Mitchell frequently participated in lottery pools with co-workers. They occasionally covered for each other and when Mitchell would advance Domingo’s share, Domingo would promptly reimburse her. Shondra Stewart and Ellen Clemons, co-workers of Domingo and Mitchell, both gave deposition testimony that Cindy Ruff, another co-worker, claimed she was present when Mitchell agreed to cover for Domingo’s share of the April 2006 lottery tickets. * * *   This summary judgment evidence, coupled with Mitchell and Domingo’s conduct and course of prior dealings with one another, is sufficient to raise a genuine issue of material fact concerning the offer . . . element[] of the alleged contract between Mitchell and Domingo. *** Accordingly, the trial court’s judgment is reversed and the cause is remanded to the trial court for further proceedings.

example, this may be enough to create a binding contract, even if it is impossible to point to a particular moment in time when the contract was created [2-204(2)]. An important difference between UCC and classical common law standards for definiteness is that under the UCC, the fact that the parties left open one or more terms of their agreement does not necessarily mean that their agreement is too indefinite to enforce. A sales contract is created if the court finds that the parties intended to make a contract and that their agreement is complete enough to allow the court to reach a fair settlement of their dispute (“a reasonably certain basis for giving an appropriate remedy” [2-204(3)]). If a term is left open in a contract that



Chapter Ten The Agreement: Offer

meets these two standards, that open term or “gap” can be “filled” by inserting a presumption found in the UCC’s “gap-filling” rules. The gap-filling rules allow courts to fill contract terms left open on matters of price [2-305], quantity [2-306], delivery [2-307, 2-308, and 2-309(1)], and time for payment [2-310] when such terms have been left open by the parties.2 Of course, if a term was left out because the parties were unable to reach agreement about it, this would indicate that the intent to contract was absent and no contract would result, even under the UCC’s more liberal rules. Intention is still at the heart of these modern contract rules; the difference is that courts applying UCC 2

Chapter 19 discusses these UCC provisions in detail.

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principles seek to further the parties’ underlying intent to contract even though the parties have failed to express their intention about specific aspects of their agreement. The following J.D. Fields & Company, Inc. v. United States Steel International, Inc.  case illustrates the UCC approach to determining whether an offer has been made. Note how the elements of intent, definiteness, and communication are intertwined in the court’s evaluation of whether the price quotes were offers. The case also highlights the general rule that price quotes are invitations to offer rather than offers (as well as when that general rule does not apply). Issues related to that general rule are discussed shortly after the case in the section “Special Offer Problem Areas.”

J.D. Fields & Company, Inc. v. United States Steel International, Inc.    426 Fed. App’x 271 (5th Cir. 2011) United States Steel International (USSI) sells and markets steel products manufactured at U.S.-based steel mills for sale on the international market. J.D. Fields & Company, Inc. (J.D. Fields) distributes steel products from producers to consumers. USSI and J.D. Fields were repeat contracting partners on at least 30 occasions over the prior five years. The typical course of their dealings was that J.D. Fields requested a price quotation from USSI, USSI provided J.D. Fields that quote, J.D. Fields sent USSI a purchase order, USSI sent J.D. Fields an order acknowledgment, and USSI shipped the product along with an invoice. The present case resulted from a dispute over two e-mail-based transactions. The first transaction involved a type of seamless carbon steel pipe for which J.D. Fields requested a price quote on February 6, 2008. USSI’s representative provided the quote for 800 feet, but clearly indicated that USSI could not manufacture that particular type of pipe without an order for at least 100 tons. On February 11, 2008, J.D. Fields sent a purchase order (PO 45850) to USSI for 880 feet of the pipe; however, 880 feet would constitute only 60 tons. On February 14, 2008, J.D. Fields inquired about the order, and USSI responded that it could not run less than 100 tons of the pipe. Thus, USSI requested a revised purchase order, which J.D. Fields never sent. USSI likewise never issued an order acknowledgment for PO 45840. On March 6, 2008, J.D. Fields contacted USSI for a quote on two other types of pipe. USSI responded with a quote for the price, timing, delivery location, and other details. That same day, J.D. Fields sent a second purchase order (PO 46110) matching the details of the quote. On March 26, 2008, J.D. Fields followed up on the status of PO 45850, particularly inquiring whether USSI had found any other takers for the same size pipe to fill out the 100-ton required allotment. J.D. Fields also requested an order acknowledgment on PO 45850. USSI responded that it had “not found any other order to piggyback on,” so J.D. Fields would need to order the 100-ton minimum. USSI requested instructions for how to proceed. J.D. Fields responded that it could not afford to keep its customers waiting and risk losing their business and indicated that it would “look[] into” increasing the order to hit the 100-ton minimum. Shortly thereafter, J.D. Fields’s representative and the USSI representative spoke on the phone, during which J.D. Fields’s representative claims he made a more concrete commitment to order 100 tons “if need be.” Even after these exchanges, J.D. Fields never sent a revision of PO 45850 for 100 tons or more. On April 24, 2008, J.D. Fields inquired with USSI about the status of both purchase orders. That inquiry prompted a series of increasingly contentious communications between the companies. USSI argued that J.D. Fields had never actually ordered the required 100 tons on PO 45850 and that, in any event, it was not taking new orders during the relevant time frame due to an impending price increase. As to PO 46110, USSI admitted that it may have “fallen through the cracks.” PO 46110 was never processed by USSI. Ultimately, USSI concluded that the purchase orders had not been entered into its systems, that USSI never sent J.D. Fields order acknowledgments on either purchase order, and that USSI did not plan to fill the orders. J.D. Fields filed suit against USSI for breach of contract (and other claims not relevant here) on the basis of both purchase orders. The district court granted USSI’s motion for summary judgment on the breach of contract claims. J.D. Fields appealed.

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Part Three Contracts

Aycock, Judge The first issue on appeal is whether the district court properly granted summary judgment on J.D. Fields’s breach of contract claims when it concluded that USSI’s price quotations could not reasonably be construed as offers as a matter of law. . . . When parties enter into a contract for the sale of goods, the Uniform Commercial Code (“UCC”) controls the conduct of the parties. There is no dispute that Article 2 of the UCC governs this transaction, as the contracts at issue concern the sale of steel. Steel qualifies as a “thing[] . . . which [is] movable at the time of identification to the contract for sale,” and therefore it is considered a “good.” Tex. Bus. & Com. Code Ann. § 2.105(a). Where the UCC applies, it displaces all common law rules of law regarding breach of contract and substitutes instead those rules of law and procedures set forth in the UCC. However, common law principles of law and equity continue to supplement its provisions. In Texas, the essential elements of a breach of contract claim are: (1) the existence of a valid contract; (2) performance or tendered performance by the plaintiff; (3) breach of the contract by the defendant; and (4) damages sustained by the plaintiff as a result of the breach. The central dispute in this action revolves around the first element: whether the parties ever formed a valid contract as to [the two purchase orders]. Contract formation hinges on the existence of an acceptable offer. The UCC, however, provides no guidance as to what an offer is. Although the UCC does not define the term “offer,” we have held that “[a]n offer is an act that leads the offeree reasonably to believe that assent (i.e., acceptance) will conclude the deal.” Axelson, Inc. v. McEvoy-Willis, 7 F.3d 1230, 1232 (5th Cir. 1993). A contract for the sale of goods may be made in any manner sufficient to show agreement, including conduct by both parties which recognizes the existence of such a contract. Tex. Bus. & Com. Code Ann. §§ 2.201–.210. Generally, a price quotation, such as one appearing in a brochure or on a flyer, is not considered an offer; rather, it is typically viewed as an invitation to offer. Despite this general rule, a price quotation, if detailed enough, can constitute an offer capable of acceptance. However, to do so, it must reasonably appear from the price quote that assent to the quote is all that is needed to ripen the offer into a contract. Purchase Order 45850 The first e-mailed price quotation was sent from USSI to J.D. Fields on February 6, 2008. The price quotation contained the following: (i) a specified price per ton, (ii) specified payment term, (iii) a general delivery time, (iv) a validity period (“valid for 14 days”), (v) specified rolling/manufacturing time frame, (vi) product specification, (vii) the quantity (800 feet), and (viii) that the price quote was subject to heat lot accumulation of 100 tons. The price quote did not contain the specific shipping location, the mode of shipping, or the legal terms and conditions. Five days after receiving this price quote, J.D. Fields faxed USSI Purchase Order 45850.

Purchase Order 45850 contained a different quantity than the initial inquiry. That is, the purchase order requested 880 feet, whereas the price quote was for 800 feet. Importantly, neither a quantity of 800 feet nor 880 feet was enough to meet the 100ton minimum expressly required by USSI. J.D. Fields, while conceding that its quantity specifications failed to meet this 100-ton minimum, asserts that it told USSI it would increase its order. On March 26, 2008, J.D. Fields’s representative . . . e-mailed USSI’s representative . . . stating that J.D. Fields was “looking into increasing [the] order to . . . the minimum 100 tons.” Similarly, [J.D. Fields] alleged . . . that [its representative] also discussed this order with [the USSI representative] on the phone and stated that, “if need be, we will go up to 100 tons.” The exchange . . . at most establishes that J.D. Fields was considering—or “looking into”—increasing its order to reach the 100-ton minimum. There is no evidence that J.D. Fields in fact did increase its order or that the parties ever reached an agreement as to a quantity term meeting the 100-ton minimum. The quote contained a 14-day validity period. By the time the March 2008 exchange occurred, the validity period for the price quote had long lapsed. Further, [another] USSI representative repeatedly informed [J.D. Fields] that it would need a revised purchase order. J.D. Fields concedes that it never submitted such a revised order. As such, the district court did not err in finding that it was unreasonable as a matter of law for J.D. Fields to believe that the price quotation was an offer. Thus, we affirm the grant of summary judgment as to Purchase Order 45850. Purchase Order 46110 Purchase Order 46110 falls on different footing than Purchase Order 45850. While the general rule is that a price quote is not an offer, we have held that a price quote, if detailed enough, can constitute an offer capable of acceptance. In Tubelite, Inc. v. Risica & Sons, Inc., 819 S.W.2d 801, 803 (Tex. 1991), the Texas Supreme Court found a price quotation sufficiently detailed to constitute an offer under the Texas UCC when the quote stated it was valid for 60 days, was signed by Tubelite’s authorized agent, and did not limit acceptance to a specified manner. In [a similar prior case], the lower court had noted that the price quote contained product specifications, service options, and an itemized price breakdown. The price quote . . . likewise contained no language of approval, or any other indicia suggesting that an order would be subject to approval before it was accepted. Here, the price quotation preceding Purchase Order 46110 was considerably detailed. It was also only transmitted to J.D. Fields. See Restatement (Second) of Contracts § 26, cmt c (stating that a “relevant factor” for “determining whether an offer is made” is the “number of persons to whom a communication is addressed”). The quote contained the following information: (i) a specified price, (ii) delivery time, (iii) a validity period (“valid for 14 days”), (iv) specified rolling/manufacturing time frame,



Chapter Ten The Agreement: Offer

(v) product specification, (vi) a reference to the quantity listed in J.D. Fields’s e-mail, and (vii) a delivery location. Further, unlike some of the previous price quotations sent to J.D. Fields from USSI, this particular price quote was devoid of any language which would condition the formation of a contract on some further step. . . . Specifically, J.D. Fields provided evidence that previous e-mailed price quotes were explicitly conditioned on “mill and steel availability” or were “subject to prior sale.” [The J.D. Fields representative] testified via sworn affidavit that it was his understanding that when a quote from USSI gave a validity period without further condition on mill approval, it meant that the representative presenting the quote had already checked with the mill regarding the availability of the steel needed to meet the request. J.D. Fields transmitted Purchase Order 46110 five days after receiving USSI’s price quote, and the purchase order mirrored the terms contained in the price quotation. [The district court relied on industry custom and the parties’ course of dealing to determine that the price quotes could not be offers.] While the district court’s conclusions regarding industry custom and course of dealing in this case are relevant to the issue

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of reasonableness, the UCC never informs that industry custom and course of dealing are alone determinative of the issue of contract formation. As such, industry custom and course of dealing do not compel the conclusion that a price quotation cannot be construed as an offer as a matter of law. Contract formation is a question of fact under Texas law and, here, the price quotation was detailed, transmitted only to J.D. Fields, void of any conditional language, sent in direct response to an inquiry from J.D. Fields’s representative, did not limit acceptance to a specified manner, and contained a validity period. Viewing the evidence in the light most favorable to the nonmovant, there are questions of material fact present as to whether J.D. Fields could reasonably construe the price quote relating to Purchase Order 46110 as an offer. At the summary judgment stage, we may not weigh or decide factual disputes or make credibility determinations. Although we find that summary judgment was not appropriate, we express no view on the ultimate merits of J.D. Fields’s breach of contract claim. Accordingly, the grant of summary judgment as to Purchase Order 46110 is reversed and remanded for further proceedings as the district court may deem appropriate.

The Global Business Environment Under the United Nations Convention on Contracts for the International Sale of Goods (CISG), a proposal will be considered an offer to contract if it is addressed to one or more specific persons, is sufficiently definite, and indicates the intent of the offeror to be bound in

Communication to Offeree When an offeror

communicates the terms of an offer to an offeree, he objectively indicates an intent to be bound by those terms. The fact that an offer has not been communicated, on the other hand, may be evidence that the offeror has not yet decided to enter into a binding agreement. For example, assume that Stevens and Meyer have been negotiating over the sale of Meyer’s restaurant. Stevens confides in his friend Reilly that he plans to offer Meyer $150,000 for the restaurant. Reilly goes to Meyer and tells Meyer that Stevens has decided to offer him $150,000 for the restaurant and has drawn up a written offer to that effect. After learning the details of the offer from Reilly, Meyer telephones Stevens and says, “I accept your offer.” Is Stevens now contractually obligated to buy the restaurant? No. Because Stevens did not communicate the proposal to Meyer, there was no offer for Meyer to accept.

case of acceptance. Unlike the UCC, the CISG does not consider an offer to be sufficiently definite when the price term for goods is left open. The CISG states that the offer must indicate the goods and either expressly or impliedly make a provision for determining the quantity and price.

Special Offer Problem Areas Advertisements Distinguish advertisements that are considered to

LO10-3 be offers from those that are merely invitations to

negotiate.

Generally speaking, advertisements for the sale of goods at specified prices are not considered to be offers. Rather, they are treated as being invitations to offer or negotiate. The same rule is generally applied to signs, handbills, catalogs, price lists, and price quotations (as described in the previous J.D. Fields case). This rule is based on the presumed intent of the sellers involved. It is not reasonable to conclude that a seller who has a limited number of items to sell intends to

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Part Three Contracts

give every person who sees her ad, sign, or catalog the power to bind her to contract. Thus, if Customer sees Retailer’s advertisement of Fantastitab tablet computers for $650 and goes to Retailer’s store indicating his intent to buy the tablet, Customer is making an offer, which Retailer is free to accept or reject. This is so because Customer is manifesting a present intent to contract on the definite terms of the ad. In some cases, however, particular ads have been held to amount to offers. Such ads limit the power of acceptance to one offeree or a small number of offerees, are highly specific about the nature and number of items offered for sale and what is requested in return, and leave nothing further to be negotiated. This specificity precludes the possibility that the offeror could become contractually bound to an infinite number of offerees. In addition, many of the ads treated as offers have required some special performance by would-be buyers or have in some other way clearly indicated that immediate action by the buyer creates a binding agreement. For example, in one classic case,3 a newspaper advertisement that stated, “Saturday 9 A.M. . . . 1 Black Lapin Stole Beautiful, worth $139.50 . . . $1.00 First Come First Served” was held to be an offer. The ad was clear and specific about what was being offered and asked for in exchange—one had to be the first one to appear at the seller’s place of business Lefkowitz v. Great Minneapolis Surplus Store, 86 N.W.2d 689 (Minn. 1957). 3

and pay $1.00—and there were no terms left open for further discussion or negotiation. Moreover, the “first come first served” language limits the number of people who would have the power of acceptance. The potential for unfairness to those who attempt to accept such ads and their fundamental difference from ordinary ads justify treating them as offers.

Rewards Advertisements

offering rewards for lost property, for information, or for the capture of criminals are generally treated as offers for unilateral contracts. To accept the offer and be entitled to the stated reward, offerees must perform the requested act—return the lost property, supply the requested information, or capture the wanted criminal. Some courts have held that only offerees who started performance with knowledge of the offer are entitled to the reward. Other courts, however, have indicated the only requirement is that the offeree know of the reward before completing performance. In reality, the result in most such cases probably reflects the court’s perception of what is fairer given the facts involved in the particular case at hand. In any event, a reward offer must meet the basic requirements of an offer of any kind to be binding. The following Kolodziej case grapples with whether a purported reward offer made on the NBC television news program Dateline manifested the requisite intent and definiteness. While the lower court focused on issues specific to reward offers (like whether the offeree knew of the reward terms prior to performing), the appeals court targets the validity of the offer itself.

Kolodziej v. Mason   774 F.3d 736 (11th Cir. 2014) In 2006, James Cheney Mason, through his law firm J. Cheney Mason, P.A., represented Nelson Serrano in a Florida murder trial in which Serrano was accused of murdering four people on December 3, 1997, about 60 miles outside of Orlando, Florida. During Serrano’s highly publicized capital murder trial, Mason participated in an interview with NBC News, which aired on the primetime television show Dateline, in which he focused on the seeming implausibility of the prosecution’s theory of the case. Indeed, his client ostensibly had an alibi—on the day of the murders, Serrano claimed to be on a business trip in an entirely different state, several hundred miles away from the scene of the crimes in central Florida. Hotel surveillance video confirmed that Serrano was at an Atlanta, Georgia, La Quinta Inn, several hours before and after the murders occurred in Bartow, Florida. Nevertheless, the prosecution maintained that Serrano committed the murders in an approximately ten-hour span between the times that he was seen on the security camera. According to the prosecution, after being recorded by the hotel security camera in the early afternoon, Serrano slipped out of the hotel and, traveling under several aliases, flew from Atlanta to Orlando, where he rented a car, drove to Bartow, and committed the murders. From there, Serrano allegedly drove to the Tampa International Airport, flew back to Atlanta, and drove from the Atlanta International Airport to the La Quinta, to make an appearance on the hotel’s security footage once again that evening. Mason argued that it was impossible for his client to have committed the murders in accordance with this timeline; for instance, for the last leg of the journey, Serrano would have had to get off a flight in Atlanta’s busy airport, travel to the La Quinta several miles away, and arrive in that hotel lobby in only 28 minutes. After extensively describing the delays that would take place to render that 28-minute timeline even more unlikely, Mason stated in his Dateline interview, “I challenge anybody to show me, and guess what? Did they bring in any evidence to say that somebody made that route, did so? State’s burden of proof. If they can do it, I’ll challenge ’em. I’ll pay them a million dollars if they can do it.”



Chapter Ten The Agreement: Offer

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Dustin Kolodziej, then a law student at the South Texas College of Law, had been following the Serrano case and saw the edited version of Mason’s interview, which aired on Dateline. Kolodziej understood the statement as a serious challenge, open to anyone, to “make it off the plane and back to the hotel within [28] minutes”—that is, in the prosecution’s timeline—in return for $1 million. Kolodziej subsequently ordered and studied the Dateline transcript of the edited interview, interpreting it as an offer to form a unilateral contract—an offer he decided to accept by performing the challenge. In December 2007, Kolodziej recorded himself retracing Serrano’s alleged route, traveling from a flight at the Atlanta airport to what he believed was the former location of the now-defunct La Quinta within 28 minutes. Kolodziej then sent Mason a copy of the recording of his journey and a letter stating that Kolodziej had performed the challenge and requested payment. Mason responded with a letter in which he refused payment and denied that he made a serious offer in the interview. Kolodziej again demanded payment, and Mason again refused. Kolodziej sued in Texas, but that lawsuit was dismissed for lack of personal jurisdiction over Mason. Thereafter, Kolodziej discovered the existence of Mason’s unedited interview with NBC and learned that Dateline had independently edited the interview before it aired. (Mason was unaware of that editing, or that the interview in any form had aired, until he received the demand of payment from Kolodziej.) Kolodziej subsequently filed suit in the U.S. District Court for the Northern District of Georgia. That suit was transferred to the Middle District of Florida, where Mason moved for summary judgment. The district court granted summary judgment on two grounds: First, Kolodziej was unaware of the unedited Mason interview at the time he attempted to perform the challenge, and thus he could not accept an offer he did not know existed; second, the challenge in the unedited interview was unambiguously directed to the prosecution only, and thus Kolodziej could not accept an offer not open to him. The district court declined to address the arguments that Mason’s challenge was not a serious offer and that, in any event, Kolodziej did not adequately perform the challenge. This appeal ensued. Wilson, Circuit Judge We do not find that Mason’s statements were such that a reasonable, objective person would have understood them to be an invitation to contract, regardless of whether we look to the unedited interview or the edited television broadcast seen by Kolodziej. Neither the content of Mason’s statements, nor the circumstances in which he made them, nor the conduct of the parties reflects the assent necessary to establish an actionable offer—which is, of course, essential to the creation of a contract. As a threshold matter, the “spoken words” of Mason’s purported challenge do not indicate a willingness to enter into a contract. Even removed from its surrounding context, the edited sentence that Kolodziej claims creates Mason’s obligation to pay (that is, “I challenge anybody to show me—I’ll pay them a million dollars if they can do it”) appears colloquial. The exaggerated amount of “a million dollars”—the common choice of movie villains and schoolyard wagerers alike—indicates that this was hyperbole. As the district court noted, “courts have viewed such indicia of jest or hyperbole as providing a reason for an individual to doubt that an ‘offer’ was serious.” See Kolodziej v. Mason, 996 F. Supp. 2d 1237, 1252 (M.D. Fla. 2014) (discussing, in dicta, a laughter-eliciting joke made by Mason’s co-counsel during the interview). Thus, the very content of Mason’s spoken words “would have given any reasonable person pause, considering all of the attendant circumstances in this case.” See id. Those attendant circumstances are further notable when we place Mason’s statements in context. As Judge Learned Hand once noted, “the circumstances in which the words are used is always relevant and usually indispensable.” N.Y. Trust Co. v. Island Oil & Transp. Corp., 34 F.2d 655, 656 (2d Cir. 1929). . . . Here, Mason made the comments in the course of representing

a criminal defendant accused of quadruple homicide and did so during an interview solely related to that representation. Such circumstances would lead a reasonable person to question whether the requisite assent and actionable offer giving rise to contractual liability existed. Certainly, Mason’s statements—made as a defense attorney in response to the prosecution’s theory against his client—were far more likely to be a descriptive illustration of what that attorney saw as serious holes in the prosecution’s theory instead of a serious offer to enter into a contract. Nor can a valid contract be inferred in whole or in part from the parties’ conduct in this case. By way of comparison, consider Lucy v. Zehmer, 196 Va. 493, 84 S.E.2d 516 (1954), the classic case describing and applying what we now know as the objective standard of assent. That court held that statements allegedly made “in jest” could result in an offer binding the parties to a contract, since “the law imputes to a person an intention corresponding to the reasonable meaning of his words and acts.” Id. at 522. Therefore, “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.” Id. In so holding, the Lucy court considered that the offeror wrote, prepared, and executed a writing for sale; the parties engaged in extensive, serious discussion prior to preparing the writing; the offeror prepared a second written agreement, having changed the content of the writing in response to the offeree’s request; the offeror had his wife separately sign the writing; and the offeror allowed the offeree to leave with the signed writing without ever indicating that it was in jest. Id. at 519–22. Given that these “words and acts, judged by a reasonable standard, manifest[ed] an intention to agree,” the offeror’s “unexpressed state of . . . mind” was

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Part Three Contracts

immaterial. Id. at 522. Under the objective standard of assent, the Lucy court found that the parties had formed a contract. See id. Applying the objective standard here leads us to the real million-dollar question: “What did the party say and do?” Here, it is what both parties did not say and did not do that clearly distinguishes this case from those cases where an enforceable contract was formed. Mason did not engage in any discussion regarding his statements to NBC with Kolodziej, and, prior to Kolodziej demanding payment, there was no contact or communication between the parties. Mason neither confirmed that he made an offer nor asserted that the offer was serious. Mason did not have the payment set aside in escrow; nor had he ever declared that he had money set aside in case someone proved him wrong. Mason had not made his career out of the contention that the prosecution’s case was implausible; nor did he make the statements in a commercial context for the “obvious purpose of advertising or promoting [his] goods or business.” He did not create or promote the video that included his statement, nor did he increase the amount at issue. He did not, nor did the show include, any information to contact Mason about the challenge. Simply put, Mason’s conduct lacks any indicia of assent to contract. In fact, none of Mason’s surrounding commentary—either in the unedited original interview or in the edited television broadcast—gave the slightest indication that his statement was anything other than a figure of speech. In the course of representing his client, Mason merely used a rhetorical expression to raise questions as to the prosecution’s case. We could just as easily substitute a comparable idiom such as “I’ll eat my hat” or “I’ll be a monkey’s uncle” into Mason’s interview in the place of “I’ll pay them a million dollars,” and the outcome would be the same. We would not be inclined to make him either consume his headwear or assume a simian relationship were he to be proven wrong; nor will we make him pay one million dollars here. Additionally, an enforceable contract requires mutual assent as to sufficiently definite essential terms. . . . Here, even the proper starting and ending points for Mason’s purported challenge were unspecified and indefinite; Kolodziej had to speculate and decide for himself what constituted the essential terms of the challenge. For instance, in the prosecution’s theory of the

case, Serrano, using an alias, was seated in the coach section of an aircraft loaded with over one hundred other passengers. Kolodziej, however, purchased a front row aisle seat in first class and started the twenty-eight-minute countdown from that prime location. Comparably, Kolodziej did not finish his performance in the La Quinta lobby; rather, Kolodziej ended the challenge at an EconoLodge, which, based on anecdotal information, he believed was the former location of the La Quinta in which Serrano stayed. We highlight these differences not to comment as to whether Kolodziej adequately performed the challenge—which the parties dispute for a multitude of additional reasons—but instead to illustrate the lack of definiteness and specificity in any purported offer (and absence of mutual assent thereto). It is challenging to point to anything Mason said or did that evinces a “display of willingness to enter into a contract on specified terms, made in a way that would lead a reasonable person to understand that an acceptance, having been sought, will result in a binding contract.” See Black’s Law Dictionary 1189 (9th ed. 2009) (defining “offer” in contract law). Therefore, we conclude that Mason did not manifest the requisite willingness to contract through his words or conduct, and no amount of subsequent effort by Kolodziej could turn Mason’s statements into an actionable offer.

Auctions Sellers

as being “without reserve,” the seller is treated as having made an offer to sell the goods to the highest bidder and the goods cannot be withdrawn after a call for bids has been made unless no bids are made within a reasonable time.4

at auctions are generally treated as making an invitation to offer. Those who bid on offered goods are, therefore, treated as making offers that the owner of the goods may accept or reject. Acceptance occurs only when the auctioneer strikes the goods off to the highest bidder; the auctioneer may withdraw the goods at any time before acceptance. However, when an auction is advertised

*** Just as people are free to contract, they are also free from contract, and we find it neither prudent nor permissible to impose contractual liability for offhand remarks or grandstanding. Nor would it be advisable to scrutinize a defense attorney’s hyperbolic commentary for a hidden contractual agenda, particularly when that commentary concerns the substantial protections in place for criminal defendants. Having considered the content of Mason’s statements, the context in which they were made, and the conduct of the parties, we do not find it reasonable to conclude that Mason assented to enter into a contract with anyone for one million dollars. We affirm the district court’s judgment in favor of Mason. . . . AFFIRMED.

These rules and others concerned with the sale of goods by auction are contained in section 2-328 of the UCC. 4



Chapter Ten The Agreement: Offer

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CYBERLAW IN ACTION On April 27, 2020, the Twitter account for the streaming service Disney+ posted a thread of tweets including the following:

•  “Celebrate the Saga! Reply with your favorite

­ StarWars memory and you may see it somewhere # special on #MayThe4th.” • “By sharing your message with us using #MayThe4th, you agree to our use of the message and your account name in all media and our terms of use. . . .” The latter tweet included a link to The Walt Disney Company Terms of Use. After around five hours and numerous replies and retweets criticizing the notion that Disney might claim rights

Bids The

in tweets that used the hashtag MayThe4th, the thread was updated with the following: “The above legal language applies ONLY to replies to this tweet using #MayThe4th and mentioning @DisneyPlus. These replies may appear in something special on May the 4th!” According to the legal rules and principles discussed in this chapter (and particularly in light of the analysis in the Cordas case below), would you expect that the original Twitter thread is an offer for a unilateral contract that would bind anyone tweeting with #MayThe4th to grant Disney rights in their tweet and subject them to the Terms of Use? Does the follow-up tweet clarifying that only replies to the original tweet and mentioning @DisneyPlus change the analysis at all?

so that it can determine the terms of the parties’ contract. Put another way, which terms of the offer are binding on the offeree who accepts it? Should offerees, for example, be bound by fine-print clauses or by clauses on the back of the contract? Originally, the courts tended to hold that offerees were bound by all the terms of the offer on the theory that every person had a duty to protect himself by reading agreements carefully before signing them. In today’s world of lengthy, complex form contracts, however, people often sign agreements that they have not fully read or do not fully understand. Modern courts tend to recognize this fact by saying that offerees are bound only by terms of which they had actual or reasonable notice. If the offeree actually read the term in question, or if a reasonable person should have been aware of it, it will probably become part of the parties’ contract. A fine-print provision on the back of a theater ticket would probably not be binding on a theater patron, however, because a reasonable person would not normally expect such a ticket to contain contractual terms. By contrast, the terms printed on a multipage airline ticket might well be considered binding on the purchaser if such documents would be expected to contain terms of the contract. In the following Cordas  case, the court applies these Which Terms Are Included in the Offer?   principles in a thoroughly modern context—terms and conAfter making a determination that an offer existed, a ditions of a ride-sharing app. court must decide which terms were included in the offer bidding process is a fertile source of contract disputes. Advertisements for bids are generally treated as invitations to offer. Those who submit bids are treated as offerors. According to general contract principles, bidders can withdraw their bids at any time prior to acceptance by the offeree inviting the bids, and the offeree is free to accept or reject any bid. The previously announced terms of the bidding may alter these rules, however. For example, if the advertisement for bids unconditionally states that the contract will be awarded to the lowest responsible bidder, this will be treated as an offer that is accepted by the lowest bidder. Only proof by the offeror that the lowest bidder is not responsible can prevent the formation of a contract. Also, under some circumstances discussed later in this chapter, promissory estoppel may operate to prevent bidders from withdrawing their bids. Bids for governmental contracts are generally covered by specific statutes rather than by general contract principles. Such statutes ordinarily establish the rules governing the bidding process, often require that the contract be awarded to the lowest bidder, and frequently establish special rules or penalties governing the withdrawal of bids.

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Part Three Contracts

Cordas v. Uber Technologies, Inc.    228 F. Supp. 3d 985 (N.D. Cal. 2017)

In July 2015, Michael Cordas downloaded the Uber ride-sharing app and attempted to request a ride in New York City. His requested ride did not appear after the estimated 10-minute arrival time elapsed, and Cordas was unsuccessful in his attempts to contact the driver. Cordas received a notification from Uber that he would be charged $10 for canceling his ride, but he denies ever canceling. Cordas later experienced similar incidents in Toronto and Irvine, California. Cordas sued Uber on behalf of himself and a similarly situated class of Uber users, alleging that Uber purposely was generating millions of dollars in cancellation fees through deceptive, false, misleading, and illusory business policies and practices. According to the testimony of the Uber engineer manager responsible for overseeing the rider sign-up and registration process, which was given during a pretrial hearing, no Uber account could be created unless the user navigated through the screen containing a notice stating, “By creating an Uber account, you agree to the Terms & Conditions and Privacy Policy.” The same screen required the new registrant to click “DONE” in order to create an account. The phrase “Terms & Conditions and Privacy Policy” was displayed in a clickable box that linked a user to the pages containing the then-current terms and conditions and privacy policies. The Terms & Conditions included the following provision: ARBITRATION. You agree that any dispute, claim or controversy arising out of or relating to these Terms or the breach, termination, enforcement, interpretation or validity thereof or the use of the Services (collectively, “Disputes”) will be settled by binding arbitration between you and Uber, except that each party retains the right to bring an individual action in small claims court and the right to seek injunctive or other equitable relief in a court of competent jurisdiction to prevent the actual or threatened infringement, misappropriation or violation of a party’s copyrights, trademarks, trade secrets, patents or other intellectual property rights. You acknowledge and agree that you and Uber are each waiving the right to a trial by jury or to participate as a plaintiff or class in any purported class or representative proceeding. Further, unless both you and Uber otherwise agree in writing, the arbitrator may not consolidate more than one person’s claims, and may not otherwise preside over any form of any class or representative proceeding. The Uber engineer manager presented evidence showing that Cordas had registered and clicked “DONE,” indicating his agreement to the Terms & Conditions. Thus, Uber filed a motion to compel arbitration. Seeborg, District Judge Cordas raises a number of arguments for why Uber’s motion to compel arbitration should be denied. They are all unavailing. *** Cordas . . . argues Uber’s terms and conditions amount to an unenforceable “browsewrap” agreement. “[A] browsewrap agreement does not require the user to manifest assent to the terms and conditions expressly . . . [a] party instead gives his assent simply by using the website.” Nguyen v. Barnes & Noble Inc., 763 F.3d 1171, 1176 (9th Cir. 2014). “Thus, by visiting the website— something that the user has already done—the user agrees to the Terms of Use. . . .” Id. “Because no affirmative action is required by the website user to agree to the terms of a contract other than his or her use of the website, the determination of the validity of the browsewrap contract depends on whether the user has actual or constructive knowledge of a website’s terms and conditions.” Id. “Courts have . . . been more willing to find the requisite notice for constructive assent where the browsewrap agreement resembles a clickwrap agreement—that is, where the user is required to affirmatively acknowledge the agreement before proceeding with use of the website.” Id. (citing Fteja v. Facebook, Inc., 841 F. Supp.

2d 829, 838 (S.D.N.Y. 2012) (finding user assented by clicking “Sign Up” after being presented with notice stating: “By clicking Sign Up, you are indicating that you have read and agree to the Terms of Service.”)). The agreement at issue is not a browsewrap agreement; an Uber user is not told he has assented to Uber’s terms and conditions simply by passively viewing one screen of the Uber app. Instead, he must affirmatively assent to Uber’s terms and conditions by clicking “DONE” to complete his sign-up process on a page clearly displaying the notice: “By creating an Uber account, you agree to the Terms & Conditions and Privacy Policy.” Only by clicking “DONE” does the user assent. If he does not create an account, he does not agree to Uber’s terms and conditions. By creating an account on the Uber app, Cordas “affirmatively acknowledge[d] the agreement” and is bound by its terms. Thus, the parties agreed to arbitrate. . . .  *** CONCLUSION Uber’s motion to compel arbitration is granted, and the case is hereby stayed, pending completion of the arbitration. . . . IT IS SO ORDERED.



Chapter Ten The Agreement: Offer

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Ethics and Compliance in Action Jerry, who was in the process of opening a new small business in Connecticut, ordered an expensive new computer system from ABC Computing. As part of this transaction, ABC presented Jerry with a contract of sale. The contract was written on lightweight paper that was difficult to read. The signature line was on the bottom of the first page, but there were more contract terms on the reverse side of the page. On the reverse side, under the heading “Warranty Service,” was a provision that disclaimed all implied warranties and stated that any dispute that might arise between the parties would be resolved

Termination of Offers LO10-4

Describe the circumstances that terminate an offer and determine whether a given offer remains “on the table.”

After a court has determined the existence and content of an offer, it must determine the duration of the offer. Was the offer still in existence when the offeree attempted to accept it? If not, no contract was created and the offeree is treated as having made an offer that the original offeror is free to accept or reject. This is so because, by attempting to accept an offer that has terminated, the offeree has indicated a present intent to contract on the terms of the original offer though he lacks the power to bind the offeror to a contract due to the original offer’s termination.

Terms of the Offer The offeror is often said to

be “the master of the offer.” This means that offerors have the power to determine the terms and conditions under which they are bound to a contract. An offeror may include terms in the offer that limit its effective life. These may be specific terms, such as “you must accept by December 5, 2010,” or “this offer is good for five days,” or more general terms such as “for immediate acceptance,” “prompt wire acceptance,” or “by return mail.” General time-limitation language in an offer can raise difficult problems of interpretation for courts trying to decide whether an offeree accepted before the offer terminated. Even more specific language, such as “this offer is good for five days,” can cause problems if the offer does not specify whether the five-day period begins when the offer is sent or when the offeree receives it. Not all courts agree on such questions, so wise offerors should be as specific as possible in stating when their offers terminate.

by arbitration in California (where ABC is headquartered). Jerry signed the contract without reading the reverse side. The computer system was defective and never worked correctly. Jerry wants to sue ABC Computing but cannot afford to go to California to do so. Is it ethical for businesses who deal with consumers and other less-sophisticated parties to “hide” contract terms under misleading headings, in small print, deep in a website, or on the reverse side of the contract? If not, what sort(s) of organizational checks need to be in place at companies like ABC Computing to avoid putting consumers or less-sophisticated parties in that position?

Lapse of Time Offers that fail to provide a specific

time for acceptance are valid for a reasonable time. What constitutes a reasonable time depends on the circumstances surrounding the offer. How long would a reasonable person in the offeree’s position believe the offer is open and subject to acceptance? Offers involving things subject to rapid fluctuations in value, such as stocks, bonds, or commodities futures, have a very brief duration. The same is true for offers involving goods that may spoil, such as produce. The context of the parties’ negotiations is another factor relevant to determining the duration of an offer. For example, most courts hold that when parties bargain face-to-face or over the telephone, the normal time for acceptance does not extend past the conclusion of their conversation unless the offeror indicates a contrary intention. Where negotiations are carried out by mail or other time-delayed forms of communication, the time for acceptance would ordinarily include at least the normal time for communicating the offer and a prompt response by the offeree. Finally, in cases where the parties have dealt with each other on a regular basis in the past, the timing of their prior transactions would be highly relevant in measuring the reasonable time for acceptance.

Revocation General Rule: Offers Are Revocable As the masters of their offers, offerors can give offerees the power to bind them to contracts by making offers. They can also terminate that power by revoking their offers. The general common law rule on revocations is that offerors may revoke their offers at any time prior to acceptance, even if they have promised to hold the offer open for a stated period of time. Exceptions to the General Rule In the following situations (summarized in Figure 10.1), however, offerors are not free to revoke their offers:

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Part Three Contracts

Figure 10.1 When Offerors Cannot Revoke Options

Offeror has promised to hold offer open and has received consideration for that promise.

Unilateral Contract Offers

Offeree has started to perform requested act before offeror revokes.

Promissory Estoppel

Offeree foreseeably and reasonably relies on offer being held open, and will suffer injustice if it is revoked.

Firm Offers

Merchant offeror makes written offer to buy or sell goods, giving assurances that the offer will be held open. [Maximum duration is three months or the amount of time in the assurance, whichever is shorter.]

1. Options. An option is a separate contract in which an offeror agrees not to revoke the offer for a stated time in exchange for some valuable consideration. You can think of it as a contract in which an offeror sells to the offeree the right the offeror usually retains to revoke the offer. For example, Jones, in exchange for $5,000, agrees to give Dewey Development Co. a six-month option to purchase her farm for $550,000. In this situation, Jones would not be free to revoke the offer during the six-month period of the option. The offeree, Dewey Development, has no obligation to accept Jones’s offer. In effect, it has merely purchased the right to consider the offer for the stated time without fear that Jones will revoke it. 2. Offers for unilateral contracts. Suppose Franklin makes the following offer for a unilateral contract to Waters: “If you mow my lawn, I’ll pay you $25.” Given that an offeree in a unilateral contract must fully perform the requested act to accept the offer, can Franklin wait until Waters is almost finished mowing the lawn and then say “I revoke!”? Obviously, the application of the general rule that offerors can revoke at any time before acceptance creates the potential for injustice when applied to offers for unilateral contracts because it would allow an offeror to revoke after the offeree has begun performance but before the offeree has had a chance to complete it. To prevent injustice to offerees who rely on such offers by beginning performance, two basic approaches are available to modern courts.  Some courts have held that once the offeree has begun to perform, the offeror’s power to revoke is suspended for the amount of time reasonably necessary for the offeree to complete performance. Another approach to the

unilateral contract dilemma is to hold that a bilateral contract is created once the offeree begins performance. 3. Promissory estoppel. In some cases in which the offeree relies on the offer being kept open, the doctrine of promissory estoppel can operate to prevent offerors from revoking their offers prior to acceptance. Section 87(2) of the Restatement (Second) says: An offer which the offeror should reasonably expect to induce action or forbearance of a substantial character on the part of the offeree before acceptance and which does induce such action or forbearance is binding as an option contract to the extent necessary to avoid injustice.

Many of the cases in which promissory estoppel has been used successfully to prevent revocation of offers involve the bidding process. For example, Gigantic General Contractor seeks to get the general contract to build a new high school gymnasium for Shadyside School District. It receives bids from subcontractors. Liny Electric submits the lowest bid to perform the electrical work on the job, and Gigantic uses Liny’s bid in preparing its bid for the general contract. Here, Liny has made an offer to Gigantic, but Gigantic cannot accept that offer until it knows whether it has gotten the general contract. The school district awards the general contract to Gigantic. Before Gigantic can accept Liny’s offer, however, Liny attempts to revoke it. In this situation, a court could use the doctrine of promissory estoppel to hold that the offer could not be revoked. 4. Firm offers for the sale of goods [Note: This applies to offers for the sale of goods ONLY!]. The UCC makes a major change in the common law rules governing the revocability of offers by recognizing the concept of a firm offer [2-205]. Like an option, a firm offer is irrevocable for a period of time. In contrast to an option, however, a firm offer does not require consideration to be given in exchange for the offeror’s promise to keep the offer open. Not all offers to buy or sell goods qualify as firm offers, however. To be a firm offer, an offer must: • Be made by an offeror who is a merchant. • Be contained in a signed writing.5 • Give assurances that the offer will be kept open. An offer to buy or sell goods that fails to satisfy these three requirements is governed by the general common law rule and is revocable at any time prior to acceptance. If an offer does meet the requirements of a firm offer, however, it will be irrevocable for the time stated in the offer. If no specific time is stated in the offer, it will be irrevocable Under the UCC [1-201(39)], the word signed includes any symbol that a person makes or adopts with the intent to authenticate a writing. 5



Chapter Ten The Agreement: Offer

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CONCEPT REVIEW What Terminates Offers? • Their own terms • Lapse of time • Revocation

• Rejection • Death or insanity of offeror or offeree • Destruction of subject matter

• Intervening illegality

The Global Business Environment Several of the kinds of factors that make offers irrevocable in the United States—such as consideration and, in the case of firm offers, writing—are not required to make offers irrevocable under the CISG. The CISG states that an offer cannot be revoked if it indicates that

for a reasonable time. Regardless of the terms of the firm offer, the outer limit on a firm offer’s irrevocability is three months. For example, if Worldwide Widget makes an offer in a signed writing in which it proposes to sell a quantity of its XL Turbo Widget to Howell Hardware and gives assurances that the offer will be kept open for a year, the offer is a firm offer, but it can be revoked after three months if Howell Hardware has not yet accepted it. In some cases, however, offerees are the true originators of an assurance term in an offer. When offerees have effective control of the terms of the offer by providing their customers with preprinted purchase order forms or order blanks, they may be tempted to take advantage of their merchant customers by placing an assurance term in their order forms. This would allow offerees to await market developments before deciding whether to fill the order, while their merchant customers, who may have signed the order without reading all of its terms, would be powerless to revoke. To prevent such unfairness, the UCC requires that assurance terms on forms provided by offerees be separately signed by the offeror to effect a firm offer. For example, if Fashionable Mfg. Co. supplies its customer, Retailer, with preprinted order forms that contain a fine-print provision giving assurances that the customer’s offer to purchase goods will be held open for one month, the purported promise to keep the offer open would not be enforceable unless Retailer separately signed that provision. Time of Effectiveness of Revocations The question of when a revocation is effective to terminate an offer is often a critical issue in the contract formation process. For example, Davis offers to landscape Winter’s property for

it is irrevocable or if it was reasonable for the offeree to rely on the offer as being irrevocable and the offeree has acted in reliance on the offer. However, even when an offer is irrevocable, the CISG allows it to be revoked if the revocation reaches the offeree before or at the same time as the offer.

$1,500. Two days after making the offer, Davis changes his mind and mails Winter a letter revoking the offer. The next day, Winter, who has not received Davis’s letter, telephones Davis and attempts to accept. Contract? Yes. The general rule on this point is that revocations are effective only when they are actually received by the offeree. The only major exception to the general rule on effectiveness of revocations concerns offers to the general public. Because it would be impossible in most cases to reach every offeree with a revocation, it is generally held that a revocation made in the same manner as the offer is effective when published, without proof of communication to the offeree.

Rejection An

offeree may expressly reject an offer by indicating that the offeree is unwilling to accept it. The offeree may also impliedly reject it by making a counteroffer, an offer to contract on terms materially different from the terms of the offer. As a general rule, either form of rejection by the offeree terminates the offeree’s power to accept the offer. This is so because an offeror who receives a rejection may rely on the offeree’s expressed desire not to accept the offer by making another offer to a different offeree. Identifying whether a response is a counteroffer and, thus, a rejection is not always straightforward. The following D’Agostino case engages in that analysis with regard to a potential agreement settling a disputed legal claim. One exception to the general rule that rejections terminate offers concerns offers that are the subject of an option contract. Some courts hold that a rejection does not terminate an option contract and that the offeree who rejects still has the power to accept the offer later, so long as the acceptance is effective within the option period.

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Part Three Contracts

D’Agostino v. Federal Insurance Company    969 F. Supp. 2d 116 (D. Mass. 2013) Miia C. D’Agostino was the sole beneficiary of the Bruno D’Agostino Trust. (A trust is a relationship created by one person, the settlor, in which a trustee holds or manages the settlor’s property solely for the benefit of one or more others, the beneficiaries.) The D’Agostino Trust owned a multifamily residential property located in Cambridge, Massachusetts. The property was substantially damaged in a fire on December 9, 2008. It was insured by Federal Insurance Company under a policy issued to Bank of America, which acted as trustee for the D’Agostino Trust. Federal and D’Agostino disputed the amount of money to which D’Agostino was entitled to compensate for her losses. D’Agostino filed this lawsuit against Federal, claiming breach of contract and charging that Federal engaged in unfair and deceptive practices under Massachusetts law. Nonetheless, D’Agostino’s attorney, Richard Goren, and Federal’s attorneys continued to engage in negotiations to settle the claims. D’Agostino’s conditions for settlement included an amount of money in exchange for a full release of any claims against Federal, while clearly maintaining her right to sue Bank of America. Federal had been generally agreeable but wanted D’Agostino to guarantee that she would indemnify Federal against any claims Bank of America might press against Federal. (To indemnify another party means to reimburse or promise to reimburse them from a loss or to otherwise act as security or protection against that loss.)   On February 6, 2009, Goren sent a settlement offer to Federal’s attorneys demanding a monetary settlement of $1.15 million, releasing the claims against Federal, and reserving D’Agostino’s right to sue Bank of America. Goren, however, explicitly and definitively rejected the notion that D’Agostino might indemnify Federal against Bank of America’s potential claims. Eventually, Federal’s attorneys formally responded to Goren’s settlement offer with a seven-page “Confidential Release and Settlement Agreement.” Among the Release’s 18 paragraphs was an agreement to pay D’Agostino $1.15 million in return for a release of her claims against Federal (though not against Bank of America). In addition, the Release included clauses addressing choice of law, termination of the litigation, nondisparagement, confidentiality, and indemnification. Some of these were boilerplate; others were more substantive. D’Agostino purported to reject the Release and continued to litigate the case against Federal. In response, Federal filed an “Emergency Motion to Enforce Settlement Agreement” with the court, arguing that the Release was an acceptance of D’Agostino’s settlement offer. Dein, U.S. Magistrate Judge The critical issue raised by Federal’s motion[] is whether the parties reached an enforceable settlement agreement. The court has “an inherent power to supervise and enforce settlement agreements entered into by parties to an action pending before the court.” Dankese v. Defense Logistics Agency, 693 F.2d 13, 16 (1st Cir. 1982). . . . In order to form a contract under Massachusetts law, “[a]n offer must be matched by an acceptance. A counteroffer proposing a term that is materially different from that contained in the original offer constitutes a rejection of the offer and negates any agreement.” Kennedy v. JPMorgan Chase Nat’l Corp., No. 10-CV-11324-RGS, 2011 U.S. Dist. LEXIS 44664, at *2 (D. Mass. Apr. 26, 2011) (internal citation omitted). [W]hile “[i]t is not required that all terms of the agreement be precisely specified, and the presence of undefined or unspecified terms will not necessarily preclude the formation of a binding contract[,]” in order for an enforceable contract to exist, the parties must have reached an agreement on all of the essential terms. Situation Mgmt. Sys., Inc. v. Malouf, Inc., 724 N.E.2d 699, 703 (Mass. 2000). As described below, although the parties agreed on certain essential matters, they

failed to reach agreement on all the material terms of a settlement. Therefore, this court concludes that . . . the defendant’s motion[] should be denied. Failure to Reach an Enforceable Settlement Agreement Federal contends that an enforceable settlement agreement was created on February 6, 2013, when its counsel sent Attorney Goren the Release for his client’s execution. In particular, the defendant argues that because the Release contained an agreement by Federal to pay D’Agostino $1.15 million, and provided for the release of the plaintiff’s claims against Federal, it constituted an acceptance of the plaintiff’s settlement offer and resulted in a binding contract. D’Agostino denies that any binding agreement occurred on February 6 or at any other time during the course of the parties’ communications. According to D’Agostino . . . the Release was a counteroffer rather than an acceptance because it contained significant additional terms beyond those set forth in D’Agostino’s proposal. . . . For the reasons that follow, this court finds . . . that Federal’s response to the offer was timely. However, because this court also finds the response was a counteroffer, which was never accepted in full by the plaintiff,



Chapter Ten The Agreement: Offer

this court concludes that there is no enforceable settlement agreement. Nature of Federal’s Response D’Agostino . . . argues that to the extent there was an offer, there was no agreement by the parties because Federal never accepted the offer. Instead, according to D’Agostino, Federal’s transmittal of a Release containing different terms constituted a counteroffer and thereby terminated the defendant’s power to accept the original offer. This court agrees that the defendant’s decision to send a Release containing additional material terms rendered its response a counteroffer, which could only become binding upon the plaintiff’s acceptance. It is undisputed that on February 6, 2013, Federal replied to D’Agostino’s settlement offer by sending her a seven-page Release, along with an e-mail requesting that the plaintiff “execute the release as soon as possible[.]” Although the Release was consistent with the plaintiff’s offer to the extent it provided for a $1.15 million payment to D’Agostino and the release of the plaintiff’s claims against Federal, it contained numerous additional terms beyond those set forth in the plaintiff’s settlement offer. “A reply to an offer which purports to accept it but is conditional on the offeror’s assent to terms additional to or different from those offered is not an acceptance but is a counter-offer.” Restatement (Second) of Contracts § 59 (1981). By asking D’Agostino to sign a document that was conditional upon D’Agostino’s assent to numerous additional terms, Federal rejected the plaintiff’s offer and created a counteroffer. Federal acknowledges that the Release contained various additional terms. Nevertheless, it argues that the Release constituted an acceptance because it expressed Federal’s agreement on the only two material terms that had been articulated by the plaintiff, and all other matters were merely subsidiary. This argument is not persuasive. Where the parties have reached agreement on all material matters, the existence of unresolved subsidiary matters will not preclude enforcement of the contract. Here, however, the Release contained certain additional terms that were essential to a settlement and could not be characterized as “subsidiary.” Therefore, Federal’s response to D’Agostino’s offer did not create a binding agreement. [T]he Release was not limited to standard, boilerplate provisions. It also contained provisions which had not been included in the original offer, and which sought to impose significant obligations upon the plaintiff. For example, the Release contained a lengthy confidentiality provision that imposed strict requirements on the plaintiff, including an obligation to forfeit the entire amount of the $1.15 [million] settlement payment if she were to violate its terms, even absent evidence of any harm to the defendant. Moreover, as set forth in the Release, the plaintiff’s “representations and promises of strict confidentiality . . . go to the essence

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of and form a valuable part of the consideration for [Federal] to make the Settlement Payment and enter into this Agreement[.]” Accordingly, the express language of the document demonstrates that the confidentiality provision was an “essential and inducing feature of the contract” and was therefore material to a settlement agreement. This court also finds that Federal’s inclusion of an indemnity provision introduced a material term which rendered the Release a counteroffer. . . . [T]he indemnity provision would have required D’Agostino to indemnify Federal against claims relating to the December 9, 2008, fire at the Property. Therefore, as the plaintiff argues, “[i]f the Bank were to make a claim against [Federal] as a result of plaintiff’s claims against the Bank, under the Draft Release [Federal] would be entitled to indemnification from plaintiff.” However, Attorney Goren had made it clear at the time he conveyed the plaintiff’s settlement offer on January 17, 2013, that D’Agostino was unwilling to enter into an agreement which would require her to indemnify Federal for any claims which Bank of America might assert against [Federal] or any obligations that Federal might have to the Bank. He reiterated this position following his receipt of the Release, in a letter to Federal’s counsel dated February 22, 2013. As Attorney Goren wrote in his letter, “[i]n previous communications I believe I made clear, and I repeat herein, there will be no separate settlement with [Federal] pursuant to which Ms. D’Agostino will hold [Federal] harmless from any claims or liabilities from third parties.” Thus, the proposed Release varied materially from D’Agostino’s original offer, thereby making it a counteroffer. To the extent Federal now contends that it did not consider these matters essential to a settlement with the plaintiff and would have been willing to dispense with them in order to reach an agreement, its argument is insufficient to support enforcement of a settlement agreement. . . . If Federal actually believed at the time it sent the Release that the additional terms contained therein were immaterial, it could have conveyed that information to the plaintiff or simply accepted the offer on the terms set forth in Attorney Goren’s January 17, 2013, e-mail correspondence. Instead, Federal sent the Release to D’Agostino’s counsel and asked that the plaintiff “execute the release as soon as possible[.]” Because the Release contained material matters beyond those addressed in D’Agostino’s offer, Federal effectively rejected the offer and terminated its power to accept it.

CONCLUSION For . . . the reasons described herein, this court recommends to the District Judge to whom this case is assigned that “Defendant Federal Insurance Company’s Emergency Motion to Enforce Settlement Agreement” be DENIED.

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Part Three Contracts

Time of Effectiveness of Rejections As a general rule, rejections, like revocations, are effective only when actually received by the offeror. Therefore, an offeree who has mailed a rejection could still change her mind and accept if she communicates the acceptance before the offeror receives the rejection.6

Death or Mental Incapacity of Either Party If either party to an offer dies or becomes men-

tally incapacitated (sometimes referred to in cases and other texts as being “insane”), the offer is automatically terminated without notice. Agreement between the parties is clearly impossible when one of them is dead or no longer has the mental capacity to contract.7

Destruction of Subject Matter If, prior to acceptance of an offer, the subject matter of a proposed

contract is destroyed without the knowledge or fault of either party, the offer is terminated.8 So, if Marks offers to sell Wiggins his lakeside cottage and the cottage is destroyed by fire before Wiggins accepts, the offer was terminated on the destruction of the cottage. Subsequent acceptance by Wiggins would not create a contract.

Intervening Illegality An

offer is terminated if the performance of the contract it proposes becomes illegal before the offer is accepted. So, if a computer manufacturer offered to sell sophisticated computer equipment to another country, but two days later, before the offer was accepted, Congress placed an embargo on all sales to this country, the offer was terminated by the embargo.9 In some circumstances, destruction of subject matter can also serve as a legal excuse for a party’s failure to perform obligations under an existing contract. Chapter 18 discusses this subject. 8

Chapter 11 discusses this subject in detail. 7 Even after the formation of a contract, a party who is obligated by it to perform personal services can be excused from that performance based on death or mental incapacity. Chapter 18 discusses this in more detail. 6

Problems and Problem Cases 1. Armstrong and Pottle worked as ceramic grinders at Morton International’s Spencer facility. When the Rohm & Haas Co. (R&H) acquired Morton, it gave employees a month to decide whether to quit and receive a severance payment or transfer to another facility and receive a larger incentive payment. Armstrong and Pottle wanted to keep their jobs, but the plant manager told them that they would make more money if they would resign and start their own business handling R&H’s outsourced grinding work. He stated that R&H would give Armstrong and Pottle’s new business all the outsourced work they could handle and that the company would like to give them all its outsourced work. Armstrong and Pottle followed this advice, and their business failed. In addition, R&H continued giving outsourced work to another firm. Armstrong and Pottle asserted the formation of an oral contract and claimed that R&H breached it. Were they correct? 2. Frank Meram attended a presentation by Robert MacDonald, who was promoting his new book, Cheat to Win. MacDonald was a multimillionaire who had started as an insurance agent and built his company, LifeUSA, to a worth of more than a billion dollars at the time of the presentation. Meram attended along with approximately 100 other people. At the beginning of the presentation, MacDonald announced that one of the attendees would

In some circumstances, intervening illegality can also serve as a legal excuse for a party’s failure to perform obligations under an existing contract. Chapter 18 discusses this subject. 9

leave that day with $1 million. All that was required was to place a business card in the basket that he passed around and to stay until the end of the presentation. MacDonald pulled Meram’s business card from the basket. He congratulated Meram and then explained “how this works.” MacDonald said Meram would receive one dollar per year for a million years. He gave Meram $100 in cash for the first 100 years. According to MacDonald, all Meram had to do was attend a presentation once a year to claim the rest of the million dollars. MacDonald laughed and thanked everyone for coming. Meram, on the other hand, filed suit against MacDonald and his company’s parent, Allianz Sales, seeking the remainder of the promised $1 million. Did MacDonald make a valid offer that Meram accepted by placing his business card in the basket and staying until the end of the presentation?  3. Rodziewicz was driving a 1999 Volvo conventional tractor-trailer on I-90 in Lake County, Indiana, when he struck a concrete barrier. His truck was stuck on top of the barrier, and the state police contacted Waffco Heavy Duty Towing to help in the recovery. Before Waffco began working, Rodziewicz asked how much it would cost to tow the truck. He was told that the fee would be $275, and there was no discussion of labor or other costs. Rodziewicz instructed Waffco to take his truck to a Volvo dealership. After a few minutes of work, Waffco pulled Rodziewicz’s truck off the barrier and towed the truck to its towing yard a few miles away.



Chapter Ten The Agreement: Offer

Subsequently, Waffco notified Rodziewicz that, in addition to the $275 towing fee, he would have to pay $4,070 in labor costs. Waffco calculated its labor charges as $.11 cents per pound. Waffco would not release the truck until payment was made, so Rodziewicz paid the total amount. Was Rodziewicz contractually obligated to pay Waffco the $4,070 labor fee? 4. Comedian Bill Maher appeared on the January 7, 2013, episode of The Tonight Show with Jay Leno. In an interview largely focused on poking fun at politicians, Maher turned his attention to then-real-estate-mogul and reality-television-star Donald Trump, who had recently offered to pay $5 million to the charity of President Barak Obama’s choice, if Obama released his college and passport records and applications. Maher began by noting that an orangutan’s hair was the only thing in nature that matched the color of Trump’s hair. Maher further stated that he would donate $5 million to Trump, which Trump would then donate to a charity of his choice, if Trump would provide evidence that he was not “the spawn of his mother having sex with an orangutan.” Maher suggested Trump might choose the “Hair Club for Men” or the “Institute for Incorrigible Douchebaggery” as his charities. On January 8, Scott Balber, one of Trump’s attorneys, sent a letter to Maher, which stated, “I write on [Donald Trump’s] behalf to accept your offer (made during the Jay Leno Show on January 7, 2013) that Mr. Trump prove he is not ‘the spawn of his mother having sex with an orangutan.’” Balber enclosed with the letter a copy of Trump’s birth certificate, indicating that it showed Trump’s father to be “Fred Trump, not an orangutan” and demanding that Maher “remit $5 million to Mr. Trump immediately.” The letter indicated that Trump would allocate the money in equal shares to four charities. When Maher ignored the letter and a subsequent demand, Trump’s attorneys filed a lawsuit against Maher for breach of contract. Was Maher’s statement on The Tonight Show an offer that created a contractual obligation once Trump accepted by providing evidence of his actual, non-orangutan parentage? 5. Leonard saw a “Pepsi Stuff” commercial encouraging consumers to collect “Pepsi Points” from specially marked packages of Pepsi or Diet Pepsi and redeem these points for merchandise featuring the Pepsi logo. The commercial depicts a teenager preparing to leave for school, dressed in a shirt emblazoned with the Pepsi logo. The drumroll sounds as the subtitle “T-SHIRT 75 PEPSI POINTS” scrolled across the screen. The teenager strides down the hallway wearing a leather jacket, and the subtitle “LEATHER JACKET 1450 PEPSI POINTS” appears. The teenager opens the door of his house and puts on a pair of sunglasses. The drum roll then accompanies the

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subtitle “SHADES 175 PEPSI POINTS.” A voiceover then intones, “Introducing the new Pepsi Stuff catalog.” The scene then shifts to three young boys sitting in front of a high school building. The boy in the middle is intent on his Pepsi Stuff catalog, while the boys on either side are drinking Pepsi. The three boys gaze in awe at an object approaching overhead. The military music swelled, and the viewer senses the presence of a mighty plane as the extreme winds generated by its flight create a paper maelstrom in a classroom devoted to an otherwise dull physics lesson. Finally, a Harrier jet swings into view and lands by the side of the school building, next to a bicycle rack. Several students run for cover, and the velocity of the wind strips one faculty member down to his underwear. The voiceover announces, “Now the more Pepsi you drink, the more great stuff you’re gonna get.” The teenager opens the cockpit of the fighter and can be seen, holding a Pepsi. “Sure beats the bus,” he says. The military drum roll swells a final time and the following words appear: “HARRIER FIGHTER 7,000,000 PEPSI POINTS.” Inspired by the commercial, Leonard set out to get a Harrier jet. He consulted the Pepsi Stuff catalog, but it did not contain any entry or description of the Harrier jet. The amount of Pepsi Points necessary to get the listed merchandise ranged from 15 for a “jacket tattoo” to 3,300 for a mountain bike. The rear foldout pages of the catalog contained directions for redeeming Pepsi Points for merchandise. These directions note that merchandise may be ordered “only” with the original Order Form. The catalog notes that in the event that a consumer lacks enough Pepsi Points to obtain a desired item, additional Pepsi Points may be purchased for 10 cents each; however, at least 15 original Pepsi Points must accompany each order. Leonard initially set out to collect 7,000,000 Pepsi Points by consuming Pepsi products, but then switched to buying Pepsi Points. Leonard ultimately raised about $700,000. In March 1996, Leonard submitted an Order Form, 15 original Pepsi Points, and a check for $700,008.50. At the bottom of the Order Form, Leonard wrote in “1 Harrier Jet” in the “Item” column and “7,000,000” in the “Total Points” column. In a letter accompanying his submission, he stated that the check was to purchase additional Pepsi Points for obtaining a new Harrier jet as advertised in the Pepsi Stuff commercial. Several months later, Pepsico’s fulfillment house rejected Leonard’s submission and returned the check, explaining that the item he requested was not part of the Pepsi Stuff collection, and only catalog merchandise could be redeemed under this program. It also stated, “The Harrier jet in the Pepsi commercial is fanciful and is simply included to create a humorous and entertaining ad.” Leonard sued Pepsico for breach of contract. Will he win?

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Part Three Contracts

6. Pernal owned a parcel of real estate adjacent to property owned by St. Nicholas Greek Orthodox Church. Pernal sent a letter to the church indicating that he was offering it for sale for “$825,000 cash/mortgage, ‘as is,’ with no conditions, no contingencies related to zoning and 120 days post closing occupancy for the present tenants.” This offer was dated June 3, 2003, and expressly provided that it would remain open for a two-week period. On the same day, Pernal also sent the same offer to sell the property on the same terms to another prospective purchaser, White Chapel Memorial Association Park Perpetual Care Trust. On June 4, the church sent a letter indicating that it accepted the terms of the offer that Pernal had set forth in his letter. However, the church’s letter also referenced an attached purchase agreement. The purchase agreement agreed with Pernal’s purchase price and the close occupancy period, but contrary to the offer, it contained additional terms. The church’s president signed this attached purchase agreement, but defendant did not sign it. The offer by letter dated June 3, 2003, did not reference other potential purchasers. On June 10, White Chapel, by letter, offered to pay $900,000 cash for the property, with no conditions or contingencies related to zoning and 180 days post closing occupancy rent free. On that same date (June 10), Pernal sent a letter to both potential purchasers. This letter indicated that “amended offers” had been received. The letter further provided that the offer would remain open for two weeks’ time as provided in the initial offering letter. On June 13, the church sent a letter to Pernal, stating that the offer had been accepted on June 4, and that an enforceable contract was formed. The church sued Pernal for breach of contract. Will it win? 7. Michael Freeman and Cindy Hazen listed an auction on eBay for their historic home, which was once owned by Elvis Presley. A partnership formed to participate in the auction for the home and used partner Peter Gleason’s eBay account to do so. eBay’s terms and conditions state, “eBay Real Estate’s auctions-style advertisements of real property do not involve legally binding offers to buy and sell. Instead, eBay Real Estate’s auctions are simply a way for sellers to advertise their real estate and meet potential buyers.” The sellers’ real estate broker, however, contradicted that language on the home’s eBay auction site, stating the following: “Please note that bidding on eBay is a legally binding contract in which the winner commits to following through on the purchase.” The broker included that language to deter frivolous bids. During the bidding process, Mike Curb offered to buy the house immediately and stop the auction; however, he was not willing to meet the sellers’ $1.3 million ask. So, the auction continued. When the bidding officially ended, an

eBay automated message informed the Gleason partnership that they had submitted the winning bid of just over $900,000. Two days later, the partnership’s real estate agent sent the sellers a “proposed sale contract,” about which they had further discussion. A few days later, Curb renewed his offer to purchase the house, this time for $1 million. The sellers and Curb signed a contract for the sale of the house later that week and refused to sell to the Gleason partnership. The partnership sued for breach of contract arguing that the language the sellers’ broker appended to the listing overrode the eBay terms and conditions and created a binding contract upon their bid being declared a winner. Are the Gleason partners correct? 8. Family Video made a written offer to buy out Home Folks’ lease because it wanted to purchase and open a video store on the property on which Home Folks operated a restaurant. Over four months went by and Home Folks’ operators did not sign the offer. The property was destroyed by fire and then Home Folks signed the offer and attempted to accept. Did Home Folks and Family Video have an enforceable contract? 9. Cynthia Hines purchased a vacuum cleaner online from Overstock.com, believing that she was buying an unused product. When the vacuum cleaner was delivered, however, Hines discovered that it was not new but rather had been “refurbished.” Hines returned the vacuum, and Overstock credited her with the purchase price less a $30 “restocking fee.” Hines brought suit against Overstock on behalf of a class of customers who had been charged such fees. Overstock moved to dismiss the case or stay the action in favor of arbitration, arguing that the “Terms and Conditions” of its website contained an arbitration clause, and therefore, the parties had an agreement to arbitrate the dispute. Overstock presented no evidence, however, that Hines had actually had the opportunity to see or read the Terms and Conditions prior to allegedly “accepting” them simply by using the website. Should the parties be forced to arbitrate? 10. Jeff visited a car dealership and test-drove a used car. After discussing the price with the salesman, Jake, and learning that he could purchase the car for $500 less than the sticker price, Jeff asked Jake to hold the car for him until 8:00 that evening so that he could bring his wife back to see the car. Jake agreed, writing out a note promising not to sell the car before 8:00 P.M. The note was written on dealership stationery, but Jake did not sign his name. The dealership broke its promise and sold the car to Jones before 8:00 P.M. Was it free to revoke its offer to Jeff? Jones, the new purchaser of the car (and a nonmerchant), later offered in a signed writing to sell the car to Jill and to hold the car for her until she returned with her husband. Could Jones revoke this offer?

CHAPTER 11

The Agreement: Acceptance

F

irst Texas Savings Association promoted a “$5,000 Scoreboard Challenge” contest. Contestants who completed an entry form and deposited it with First Texas were eligible for a random drawing. The winner was to receive an $80 savings account with First Texas, plus four tickets to a Dallas Mavericks home basketball game chosen by First Texas. If the Mavericks held their opponent in the chosen game to 89 or fewer points, the winner was to receive an additional $5,000 money market certificate. In October 1982, Jergins deposited a completed entry form with First Texas. On November 1, 1982, First Texas tried to amend the contest rules by posting a notice at its branches that the Mavericks would have to hold their opponent to 85 or fewer points before the contest winner would receive the $5,000. In late December, Jergins was notified that she had won the $80 savings account and tickets to the January 22, 1983, game against the Utah Jazz. The notice contained the revised contest terms. The Mavericks held the Jazz to 88 points at that game. • Did Jergins accept First Texas’s offer? • If so, when was the acceptance effective? • Did First Texas have the right to revoke its original offer? • Does Jergins have the right to collect the $5,000 money market certificate?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 11-1 Explain the elements of an acceptance under both common law and the Uniform Commercial Code (UCC). 11-2 Determine how acceptance can be communicated in a given scenario and analyze the time at which acceptance is likely to be effective.

CHAPTER 10 DISCUSSED the circumstances under which a proposal will constitute the first stage of an agreement: the offer. This chapter focuses on the final stage of forming an agreement: the acceptance. The acceptance is vitally important because it is with the acceptance that the contract is formed. This chapter discusses the requirements for making a valid acceptance as well as the rules concerning the time at which a contract comes into being.

11-3 Identify the circumstances under which silence is acceptance. 11-4 Determine whether an oral acceptance is effective in a situation in which the parties anticipate putting their contract in writing.

What Is an Acceptance? LO11-1

Explain the elements of an acceptance under both common law and the UCC.

An acceptance is “a manifestation of assent to the terms [of the offer] made by the offeree in the manner invited or required by the offer.”1 In determining if an offeree accepted an Restatement (Second) of Contracts § 50(1) (1981).

1

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Part Three Contracts

offer and created a contract, a court will look for evidence of three factors: (1) the offeree intended to enter the contract, (2) the offeree accepted on the terms proposed by the offeror, and (3) the offeree communicated acceptance to the offeror.

Intention to Accept In

determining whether an offeree accepted an offer, the court is looking for the same present intent to contract on the part of the offeree that it found on the part of the offeror. And, as is true of intent to make an offer, intent to accept is judged by an objective standard. The difference is that the offeree must objectively indicate a present intent to contract on the terms of the

offer for a contract to result. As the master of the offer, the offeror may specify in detail what behavior is required of the offeree to bind the offeree to a contract. If the offeror does so, the offeree must ordinarily comply with all the terms of the offer before a contract results. Intent to accept is objectively demonstrated by words or conduct or a combination of the two. The following Long case illustrates how these longstanding, general rules endure even in the face of changes wrought by the increasing incidence of commerce on the Internet. Note how an Internet user’s assent to contract terms is determined by an objective standard.

Long v. Provide Commerce, Inc.   245 Cal. App. 4th 855 (2016) Provide Commerce, Inc. (Provide) is an online retailer that operates several websites, including ProFlowers.com, through which it advertises and sells a variety of floral products. Brett Long purchased a floral arrangement on ProFlowers.com, which he claimed had been depicted on the website as an assembled bouquet, but which arrived as a “do-it-yourself kit” requiring assembly by the buyer. Long sued Provide on behalf of himself and a class of California consumers who purchased similarly depicted floral arrangements on ProFlowers.com. Long relied on a claim pursuant to California’s Consumers Legal Remedies Act and Unfair Competition Law. Provide filed a motion in that case requesting the court to compel arbitration, arguing that Long was bound by the Terms of Use for ProFlowers.com, which included a dispute resolution provision requiring mandatory arbitration of any disputes. According to a series of screenshots of the ProFlowers.com site, which Provide submitted as evidence along with the motion to compel arbitration, the Terms of Use were accessible via a capitalized and underlined hyperlink titled “TERMS OF USE” located at the bottom of each page on the ProFlowers.com site. Each page was lime green in color and the hyperlinked typeface was light green in color. The hyperlink for the Terms of Use was situated alongside 14 other capitalized and underlined hyperlinks of the same color, font, and size. Provide’s evidence also showed that, to complete his order, Plaintiff was required to input information and click through a multipage “checkout flow.” The checkout flow screenshots showed the customer information fields and click-through buttons displayed in a bright white box set against the website’s lime green background. At the bottom of the white box was a notice indicating “Your order is safe and secure,” displayed next to a “VeriSign Secured” logo. Below the white box was a dark green bar with a hyperlink titled “SITE FEEDBACK” displayed in light green typeface. Finally, below the dark green bar, at the bottom of each checkout flow page, were two hyperlinks titled “PRIVACY POLICY” and “TERMS OF USE,” displayed in the same light green typeface on the site’s lime green background. Following Long’s purchase, he also received a confirmatory e-mail message. That message also included a link to the Terms of Use, along with a litany of other links. The link for the Terms of Use was near the bottom of the message and was in the same gray typeface as pro forma information about customer service contact information and Provide’s corporate address. Long objected to Provide’s motion to compel arbitration because he “did not notice a reference of any kind to ProFlowers ‘Terms and Conditions’ nor a hyperlink to ProFlowers ‘Terms of Use” when he purchased the flowers. Thus, he argued he could not have assented to the Terms of Use and could not be bound by them. The trial court agreed with Long, concluding the hyperlinks were too inconspicuous to put a reasonably prudent consumer on notice. Provide appealed.

Jones, Judge DISCUSSION A. Legal Principles; Arbitration and Browsewrap Agreements “Under ‘both federal and state law, the threshold question presented by a petition to compel arbitration is whether there is an agreement to arbitrate.’” Cruise v. Kroger Co., 233 Cal. App. 4th 390,

396 (Cal. Ct. App. 2015). . . . As our Supreme Court has observed, “[t]here is indeed a strong policy in favor of enforcing agreements to arbitrate, but there is no policy compelling persons to accept ­arbitration of controversies which they have not agreed to arbitrate.” Freeman v. State Farm Mut. Auto. Ins. Co., 535 P.2d 341 (Cal. Sup. Ct. 1975).



Chapter Eleven The Agreement: Acceptance

This requirement applies with equal force to arbitration provisions contained in contracts purportedly formed over the Internet. While Internet commerce has exposed courts to many new situations, it has not fundamentally changed the requirement that “[m]utual manifestation of assent, whether by written or spoken word or by conduct, is the touchstone of contract.” Nguyen v. Barnes & Noble Inc., 763 F.3d 1171, 1175 (9th Cir. 2014). Mutual assent is determined under an objective standard applied to the outward manifestations or expressions of the parties, i.e., the reasonable meaning of their words and acts, and not their unexpressed intentions or understandings. In applying this objective standard, outward manifestations of a party’s supposed assent are to be judged with due regard for the context in which they arise. California law is clear—“an offeree, regardless of apparent manifestation of his consent, is not bound by inconspicuous contractual provisions of which he was unaware, contained in a document whose contractual nature is not obvious.” Windsor Mills, Inc. v. Collins & Aikman Corp., 25 Cal. App. 3d 987, 993 (Cal. Ct. App. 1972). “Contracts formed on the Internet come primarily in two flavors: ‘clickwrap’ (or ‘click-through’) agreements, in which Web site users are required to click on an ‘I agree’ box after being presented with a list of terms and conditions of use; and ‘browsewrap’ agreements, where a Web site’s terms and conditions of use are generally posted on the Web site via a hyperlink at the bottom of the screen.” Nguyen, supra, 763 F.3d at 1175– 1176. The parties agree that the subject Terms of Use for the ProFlowers.com Web site falls into the browsewrap category. Unlike a clickwrap agreement, a browsewrap agreement does not require the user to manifest assent to the terms and conditions expressly . . . [a] party instead gives his assent simply by using the Web site. Indeed, “in a pure-form browsewrap agreement, the Web site will contain a notice that—by merely using the services of, obtaining information from, or initiating applications within the Web site—the user is agreeing to and is bound by the site’s terms of service.” Thus, by visiting the Web site—something that the user has already done—the user agrees to the Terms of Use not listed on the site itself but available only by clicking a hyperlink. The defining feature of browsewrap agreements is that the user can continue to use the Web site or its services without visiting the page hosting the browsewrap agreement or even knowing that such a Web page exists. Because no affirmative action is required by the Web site user to agree to the terms of a contract other than his or her use of the Web site, the determination of the validity of the browsewrap contract depends on whether the user has actual or constructive knowledge of a Web site’s terms and conditions. Nguyen, supra, 763 F.3d at 1176 (internal citations and quotes omitted). More to the point here, absent actual notice, “the validity of [a] browsewrap agreement turns on whether the Web site puts a reasonably prudent user on inquiry notice of the terms of the contract.” Id. at p. 1177. With these foundational legal principles in place, we turn our focus to the specifics of the browsewrap agreement in the instant

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case, and whether the design of Provide’s Web site and order confirmation e-mail were sufficient to conclude [Long] agreed to be bound by the Terms of Use and arbitration provision contained therein simply by placing his order on ProFlowers.com. B. The “Terms of Use” Hyperlinks Are Not Sufficiently Conspicuous to Put a Reasonably Prudent Internet Consumer on Inquiry Notice; Plaintiff Did Not Manifest His Unambiguous Assent to Be Bound by the Terms of Use Provide does not dispute Plaintiff’s testimony that he had no actual knowledge of the Terms of Use when he placed his order on ProFlowers.com. Accordingly, we must decide whether the design of the ProFlowers.com Web site and/or the conspicuousness of the hyperlinks to the Terms of Use were sufficient to put a reasonably prudent Internet consumer on inquiry notice of the browsewrap agreement’s existence and contents. It appears that no California appellate court has yet addressed what sort of Web site design elements would be necessary or sufficient to deem a browsewrap agreement valid in the absence of actual notice. Accordingly, in addition to the general contract principles discussed above, our analysis is largely guided by two federal cases from the Second and Ninth Circuit Courts of Appeals, each of which considered the enforceability of a browsewrap agreement applying the objective manifestation of assent analysis dictated by California law. See Specht v. Netscape Communs. Corp., 306 F.3d 17, 30 fn. 13 (2d Cir. 2002); Nguyen, 763 F.3d at p. 1175. In keeping with the principles articulated in these authorities, we conclude the design of the ProFlowers.com Web site, even when coupled with the hyperlink contained in the confirmation e-mail, was insufficient to put Plaintiff on inquiry notice of the subject Terms of Use. In Specht, the Second Circuit declined to enforce an arbitration provision contained in a software licensing browsewrap agreement where the hyperlink to the agreement appeared on “a submerged screen” below the Download button that the plaintiffs clicked to initiate the software download. After reviewing California contract law, the Specht court acknowledged that a user’s act of clicking a download button, combined with circumstances sufficient to put a prudent man upon inquiry as to the existence of licensing terms, would constitute a sufficient manifestation of assent to be bound. However, the court was quick to point out that the opposite must also be true—that “a consumer’s clicking on a download button does not communicate assent to contractual terms if the offer did not make clear to the consumer that clicking on the download button would signify assent to those terms.” Specht, 306 F.3d at 29–30. The design of the defendant’s Web site, the Specht court concluded, exemplified the latter circumstance. Though the Web site advised users to “Please review and agree to the terms of the . . . software license agreement before downloading and using the software,” the Specht court emphasized that users would have encountered this advisement only if

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they scrolled down to the screen below the Web site’s invitation to download the software by clicking the download button. This meant that when the plaintiffs clicked the download button, they “were responding to an offer that did not carry an immediately visible notice of the existence of license terms or require unambiguous manifestation of assent to those terms.” Specht, 306 F.3d at 31. The fact that users might have noticed from the position of the scroll bar that an unexplored portion of the Web page remained below the download button did not change the reasonableness calculation. Under the circumstances presented, “where consumers [were] urged to download free software at the immediate click of a button,” the Specht court concluded placing the notice of licensing terms on a submerged page “tended to conceal the fact that [downloading the software] was an express acceptance of [the defendant’s] rules and regulations.” Id. at p. 32. Thus, notwithstanding what the plaintiffs might have found had they taken as much time as they needed to scroll through multiple screens on a Web page, the Specht court held that “a reasonably prudent offeree in plaintiffs’ position would not have known or learned . . . of the reference to [the software’s] license terms hidden below the ‘Download’ button on the next screen.” Id. at p. 35. More than a decade after the Second Circuit decided Specht, the Ninth Circuit in Nguyen considered whether the conspicuous placement of a “Terms of Use” hyperlink, standing alone, would be sufficient to put an Internet consumer on inquiry notice. Unlike in Specht, the hyperlink in Nguyen was visible “without scrolling” on some of the Web site’s pages, while on others “the hyperlink [was] close enough to the ‘Proceed with Checkout’ button that a user would have to bring the link within his field of vision” to complete an online order. Nguyen, supra, 763 F.3d at 1178. These differences with Specht notwithstanding, the Nguyen court concluded the plaintiff’s act of placing an order did not constitute an unambiguous manifestation of assent to be bound by the browsewrap agreement, holding “proximity or conspicuousness of the hyperlink alone is not enough to give rise to constructive notice” Id. The court reasoned that Specht had only identified a circumstance that was not sufficient to impart inquiry notice—where the only reference to license terms appeared on a submerged screen. But in cases where courts had “relied on the proximity of the hyperlink to enforce a browsewrap agreement,” the Nguyen court explained, those Web sites had “also included something more to capture the user’s attention and secure her assent.” Id. at 1178, fn. 1 (emphasis added). Typically that “something more” had taken the form of an explicit textual notice warning users to “Review terms” or admonishing users that by clicking a button to complete the transaction “you agree to the terms and conditions in the agreement.” Id. From those cases, the Nguyen court derived the following bright line rule for determining the validity of browsewrap agreements: “[W]here a Web site makes its terms of use available via a conspicuous hyperlink on every

page of the Web site but otherwise provides no notice to users nor prompts them to take any affirmative action to demonstrate assent, even close proximity of the hyperlink to relevant buttons users must click on—without more—is insufficient to give rise to constructive notice.” Id. at 1178–1179. Provide argues we should disregard Nguyen as an outlier case, and follow Specht to the extent it suggests a conspicuous hyperlink that provides “immediately visible notice” of a browsewrap agreement is sufficient, standing alone, to put a reasonably prudent Internet consumer on inquiry notice of the agreement’s terms. . . . Provide argues the Terms of Use hyperlink on ProFlowers.com “is immediately visible on the checkout flow, is viewable without scrolling, and located next to several fields that the Web site user is required to fill out and the buttons he must click to complete an order.” Given this distinction, Provide argues the hyperlink was sufficiently conspicuous to “put a reasonable user on notice of the Terms of Use.” We disagree. Though it may be that an especially observant Internet consumer could spot the Terms of Use hyperlinks on some checkout flow pages without scrolling, that quality alone cannot be all that is required to establish the existence of an enforceable browsewrap agreement. Rather, as the Specht court observed, “[r]easonably conspicuous notice of the existence of contract terms and unambiguous manifestation of assent to those terms by consumers are essential if electronic bargaining is to have ­integrity and credibility.” Specht, 306 F.3d at 35. Here, the Terms of Use hyperlinks—their placement, color, size and other qualities relative to the ProFlowers.com Web site’s overall design—are simply too inconspicuous to meet that standard. Indeed, our review of the screenshots reveals how difficult it is to find the Terms of Use hyperlinks in the checkout flow even when one is looking for them. This of course is to say nothing of how observant an Internet consumer must be to discover the hyperlinks in the usual circumstance of using ProFlowers.com to purchase flowers, without any forewarning that he or she should also be on the lookout for a reference to “Terms of Use” somewhere on the Web site’s various pages. Contrary to Provide’s characterization, the subject hyperlinks in the checkout flow are not “located next to” the fields and buttons a consumer must interact with to complete his order. Those fields and buttons are contained in a separate bright white box in the center of the page that contrasts sharply with the Web site’s lime green background. To find a Terms of Use hyperlink in the checkout flow, a consumer placing an order must (1) remove attention from the fields in which he or she is asked to enter his information; (2) look below the buttons he must click to proceed with the order; (3) look even further below a “VeriSign Secured” logo and notification advising that his or her “order is safe and ­secure,” which itself includes a hyperlink to “Click here for more details”; (4) look still further below a thick dark green bar with



Chapter Eleven The Agreement: Acceptance

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a hyperlink for “SITE FEEDBACK”; and (5) finally find the “TERMS OF USE” hyperlink situated to the right of another hyperlink for the Web site’s “PRIVACY POLICY,” both of which appear in the same font and light green typeface that, to the unwary flower purchaser, could blend in with the Web site’s lime green background. True, on a handful of these pages no scrolling is required to complete the hunt. But that, in our assessment, does not change the practical reality that the checkout flow is laid out “in such a manner that it tended to conceal the fact that [placing an order] was an express acceptance of [Provide’s] rules and regulations.” Specht, 306 F.3d at 32. As for Provide’s contention that the subsequent order confirmation e-mail somehow provides the notice that was missing from the checkout flow, again, we disagree. Unlike the hyperlink on some checkout flow pages, the screenshots suggest the hyperlink

in the e-mail is located on a submerged page, requiring the customer to scroll below layers of order summary details, advertisement banners, hyperlinks to “convenient account management services,” several logos for Provide’s “Family of Brands,” and customer service contact information to finally find a reference to “Terms” printed in grey typeface on a white background. This is not the sort of conspicuous alert that can be expected to put a reasonably prudent Internet consumer on notice to investigate whether disputes related to his or her order will be subject to binding arbitration.

Intent and Acceptance on the Offeror’s Terms

purported acceptance result in an implied rejection of the offer. Even under the mirror image rule, no rejection is implied if an offeree merely asks about the terms of the offer without indicating its rejection (an inquiry regarding terms), or accepts the offer’s terms while complaining about them (a grumbling acceptance). Distinguishing among a counteroffer, an inquiry regarding terms, and a grumbling acceptance is often a difficult task. The fundamental issue, however, remains the same: Did the offeree objectively indicate a present intent to be bound by the terms of the offer? You will see an application of the traditional mirror image rule in the following Pena case.

Common Law: Traditional “Mirror Image” Rule The traditional contract law rule is that an acceptance must be the mirror image of the offer. Attempts by offerees to change the terms of the offer or to add new terms to it are treated as counteroffers because they impliedly indicate an intent by the offeree to reject the offer instead of being bound by its terms. However, recent years have witnessed a judicial tendency to apply the mirror image rule in a more liberal fashion by holding that only material (important) variances between an offer and a

*** DISPOSITION The order is affirmed.

Pena v. Fox   198 So. 3d 61 (Fla. Ct. App. 2015) Diana Pena and Matthew Fox were in an automobile accident on July 4, 2013. Pena allegedly suffered injuries as a result. Pena’s attorney worked with Fox’s insurance company, USAA Casualty Insurance, toward settling her claims against Fox. Pena’s attorney delivered to USAA a settlement offer, the terms of which included money up to Fox’s USAA policy limits. In return, Pena agreed to release all claims against Fox relating to the accident. The settlement offer also contemplated that USAA would provide a proposed release form for Pena to sign. Pena’s attorney, however, explained that certain conditions applied as to the type of release that would be acceptable to Pena. In the offer letter, Pena’s attorney described those conditions as follows: If USAA provides us all the information and funds requested above my [client] will sign a general release releasing all claims. . . . [M]y clients will sign a general release releasing all claims of my clients only. My clients will not accept, nor will they sign, a release containing a hold harmless nor an indemnity agreement, nor will my client release any claim other than your insured’s claim; nor will my client release anyone’s claim other than my client’s claims. Therefore, any attempt to provide a release which contains a hold harmless or indemnity agreement, which releases anyone other than your insured, or which releases any claim other than my client’s claim will act as a rejection of this good faith offer. (emphasis added).

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Part Three Contracts

After receiving the offer letter from Pena’s attorney, USAA responded with a settlement check along with a proposed release. The release included an introductory paragraph stating that, by signing, Pena would acknowledge the settlement funds and would “release, acquit, and forever discharge Matthew R. Fox, his/her heirs, executors and assigns, from any liability.” In addition, the release included the following term: I/We further state that while I/we hereby release all claims against Releasee(s), its agents, and employees, the payment hereunder does not satisfy all of my/our damages resulting from the accident. . . . I/We further reserve my/our right to pursue and recover all unpaid damages from any person, firm, or organization who may be responsible for payment of such damages, including first party health and automobile insurance coverage, but such reservation does not include the Releasee(s), its agents, and employees. . . . Pena considered the release to be a rejection of her offer, because she considered the language “Releasee(s), its agents, and employees” an attempt to expand the release to include USAA. Thus, she filed a lawsuit against Fox. Fox responded to Pena’s suit by filing a Motion to Enforce Settlement on the theory that the settlement agreement was complete and barred the suit. The trial court agreed with Fox, finding that Pena’s claim against him had been settled. The court held that the language in question related only to Fox and that the rest of the release’s language was clear. Finally, it held that there was no “nefarious inclusion” of USAA in the release. As a result, the court dismissed Pena’s complaint. Pena appealed.

Lucas, Judge I. This case invokes a [textbook] tenet of contract law: the symmetry needed between an offer and an acceptance to establish an enforceable agreement. . . . II. Settlement agreements are governed by contract law. . . . Like any contract, a settlement agreement is formed when there is mutual assent and a “meeting of the minds” between the parties—a condition that requires an offer and an acceptance supported by valid consideration. . . . Florida law further requires that “an acceptance of an offer must be absolute and unconditional, identical with the terms of the offer.” Ribich v. Evergreen Sales & Serv., Inc., 784 So. 2d 1201, 1202 (Fla. Ct. App. 2001) (citing Sullivan v. Econ. Research Props., 455 So. 2d 630, 631 (Fla. Ct. App. 1984)). That is, the acceptance must be a “mirror image” of the offer in all material respects, or else it will be considered a counteroffer that rejects the original offer. . . . An attempted acceptance can become a counteroffer “either by adding additional terms or not meeting the terms of the original offer.” Grant v. Lyons, 17 So. 3d 708, 711 (Fla. Ct. App. 2009). The release USAA delivered appears to have done both: it added parties beyond those Ms. Pena proposed to release in her original offer, and it materially deviated from the limitation Ms. Pena’s offer clearly expressed. The proposed release specifically releases Mr. Fox, his heirs, executors, and assigns in its first paragraph but then in another inexplicably shifts its reference to “Releasee(s),” a term that is nowhere defined within

the document. Assuming, as the parties have, that Mr. Fox, his heirs, executors, and assigns, and “Releasees” are all one and the same, USAA’s release goes on to expand the latter term to include Mr. Fox’s “agents and employees,” who are also left undefined and otherwise unidentified within the release. Presumably, the release’s inclusion of “agents and employees” meant someone other than the “Releasee(s)” or Matthew R. Fox. . . . Although the incongruity in terms may have been nothing more than boilerplate migrating across computer-generated files, nevertheless, “agents and employees” was a new term, and it was a part of USAA’s response to Ms. Pena’s offer. And that offer had been explicit: Ms. Pena would not agree to release any party other than Mr. Fox. While we share the circuit court’s view that the inclusion of Mr. Fox’s agents and employees within the release was not the product of nefarious motives, USAA’s intention when it drafted this document, whatever it might have been, was irrelevant to the issue at hand. . . . The words are what matter because they will control who will, or will not, be released. . . . Mr. Fox’s proposed acceptance would release additional parties, Mr. Fox’s agents and employees, which Ms. Pena’s offer would not. His acceptance did not mirror her offer. III. Reading Ms. Pena’s offer and Mr. Fox’s acceptance together, we conclude there was no meeting of the minds between these parties, and, thus, there was no settlement agreement that barred Ms. Pena’s claims. . . . Accordingly, we reverse the order dismissing the complaint and remand this case for further proceedings. Reversed and remanded.



Chapter Eleven The Agreement: Acceptance

UCC Standard for Acceptance on the Offeror’s Terms: The “Battle of the Forms” Strictly applying the mirror image rule to modern commercial transactions, most of which are carried out by using preprinted form contracts, would often result in frustrating the parties’ true intent. Offerors use standard order forms prepared by their lawyers, and offerees use standard acceptance or acknowledgment forms drafted by their counsel. The odds that these forms will agree in every detail are slight, as are the odds that the parties will read each other’s forms in their entirety. Instead, the parties to such transactions are likely to read only crucial provisions concerning the goods ordered, the price, and the delivery date called for, and if these terms are agreeable, believe that they have a contract. If a dispute arose before the parties started to perform, a court strictly applying the mirror image rule would hold that no contract resulted because the offer and acceptance forms did not match exactly. If a dispute arose after performance had commenced, the court would probably hold that the offeror had impliedly accepted the offeree’s counteroffer and was bound by its terms. Because neither of these results is very satisfactory, the UCC, in a very controversial provision often called the “Battle of the Forms” section [2-207] (see Figure 11.1), has changed the mirror image rule for contracts involving the sale of goods. UCC section 2-207 allows the formation of a contract even when there is some variance between the

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terms of the offer and the terms of the acceptance. It also makes it possible, under some circumstances, for a term contained in the acceptance form to become part of the contract. The UCC provides that a definite and timely expression of acceptance creates a contract, even if it includes terms that are different from those stated in the offer or even if it states additional terms that the offer did not address [2-207(1)]. An attempted acceptance that was expressly conditioned on the offeror’s agreement to the offeree’s terms would not be a valid acceptance, however [2-207(1)]. What are the terms of a contract created by the exchange of standardized forms? The additional terms contained in the offeree’s form are treated as “proposals for addition to the contract.” If the parties are both merchants, the additional terms become part of the contract unless: 1. The offer expressly limited acceptance to its own terms, 2. The new terms would materially alter the offer, or 3. The offeror gives notice of objection to the new terms within a reasonable time after receiving the acceptance [2-207(2)]. In the following Duro case, the court evaluates whether a forum selection clause included in a merchant offeree’s response is part of the contract. When the offeree has made his acceptance expressly conditional on the offeror’s agreement to the new terms

Figure 11.1 The “Battle of the Forms”—A Section 2-207 Flowchart 2-207(1) Contract

Terms?

No

Yes Offeree’s form a “definite and seasonable (timely) expression of acceptance” despite additional or different terms? No

Offeree’s acceptance expressly conditional on offeror assent to additional or different terms?

2-207(2)

Majority of courts

Between merchants, additional terms part of contract unless: Offer limited acceptance to own terms, or additional terms materially alter offer, or offeror gave notice of objection to them within reasonable time. Between non-merchants, additional terms treated as proposals by offeree to modify contract (to which offeror may assent or not without effect on contract status).

Differing terms from the offer subject to “knock-out rule.”

No Contract Yes

2-207(3) Contract

Terms?

Terms on which forms agree and supplemental UCC terms (knock-out rule).

Yes Conduct by both No parties recognizing existence of contract?

No contract

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Part Three Contracts

or when the offeree’s response to the offer is clearly not “an expression of acceptance” (e.g., an express rejection), no contract is created under section 2-207(1). A contract will result in such cases only if the parties engage in conduct that “recognizes the existence of a contract,” such as an exchange of performance. Unlike the offeror’s counterpart under traditional contract principles, however, the offeror who accepts performance in the face of an express rejection or expressly conditional acceptance is not thereby bound to all of the terms contained in the offeree’s response. Instead, the UCC provides that the

terms of a contract created by such performance are those on which the parties’ writings agree, supplemented by appropriate gap-filling provisions from the UCC [2-207(3)]. Courts and litigants often refer to this as the knock-out rule. The knock-out rule is also used by the majority of courts when there is an acceptance that contains terms that are different from (not merely additional to) the terms of the offer. That is, the contract will consist of those terms on which the parties’ writings agree plus any appropriate gapfilling presumptions of the UCC.

Duro Textiles, LLC v. Sunbelt Corporation   12 F. Supp. 3d 221 (D. Mass. 2014) Duro Textiles produces and distributes textile products. In November 2011, Duro ordered and received a large amount of blue dye from defendant Sunbelt Corporation. Duro alleges that when it used Sunbelt’s dye in its production process, random blue spots appeared on its product. As a result, Duro claimed, it sustained losses totaling more than $550,000. Duro sued Sunbelt for breach of contract, breach of the implied covenant of good faith and fair dealing, and negligent misrepresentation. Sunbelt moved to dismiss. It asserted that an invoice that it sent to Duro included a forum selection clause that granted exclusive jurisdiction for any dispute under the contract to South Carolina courts. Sunbelt sent the invoice to Duro along with Sunbelt’s shipment of dye and also, separately, by U.S. Mail. Sunbelt claimed that the forum selection clause was part of the contract under UCC 2-207, the “battle of the forms.” Duro opposed the motion to dismiss, arguing that the forum selection clause was not part of the parties’ contract because it “materially altered” the terms of the contract. Wolf, District Judge II. Analysis Forum selection clauses are “prima facie valid and should be enforced unless enforcement is shown by the resisting party to be ‘unreasonable’ under the circumstances.” The Bremen v. Zapata Off Shore Co., 407 U.S. 1, 10 (1971). Duro’s position is not that the forum selection clause on which Sunbelt relies is “unreasonable,” however, but that this clause is not part of the contract between the parties. . . . Under Massachusetts law, where a contractual provision is presented to a buyer in a seller’s invoice, the analysis of whether that provision becomes part of the sales contract is governed by § 2-207. This section provides, in part, that if a seller’s “written confirmation . . . is sent within a reasonable time,” a contract is formed, and “[t]he additional or different terms are to be construed as proposals for ­addition to the contract.” § 2-207(1). Between “merchants,” these additional or different terms: become part of the contract unless: (a) the offer expressly limits acceptance to the terms of the offer; (b) they 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.

§ 2-207(2). Duro and Sunbelt tacitly agree that they are each a “merchant,” namely “a person 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. . . .” Mass. Gen. Laws ch. 106, § 2-104(1). Duro’s primary argument is that Sunbelt’s forum selection clause “materially altered” the contract and, therefore, was not incorporated into it. The official comments to § 2-207 “advise that a new term proposed by the seller is a ‘material alteration’ where it would ‘result in [unreasonable] surprise or hardship [to the buyer] if incorporated without [the buyer’s] express awareness.’ . . . Ultimately, whether a term is material should be judged in the specific context of all relevant facts and circumstances. Thus, what is appropriate is a fact specific, case-by-case analysis.” Sibcoimtrex, Inc. v. Am. Foods Grp., Inc., 241 F. Supp. 2d 104, 109 (D. Mass. 2003). The parties have not cited, and the court has not identified, any binding precedent that examines, under Massachusetts law, whether a forum selection clause materially alters a contract. In general, however, courts have considered forum selection clauses to be material. The Southern District of New York has explained that: [T]he [forum selection] clause proposes that defendant is required to give up the right it would otherwise enjoy, to [sue or] be sued where it is doing business, or in the state of



Chapter Eleven The Agreement: Acceptance

its principal office, and consent to [sue or] be sued in an adjoining state. A reasonable merchant would probably regard this as a material alteration. There are still subtle differences between the courts in various states. Certainly the jurors are selected from different economic, political and social backgrounds, which may affect their attitudes even in commercial matters. Counsel other than the party’s regular attorney may be needed, at additional expense. The bench and bar has always regarded choice of forum as a significant right. . . . [A] party, by agreeing to such a change, “waives in large part many of his normal rights under the procedural and substantive law of the state, and it would be unfair to infer such a significant waiver on the basis of anything less than a clear indication of intent.” Gen. Instr. Corp. v. Tie Mfg., Inc., 517 F. Supp. 1231, 1235 (S.D.N.Y. 1981) (quoting Nat’l Mach. Exch., Inc. v. Peninsular Equip. Corp., 431 N.Y.S.2d 948 (Sup. Ct. N.Y. 1980)). The conclusion that a forum selection clause materially alters a contract has also been reached by various other courts under the

Communication of Acceptance To accept an

offer for a bilateral contract, the offeree must make the promise requested by the offer. In Chapter 10, you learned that an offeror must communicate the terms of his proposal to the offeree before an offer results. This is so because communication is a necessary component of the present intent to contract required for the creation of an offer. For similar reasons, it is generally held that an offeree must communicate his intent to be bound by the offer before a contract can be created. To accept an offer for a unilateral contract, however, the offeree must perform the requested act. The traditional contract law rule on this point assumes that the offeror will learn of the offeree’s performance and holds that no further notice from the offeree is necessary to create a contract unless the offeror specifically requests notice. Manner of Communication The offeror, as the master of the offer, has the power to specify the precise time, place, and manner in which acceptance must be communicated. This is called a stipulation. If the offeror stipulates a particular manner of acceptance, the offeree must respond in this way to form a valid acceptance. Suppose Prompt Printing makes an offer to Jackson and the offer states that Jackson must respond by certified mail. If Jackson deviates from the offer’s instructions in any significant way, no contract results unless Prompt Printing indicates a willingness to be bound by the deviating acceptance. If, however, the offer merely suggests a method or place of communication or is

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laws of various other jurisdictions[, including Michigan, Indiana, Oklahoma, Pennsylvania, and Washington]. While a fact specific, case-by-case analysis is appropriate, the reasoning followed by other courts in other fact patterns is applicable to the instant case. Duro asserts, and Sunbelt does not dispute, that Duro’s principal place of business is in Fall River, Massachusetts, and that Sunbelt’s principal place of business is in Rock Hill, South Carolina. The forum selection clause in question would require Duro to litigate any disputes in Sunbelt’s home state, in a forum far from Duro’s own principal place of business and state of incorporation. Enforcement of the forum selection clause would entail “[s]ubtle differences in courts, jurors and law . . . and considerations of litigation expense . . . [that] most merchants would consider important.” The court, therefore, finds that Sunbelt’s forum selection clause is a material alteration to the contract within the meaning of § 2-207(2)(b). Consequently, this provision is not part of the contract between the parties. Sunbelt’s motion to dismiss is being denied on the foregoing grounds. . . .

silent on such matters, the offeree may accept within a reasonable time by any reasonable means of communication. So, if Prompt Printing’s offer did not require any particular manner of accepting the offer, Jackson could accept the offer by any reasonable manner of communication within a reasonable time.

When Is Acceptance Communicated? Determine how acceptance can be communicated in a

LO11-2 given scenario and analyze the time at which acceptance is

likely to be effective.

Acceptances by Instantaneous Forms of Communication When the parties are dealing faceto-face, by telephone, or by other means of communication that are virtually instantaneous, there are few problems determining when the acceptance was communicated. As soon as the offeree says, “I accept,” or words to that effect, a contract is created, assuming that the offer is still in existence.

Acceptances by Noninstantaneous Forms of Communication Suppose the circumstances under

which the offer was made reasonably led the offeree to believe that acceptance by some noninstantaneous form of communication is acceptable, and the offeree responds by using

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Part Three Contracts

postal mail or some other means of communication that creates a time lag between the dispatching of the acceptance and its actual receipt by the offeror. The practical problems involving the timing of acceptance multiply in such transactions. The offeror may be attempting to revoke the offer while the offeree is attempting to accept it. An acceptance may get lost and never be received by the offeror. The time limit for accepting the offer may be rapidly approaching. Was the offer accepted before a revocation was received or before the offer expired? Does a lost acceptance create a contract when it is dispatched, or is it totally ineffective? Under the so-called mailbox rule, properly addressed and dispatched acceptances can become effective when they are dispatched, even if they are lost and never received by the offeror. The mailbox rule, which is discussed further in the following Wilson case, protects the offeree’s reasonable belief that a binding contract was created when the acceptance was dispatched. By the same token, it exposes the offeror to the risk of being bound by an acceptance that the offeror has never received. The offeror, however, has the ability to minimize this risk by stipulating in the offer that the offeror must actually receive the acceptance for it to be effective. Offerors who do this maximize the time that they have to revoke their offers and ensure that they will never be bound by an acceptance that they have not received. Operation of the Mailbox Rule: Common Law of Contracts As traditionally applied by the common law

of contracts, the mailbox rule would make acceptances effective upon dispatch when the offeree used a manner of communication that was expressly or impliedly authorized (invited) by the offeror. Any manner of communication suggested by the offeror (e.g., “You may respond by mail”) would be expressly authorized, resulting in an acceptance sent by the suggested means being effective on dispatch. Unless circumstances indicated to the contrary, a manner of communication used by the offeror in making the offer would be impliedly authorized (e.g., an offer sent by mail would impliedly authorize an acceptance by mail), as would a manner of communication common in the parties’ trade or business (e.g., a trade usage in the parties’ business that offers are made by mail and accepted by telegram would authorize an acceptance by telegram). Conversely, an improperly dispatched acceptance or one that was sent by some means of communication that was nonauthorized would be effective when received, assuming that the offer was still open at that time. This placed on the offeree the risk of the offer being revoked or the acceptance being lost.  The mailbox rule is often applied more liberally by courts today. A modern version of the mailbox rule that is sanctioned by the Restatement (Second) holds that an offer that does not indicate otherwise is considered to invite acceptance by any reasonable means of communication, and a properly dispatched acceptance sent by a reasonable means of communication within a reasonable time is effective on dispatch.

United States Life Insurance Company in the City of New York v. Wilson    18 A.3d 110 (Md. Ct. App. 2011) On November 15, 1998, Dr. John G. Griffith purchased a life insurance policy underwritten by United States Life Insurance Company in the City of New York (US Life) through the AMA Insurance Agency Inc. (AMAIA). The policy was for a 10-year term, and Dr. Griffith was obligated to make premium payments every six months. If he missed a payment, the policy included a 31-day grace period, during which he could remit the missed payment and continue coverage. The policy further stated that US Life could extend the grace period by written notice. If, however, Dr. Griffith failed to make a premium payment even within the grace period, the policy could be reinstated within 90 days of the due date of the first missed premium by making all outstanding premium payments and by receiving written approval from US Life that he remained insurable. However, if the reinstatement payment was received within 31 days of the end of the grace period, then written approval and evidence of insurability was not required. Dr. Griffith made timely premium payments through 2006. He did not timely pay his May 15, 2007, premium, though. AMAIA sent Dr. Griffith a “REMINDER NOTICE,” stating: “To assure active coverage, full payment of the premium must be received no later than 60 days from the due date.” Sometime shortly after June 15, 2007, AMAIA sent Dr. Griffith a “LAPSE NOTICE,” which informed him that his coverage had lapsed and that if he wished to continue it he needed to reinstate the policy. On July 23, 2007, Dr. Griffith logged on his online Bank of America account and directed that the missing premium payment be made. Bank of America sent a check to AMAIA on July 25, 2007. On August 2, 2007, AMAIA rejected the payment and returned the check with a letter stating that Dr. Griffith’s payment was received more than 30 days after the end of the grace period and, therefore, he had to present evidence of insurability in order to reinstate the policy.



Chapter Eleven The Agreement: Acceptance

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Meanwhile, on Saturday, July 28, 2007, Dr. Griffith was killed while riding his bicycle. His wife, Elizabeth Wilson, who was the sole beneficiary of the life insurance policy, subsequently submitted a claim on the policy. AMAIA denied the claim, indicating that the policy lapsed on May 15, 2007. Ms. Wilson sued US Life and AMAIA for breach of contract. The parties filed competing motions for summary judgment. The trial court denied the defendants’ motions and granted Ms. Wilson’s motion, entering a judgment in her favor for the full amount of the policy plus costs and prejudgment interest. US Life and AMAIA appealed. In portions of the opinion not reproduced here, the court determined that the “REMINDER NOTICE” acted as a written extension of the grace period as provided in the policy. As a result, it found that the policy lapsed on July 15, 2007. Nonetheless, the policy allowed for reinstatement for up to 90 days after the first missed premium payment. Because of the extended grace period, the court found that Dr. Griffith could reinstate the policy without written permission or evidence of insurability. Thus, the question for the court was whether Dr. Griffith had reinstated the policy by payment of the unpaid premium prior to his death on July 28, 2007.

Deborah S. Eyler, Judge Insurance contracts initially are formed when an insurer unconditionally accepts an insured’s application, which constitutes an offer, for coverage. From then on, the life insurance policy operates as a unilateral contract, . . . i.e., one that is formed by performance. “The periodic payment of premiums is the mechanism by which the insured opts to keep the insurance policy in force.” 29 APPLEMAN ON INSURANCE 2d § 179.0-3, at 230 (2006). Failure to pay the premiums will result in coverage lapsing. Life insurance policies have standard non-forfeiture clauses that allow for reinstatement after a lapse in coverage. The “REINSTATEMENT” clause in the Policy in this case is such a standard non-forfeiture clause. . . . Under the policy, when the relevant time frame for reinstatement is “within 31 days after the end of the Grace Period” (as it is here), the “REINSTATEMENT” clause is a promise by the insurer to reinstate coverage upon performance by the insured of a single act—payment of the overdue premium. In that situation, the insurer is not being asked to consider and either accept or reject an offer by the insured to enter into a life insurance contract. Thus, the plain language of the “REINSTATEMENT” clause of the Policy establishes that, upon payment by the insured of the overdue premium within 31 days after the end of the grace period, the Policy is revived. In other words, in that situation, the “REINSTATEMENT” clause is an offer of a unilateral contract to revive the Policy, with the insurer promising that revival will take place upon the insured’s performing by paying the overdue premium. It is within the context of Dr. Griffith’s acceptance by performance (that is, by payment of the overdue premium) of US Life’s offer to revive the Policy that we must determine when payment took place. At common law, what is often called the “mailbox rule,” the “dispatch rule,” or sometimes the “postal acceptance rule” is the widely adopted convention for pinpointing the time that an offer is accepted and a contract is formed. [The state law at issue here] recognizes the rule, by which the mailed acceptance of an offer is effective when mailed, not when received or acknowledged.

Section 63(a) of the RESTATEMENT (SECOND) OF CONTRACTS (1979), while not using any of the familiar mailbox rule nomenclature, recognizes with respect to the time that acceptance of an offer takes effect that, unless an offer states otherwise, “an acceptance made in a manner and by a medium invited by the offer is operative and completes the manifestation of mutual assent as soon as put out of the offeree’s possession, without regard to whether it ever reaches the offeror.” The rationale for the rule . . . is, essentially, certainty and predictability. [E]ven though it may be possible under United States postal regulations for a sender to stop delivery and reclaim a letter, it remains the case that one to whom an offer has been made “needs a dependable basis for his decision whether to accept,” and has such a basis when he knows that, once properly dispatched, his acceptance is binding and the offer cannot be revoked. Id. In 2 WILLISTON ON CONTRACTS § 6:32 (4th ed. Richard A. Lord, 2007) (“WILLISTON”), the author explains that the “dispatch rule” applies equally to bilateral and unilateral contracts. If an offer for a unilateral contract calls for the performance of an act by the offeree that can be accomplished by sending money through the mail, including in the form of a check, “as soon as the money is sent it would become the property of the offeror, and the offeror would become bound to perform its promise for which the money was the consideration.” Id. at 441–42 (footnote omitted). The offeror must have authorized the use of the particular medium . . . as a means of acceptance, and the acceptance must have been properly dispatched. In addressing with particularity when acceptance is dispatched, WILLISTON states: “An acceptance is dispatched within the meaning of the rule under consideration when it is put out of the possession of the offeree and within the control of the postal authorities, telegraph operator, or other third party authorized to receive it.” § 6:37, at 484. However, “mere delivery of an acceptance to a messenger with directions to mail it amounts to no

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Part Three Contracts

acceptance until the messenger actually deposits it in the mail.” Id. The treatise continues: The private delivery service, under the modern view, would have to be independent of the offeree, reliable both in terms of its delivery obligations and record keeping, and of a type that would customarily be used to communicate messages of this sort. Such agencies as the United Parcel Service, Federal Express, or even private messenger services in urban areas would qualify, and as soon as the communication leaves the offeree’s possession and is placed with an authorized recipient of the instrumentality, an effective dispatch will be deemed to have occurred. WILLISTON § 6:37, at 486–87 (emphasis added)  (footnote omitted).

We conclude that the long-recognized mailbox rule governing the time of formation of a contract by written acceptance applies in the case at bar to control the time the Policy was reinstated, that is, when coverage under the Policy was revived. The transaction at issue here is not wholly traditional, that is, one in which a paper document, whether a check or otherwise, is mailed by the offeree to the offeror, in that it began electronically, as an online banking directive by Dr. Griffith on July 23, 2007. The Bank of America documents in the summary judgment record show, however, that the directive was acted upon by preparation of a paper check drawn on a JPMorgan Chase Bank, N.A. account under Dr. Griffith’s name, and bearing his “Authorized Signature”; and that the paper check then was “sent” to AMAIA on July 25, 2007, coming into AMAIA’s physical possession on July 30, 2007. The transaction thus resembles a traditional acceptance by writing mailed to the offeror, in that a writing (the check) was “sent” to AMAIA, even though its creation was directed electronically and it was created not by the offeree but by his bank. A writing thus was generated by actions taken by Dr. Griffith; the writing complied with that which was necessary to accept the

Operation of the Mailbox Rule: UCC The UCC, like the Restatement (Second), provides that an offer that does not specify a particular means of acceptance is considered to invite acceptance by any reasonable means of communication. It also provides that a properly dispatched acceptance sent by a reasonable means of communication within a reasonable time is effective on dispatch. What is reasonable depends on the circumstances in which the offer was made. These include the speed and reliability of the means used by the offeree, the nature of the transaction (e.g., does the agreement involve goods subject to rapid price fluctuations?), the existence of any trade usage governing the transaction, and the existence of prior dealings between the

reinstatement offer; and the writing was “sent,” which was a permissible mode of acceptance, and subsequently was delivered to AMAIA, the proper recipient. The nature of the transaction, involving the sending of a written acceptance, is such that, just like a transaction in which a written acceptance is prepared in writing and mailed, or a written acceptance is prepared by telegram and sent, the mailbox rule is a necessary tool to establish the time that the new agreement—here, one to revive a prior contract—was formed. The nature of the transaction is not akin to those that have been determined to be outside the sphere of the dispatch rule[, like telephones or teletypes.] Application of the mailbox rule to the undisputed material facts in this case produces the legal conclusion that the date of payment of the overdue premium was July 25, 2007. On July 23, 2007, Dr. Griffith electronically instructed Bank of America, as his agent, to make payment to AMAIA. The evidence viewed most favorably to the appellants supports a reasonable ­inference that Dr. Griffith could have reinstructed Bank of America not to make the payment; therefore, as of July 23, 2007, he had set in motion the means to accept the offer of reinstatement but still had the power to reverse course. On July 25, 2007, however, Bank of America remitted payment to AMAIA by sending it a check, drawn on the ­JPMorgan Chase Bank, N.A. account, for $369.46. At that point, the permissible means for ­acceptance was in motion and, so far as is established by the common law mailbox rule, was beyond Dr. Griffith’s power to stop. This would be true whether Bank of America sent the check through the U.S. Postal Service, a courier service, or otherwise. *** Judgment in favor of Elizabeth Wilson against the United States Life Insurance Company in the City of New York affirmed.

parties (e.g., has the offeree previously used the mail to accept telegraphed offers from the offeror?). So, under proper circumstances, a mailed response to a telegraphed offer or a telegraphed response to a mailed offer might be considered reasonable and therefore effective on dispatch. What if an offeree attempts to accept the offer by some means that is unreasonable under the circumstances or if the acceptance is not properly addressed or dispatched (e.g., misaddressed or accompanied by insufficient postage)? The UCC rejects the traditional rule that such acceptances cannot be effective until received. It provides that an acceptance sent by an unreasonable means would be effective on dispatch if it is received within the time



Chapter Eleven The Agreement: Acceptance

that an acceptance by a reasonable means would normally have arrived.

Stipulated Means of Communication As

discussed earlier, an offer may stipulate the means of communication that the offeree must use to accept by saying, in effect: “You must accept by mail.” An acceptance by the stipulated means of communication is effective on dispatch, just like an acceptance by any other reasonable or authorized means of communication (see Figure 11.2). The difference is that an acceptance by other than the stipulated means does not create a contract because it is an acceptance at variance with the terms of the offer.

Special Acceptance Problem Areas Acceptance in Unilateral Contracts A uni-

lateral contract involves the exchange of a promise for a requested act. To accept an offer to enter such a contract, the offeree must perform the requested act. As you learned in Chapter 10, however, courts applying modern contract rules may prevent an offeror from revoking such an offer once the offeree has begun performance. This is achieved by holding either that a bilateral contract is created by the

11-13

beginning of performance or that the offeror’s power to revoke is suspended for the period of time reasonably necessary for the offeree to complete performance.

Acceptance in Bilateral Contracts A bilateral

contract involves the exchange of a promise for a promise of some requested performance in return. As a general rule, to accept an offer to enter such a contract, an offeree must make the promise requested by the offer. This may be done in a variety of ways. For example, Wallace sends Stevens a detailed offer for the purchase of Stevens’s business. Within the time period prescribed by the offer, Stevens sends Wallace a letter that says, “I accept your offer.” Stevens has expressly accepted Wallace’s offer, creating a contract on the terms of the offer. Acceptance, however, can be implied as well as expressed. Offerees who take action that objectively indicates agreement risk the formation of a contract. For example, offerees who act in a manner that is inconsistent with an offeror’s ownership of offered property are commonly held to have accepted the offeror’s terms. So, if Arnold, a farmer, leaves 10 bushels of corn with Porter, the owner of a grocery store, saying, “Look this corn over. If you want it, it’s $5 a bushel,” and Porter sells the corn, he has impliedly accepted Arnold’s offer. But what if Porter just let the corn sit and, when Arnold returned a week later, Porter told Arnold that he did not want it? Could Porter’s failure to act ever amount to an acceptance?

Figure 11.2 Time of Acceptance

Yes Yes

Did the offeree accept by the stipulated means?

Contract formed upon dispatch of acceptance unless offer states to the contrary.

No No contract formed.

Does the offer stipulate a particular means of acceptance?

No

Did the offeree use an authorized (traditional contract law) or reasonable (modern contract law) means of communicating acceptance?

Yes

Contract formed upon dispatch of acceptance.

No Traditional Common Law: Contract formed upon receipt of acceptance (if offer is still open at that time). UCC and Modern Common Law: Contract formed upon dispatch of acceptance if it arrives within the time that an acceptance by a reasonable means would have arrived (if offer is still open at that time).

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Part Three Contracts

Silence as Acceptance LO11-3

Identify the circumstances under which silence is acceptance.

Because contract law generally requires some objective indication that an offeree intends to contract, the general rule is that an offeree’s silence, without more, is not an acceptance. In general, an offeror cannot impose on the offeree a duty to respond to the offer. So, even if Arnold made an offer to sell corn to Porter and said, “If I don’t hear from you in three days, I’ll assume you’re buying the corn,” Porter’s silence would still not amount to acceptance. On the other hand, the circumstances of a case sometimes impose a duty on the offeree to reject the offer affirmatively or be bound by its terms. These are cases in which the offeree’s silence objectively indicates an intent to accept. Customary trade practice or prior dealings between the parties may indicate that silence signals acceptance. So, if Arnold and

Porter had dealt with each other on numerous occasions and Porter had always promptly returned items that he did not want, Porter’s silent retention of the goods for a week would probably constitute an acceptance. Likewise, an offeree’s silence can also operate as an acceptance if the offeree has indicated that it will. For example, Porter (the offeree) tells Arnold, “If you don’t hear from me in three days, I accept.” In Bauer v. Qwest Communications Company, which follows, the court has to determine whether the prior dealings of the parties are such that one party’s silence is an objective manifestation of intent to accept. Finally, it is generally held that offerees who accept an offeror’s performance knowing what the offeror expects in return for his performance have impliedly accepted the offeror’s terms. So, if Apex Paving Corporation offers to do the paving work on a new subdivision being developed by Majestic Homes Corporation, and Majestic fails to respond to Apex’s offer but allows Apex to do the work, most courts would hold that Majestic is bound by the terms of Apex’s offer.

Bauer v. Qwest Communications Company, LLC   743 F.3d 221 (7th Cir. 2014) For more than 13 years, trial lawyers across the United States challenged the installation of fiber-optic cable on property without the landowners’ consent. Following a long process of complex litigation in a number of state courts, these challenges began to settle on a state-by-state basis. As a result, the numerous lawyers who worked on the cases were left to sort out the allocation of attorney fees that were being held by a disinterested third-party while the attorneys tried to resolve the share of that money each was entitled to get. The lawyers had informally split among three factions for purposes of the fee-allocation dispute. Arthur Susman and his colleagues made up one group (Susman). A former collaborator and now rival of Susman, William Gotfryd, represented another faction (Gotfryd). The final faction consisted of a coalition of 48 law firms (the 48-Firm Group). The parties engaged in court-mandated mediation; however, they were not able to quickly resolve their disputes. The mediators made a “final effort” at resolution by offering a final “Mediator’s Proposal,” which awarded each faction a certain percentage of the nationwide fees. The proposal was “blind” in that each lawyer or group of lawyers knew only the percentage allocation he or it would receive. Thereby, parties would be forced to focus only on the adequacy of their own absolute percentage, rather than worry about the amount of their awards relative to others. The proposal was take-it-or-leave-it, meaning that each party could respond only with “Accept” or “Reject.” Everyone accepted the proposal. The mediators notified the parties that the proposal was unanimously accepted and the lawyers set about memorializing it in a written agreement. A representative of the 48-Firm Group drafted an agreement and distributed it. Susman quickly responded with two minor points to be clarified. Others sought some changes as well. Based on that feedback, a couple of additional drafts were produced, until the final version was distributed for signature. After the initial draft, Susman never objected to any of the versions or the final version, despite having around two weeks to do so. Nonetheless, after everyone else had signed, Susman refused to sign the final agreement. He formally objected to terms dealing with enforcement of the agreement through arbitration; however, the others suspected he truly objected to the percentage allocation he received in the settlement, which was about half of Gotfryd’s percentage allocation. The other lawyers asked the court to enforce the agreement, despite Susman’s refusal to sign. The judge held that Susman was bound by the final written agreement. Susman appealed. Sykes, Circuit Judge On appeal Susman acknowledges that he approved the mediators’ fee-allocation proposal but insists that he never agreed to

the additional terms that appeared in the final written agreement. More specifically, he objects to . . . the enforcement provisions ­empowering the mediators to arbitrate future disputes and “forfeit”



Chapter Eleven The Agreement: Acceptance

the fees of attorneys who do not cooperate in implementing the agreement in state-by-state settlements. Susman relies heavily on the fact that he did not sign the agreement. Illinois contract law applies. “Under Illinois contract law, a binding agreement requires a meeting of the minds or mutual assent as to all material terms.” Abbott Lab. v. Alpha Therapeutic Corp., 164 F.3d 385, 387 (7th Cir. 1999). “Whether the parties had a ‘meeting of the minds’ is determined not by their actual subjective intent,” [id.], but rather based an [sic] “objective theory of intent,” Newkirk v. Village of Steger, 536 F.3d 771, 774 (7th Cir. 2008). To determine whether a party assented, the court “look[s] first to the written records, not to mental processes.” [Id.] . . . The critical question here is a factual one: Did Susman objectively manifest assent to be bound even though he did not sign the agreement? The district court answered that question “yes,” and we review that determination deferentially. “Generally, one of the acts forming the execution of a written contract is its signing. Nevertheless, ‘a party named in a contract may, by his acts and conduct, indicate his assent to its terms and become bound by its provisions even though he has not signed it.’” Carlton at the Lake, Inc. v. Barber, 401 Ill. App. 3d 528, 928 N.E.2d 1266, 1270, 340 Ill. Dec. 669 (Ill. Ct. App. 2010) (citation omitted) (quoting Landmark Props., Inc. v. Architects Int’l—Chi., 172 Ill. App. 3d 379, 526 N.E.2d 603, 606, 122 Ill. Dec. 344 (Ill. 1988)). Silence reasonably may be interpreted as acceptance of a contract in certain limited circumstances. Silence may be construed as acceptance where “because of previous dealings or otherwise, it is reasonable that the offeree should notify the offeror if he does not intend to accept.” RESTATEMENT (SECOND) OF CONTRACTS § 69(1)(c) (1981). In this situation, “the offeree’s silence is acceptance, regardless of his actual intent, unless both parties understand that no acceptance is intended.” RESTATEMENT (SECOND) OF CONTRACTS § 69 cmt. d (1981). The district court found that under the circumstances here, Susman’s silence should be interpreted as assent to the written agreement. That was a reasonable determination. The parties had worked on the fiber-optic-cable class actions for more than a decade, whether as cocounsel or in clear awareness of the parallel litigation activity in multiple states. They had recently worked out a system for settling the litigation on a state-by-state basis, and they were close to the end of a long and contentious fight over fees. Susman in particular had been a holdout on that front, having rejected [an earlier attempt to resolve the dispute]; he admits that he had a history of promptly speaking up when he found something objectionable. True to form, in this case Susman raised two minor points to the initial draft of the agreement within hours of its circulation. His suggestions were immediately addressed and incorporated into a subsequent draft.

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Tellingly, he did not object to any of the terms he now complains of. . . . As to these terms, he remained silent for two weeks. By this time the lawyers were a sort of community of interest, working together toward a final resolution of the fee dispute and an end to the litigation. They accepted the mediators’ fee-division proposal with the understanding that it was a final effort to get “the entire fee fight settled” once and for all—to achieve “global peace,” as Gotfryd put it at oral argument. The declarations submitted to the district court by Gotfryd and various members of the 48-Firm Group indicate that they accepted the mediators’ proposal largely because they understood it to put an end to uncertainty and bring about an expeditious distribution of attorney’s fees with no further threat of litigation. Indeed, it’s hard to imagine that their acceptance of the fee-allocation proposal could be understood in any other way. The unanimous approval of the mediators’ proposal included the agreed-upon division of fees but also plainly contemplated an enforcement mechanism that would foreclose future litigation. Consistent with this understanding, the written agreement provided for enforcement by arbitration if necessary. Needless to say, alternative dispute resolution is commonplace in this context, and under the particular circumstances here, the arbitration provisions could not have been unexpected. As the district court noted, it would be “remarkable . . . that you would work out this kind of arrangement and it wouldn’t include some kind of arbitration or other dispute resolution mechanism in light of the fact that there are several other states that are out there.” Susman’s past hostility toward arbitration isn’t incongruous with construing his silence as a lack of objection rather than a lack of assent. His previous rejection of arbitration pertained to the substantive fee-division issue, but that issue was now resolved. The arbitration provisions he now finds objectionable cover future disagreements that may arise in the implementation of the fee-allocation agreement. Susman cannot rely on his past objection to arbitration to explain his two-week silence in the face of a sense of urgency and a need for repose that was known to all. The parties had settled their substantive dispute, and the written agreement memorializing that settlement unsurprisingly contained an enforcement mechanism ensuring that the implementation would proceed without the threat of litigation. In short, it was reasonable for the other lawyers to expect Susman to promptly raise his objections to the written agreement and to construe his two-week silence as assent. . . . Given the parties’ lengthy relationship and course of dealings, the district court reasonably construed Susman’s silence as an assent to be bound. Affirmed.

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Part Three Contracts

Acceptance When a Writing Is Anticipated Determine whether an oral acceptance is effective in

LO11-4 a situation in which the parties anticipate putting their

contract in writing.

Frequently, the parties to a contract intend to prepare a written draft of their agreement for both parties to sign. This is a good idea not only because the law requires written evidence of some contracts,2 but also because it provides written evidence of the terms of the agreement if a dispute arises at a later date. If a dispute arises before such a writing has been prepared or signed, however, a question may arise concerning whether the signing of the agreement was a necessary condition to the creation of a contract. A party to the Chapter 16 discusses this subject in detail.

2

agreement who now wants out of the deal may argue that the parties did not intend to be bound until both parties signed the writing. A clear expression of such an intent by the parties during the negotiation process prevents the formation of a contract until both parties have signed. However, in the absence of such a clear expression of intent, the courts ask whether a reasonable person familiar with all the circumstances of the parties’ negotiations would conclude that the parties intended to be bound only when a formal agreement was signed. If it appears that the parties had concluded their negotiations and reached agreement on all the essential aspects of the transaction, most courts would probably find a contract at the time agreement was reached, even though no formal agreement had been signed. The following Cabot Oil case requires the court to determine whether a formal written agreement was necessary to create a binding contract. The court notes six factors to be considered.

Cabot Oil & Gas Corporation v. Daugherty Petroleum, Inc.    479 F. App’x 524 (4th Cir. 2012) Cabot Oil issued a solicitation for bids to purchase several oil and gas leases it owned in West Virginia. The solicitation letter invited recipients to submit a “preliminary bid or proposal” and stated that “those submitting such proposals, if any, will be notified for further discussion and negotiation.” Daugherty Petroleum received the solicitation and responded with a letter that it called alternatively a “bid” and an “offer.” Daugherty Petroleum proposed a purchase price and indicated its ability to close on the deal within 75 days of Cabot Oil’s acceptance. The Daugherty Petroleum letter emphasized, however, that it was “contingent and conditioned” on the negotiation of various terms, including form of payment, due diligence issues, and a requirement that Cabot Oil take the leases off the market for 60 days to allow the due diligence process to be completed. The parties referred to the latter as the “exclusivity period.” Finally, Daugherty Petroleum indicated that, during the due diligence process, the parties would “negotiate the terms and conditions of an asset purchase agreement.” Eventually, after some delay when the parties communicated informally and Cabot Oil executives contemplated the bid, Cabot Oil sent Daugherty Petroleum a letter in which it agreed to the purchase price and the proposed form of payment. Cabot Oil indicated that it preferred to move directly into hammering out a purchase and sale agreement (PSA), during which Daugherty Petroleum could perform whatever due diligence it deemed necessary. To that end, Cabot Oil indicated that it would begin drafting the PSA immediately. Cabot Oil’s letter omitted any reference to the exclusivity period. Around six weeks later, after numerous failed attempts to communicate with Daugherty Petroleum and hearing nothing, Cabot Oil sent a letter indicating that it had accepted Daugherty Petroleum’s offer to purchase the leases and threatening to pursue legal action. Daugherty Petroleum responded that their bid was conditioned on the negotiation of a PSA and the completion of due diligence. Shortly thereafter, Cabot Oil sent Daugherty Petroleum a 12-page draft PSA. The terms differed in certain respects from Daughtery Petroleum’s letter, including terms governing form and timing of payment. It also included additional terms not previously contemplated in their communications. Daugherty Petroleum never responded to the PSA despite Cabot Oil’s numerous attempts to make contact. Cabot Oil sued Daugherty Petroleum in West Virginia for breach of contract, seeking more than $2 million in damages. Both companies moved for summary judgment. The district court granted Daugherty Petroleum’s motion and denied Cabot Oil’s motion, finding that the correspondence between the parties did not create a binding contract. Cabot Oil appealed.



Chapter Eleven The Agreement: Acceptance

Per Curiam A. The fundamental elements of a binding, enforceable contract are competent parties, legal subject-matter, valuable consideration, and mutual assent. Mutuality of assent, in turn, generally requires an offer by one party and acceptance by the other. Offer and acceptance may be manifested through word, act, or conduct that evinces the intention of the parties to contract. . . . Parties may form binding contracts through correspondence. Yet courts must be careful not to construe correspondence as constituting a binding agreement if the parties intended for it to serve merely as preliminary negotiations. If the correspondence reflects that the parties intended to reduce an agreement to a formal written contract, a presumption arises under West Virginia law that the correspondence does not constitute a binding contract, but instead only preliminary negotiations. Strong evidence is necessary to rebut this presumption. In considering whether a party has rebutted this presumption, the overarching goal is to discern whether the parties intended for a final written document to be merely a “convenient memorial” of their agreement or the “consummation of the negotiation.” The Supreme Court of West Virginia has recognized six factors to guide courts in making this determination: (1) “whether the contract is of that class . . . usually found to be in writing”; (2) “whether it is of such nature as to need a formal writing for its full expression”; (3) “whether it has few or many details”; (4) “whether the amount involved is large or small”; (5) “whether it is a common or unusual contract”; and (6) “whether the negotiations themselves indicate that a written draft is contemplated as a final conclusion of the negotiations.” Blair v. Dickinson, 133 W. Va. 38, 54 S.E.2d 828, 844 (W. Va. 1949) (quoting Elkhorn-Hazard Coal Co. v. Ky. River Coal Corp., 20 F.2d 67, 70 (6th Cir. 1927)) (internal quotation marks omitted). Moreover, “[i]f a written draft is proposed, suggested or referred to, during the negotiations, it is some evidence that the parties intended it to be the final closing of the contract.” Id. (quoting Elkhorn-Hazard, 20 F.2d at 70) (internal quotation marks omitted). And if “the parties to an agreement make its reduction to writing and signing a condition precedent to its completion, it will not be a contract until this is done, although all of the terms of the contract have been agreed upon.” Id. at 843 (quoting Brown v. W. Md. Ry. Co., 114 S.E. 457, 457 (W. Va. 1922)) (internal quotation marks omitted). B. We begin by recognizing that from the start the parties manifested their intention to reduce any agreement into a final purchase and sale agreement. Daugherty Petroleum’s . . . letter proposing a purchase price made the negotiation of such an agreement a condition to its bid. Likewise, Cabot Oil’s purported acceptance of Daugherty Petroleum’s proposed purchase price reflected an understanding that

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the parties needed to negotiate a [PSA]. Barr’s response to Cabot Oil’s follow-up e-mail and letter again emphasized that Daugherty Petroleum conditioned its offer on the execution of a mutually agreeable [PSA]. Most emblematic of the parties’ mutual understanding that they would negotiate a formal contract, however, is the [draft PSA] that Cabot Oil composed and sent to Daugherty Petroleum. Hence, because the parties manifested their mutual intention to memorialize any agreement in a formal written contract, we begin with the presumption that their correspondence did not create a binding agreement in the absence of such a formal contract. Using the factors recognized by the Supreme Court of West Virginia, we next conclude that Cabot Oil has not offered strong evidence to overcome this presumption. Even accepting as true Cabot Oil’s suggestion that these types of lease contracts are not unusual, we find that the other five factors reinforce that an executed [PSA] was necessary to form a binding contract. We address these five factors in turn. First, as the district court noted and Cabot Oil acknowledged at oral argument, representatives from both parties indicated in depositions that formal [PSAs] are customary for these types of lease transactions. Second, a formal contract appears to have been necessary to fully express the parties’ agreement. Although the parties’ correspondence contained a number of essential terms of an agreement, such as a proposed price term, general information about the leases, and so forth, it left many terms for the parties to negotiate later. Third, the numerous details that the parties still needed to negotiate after their initial correspondence are evidenced by the [draft PSA], which spans twelve pages in length and includes a multitude of terms that either conflicted with or were additional to Daugherty Petroleum’s letter. Fourth, the amount involved in the transaction—over $2,600,000—is large. Finally, the parties’ correspondence not only reveals that a final [PSA] was contemplated as a conclusion to their negotiations, but, as reflected in Daugherty Petroleum’s initial proposal, it was a condition to the bid. Because these factors militate in Daugherty Petroleum’s favor, Cabot Oil has failed to rebut the presumption that a formal [PSA] was necessary to form a binding contract. We therefore agree with the district court that the undisputed facts indicate that the parties merely engaged in preliminary negotiations and there was no mutual assent. From the start, the parties’ correspondence reflected that the execution of a mutually agreeable [PSA] was necessary to consummate their negotiations and would not merely be a convenient memorial of a preexisting agreement. And, furthermore, such a [PSA] was a condition precedent to the formation of a binding agreement. In the absence of an executed [PSA], we agree with the district court that under West Virginia law no binding contract exists between the parties. As a result, Daugherty Petroleum’s decision to abandon the negotiations and not to purchase the leases does not constitute a breach of contract. For these reasons, we affirm the district court’s grant of summary judgment.

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Part Three Contracts

Acceptance of Ambiguous Offers Although offerors have the power to specify the manner in which their offers can be accepted by requiring that the offeree make a return promise (a bilateral contract) or perform a specific act (a unilateral contract), often an offer is unclear about which form of acceptance is necessary to create a contract. In such a case, the offer may be accepted in any manner that is reasonable in light of the circumstances surrounding the offer. Thus, either a promise to perform or performance, if reasonable, creates a contract.

Acceptance by Shipment The UCC specifically elaborates on the rule stated in the preceding section by stating that an order requesting prompt or current shipment of goods may be accepted either by a prompt promise to ship or by a prompt or current shipment of the goods [2-206(1)(b)]. So, if Ampex Corporation orders 500 Apple iPads from Marks Office Supply, to be shipped immediately, Marks could accept either by promptly promising to ship the goods or by promptly shipping them. If Marks accepts by shipping, any subsequent attempt by Ampex to revoke the order will be ineffective.

What if Marks did not have 500 iPads in stock and Marks knew that Ampex desperately needed the goods? Marks might be tempted to ship another brand of tablet (that is, nonconforming goods—goods different from what the buyer ordered), hoping that Ampex would be forced by its circumstances to accept them because by the time they arrived it would be too late to get the correct goods elsewhere. Marks would argue that by shipping the wrong goods it had made a counteroffer because it had not performed the act requested by Ampex’s order. If Ampex accepts the goods, Marks could argue that Ampex has impliedly accepted the counteroffer. If Ampex rejects the goods, Marks would arguably have no liability because it did not accept the order. The UCC prevents such a result by providing that prompt shipment of either conforming goods (what the order asked for) or nonconforming goods (something else) operates as an acceptance of the order [2-206(1)(b)]. This protects buyers such as Ampex because sellers who ship the wrong goods have simultaneously accepted their offers and breached the contract by sending the wrong merchandise.3 Chapter 19 discusses the rights and responsibilities of the buyer and seller following the shipment of nonconforming goods. 3

Ethics and Compliance in Action Marble Publications is a publisher of various magazines and newsletters. Samantha has a subscription to one of Marble’s publications, Parent’s World. In 2018, Marble sends Samantha a complimentary copy of another of its publications, Gardens Unlimited, along with a letter that states that Samantha will receive Gardens Unlimited free of charge for three months, but if she does not want to receive any further copies of Gardens Unlimited,

she must contact Marble and cancel. The letter states that if Samantha fails to contact Marble, she will be subscribed for one year at a cost of $24.95. Samantha does not read the letter carefully and never contacts Marble. After three months, she receives a bill for $24.95. Is this an ethical way of marketing Gardens Unlimited? What ethical problems might arise if silence were generally considered to constitute acceptance?

The Global Business Environment Under the United Nations Convention on Contracts for the International Sale of Goods (CISG), as under U.S. law, statements or other conduct by the offeree that shows assent is an acceptance, and silence alone generally does not suffice as acceptance. And, as is true under U.S. law, a contract is concluded when an acceptance of an offer becomes effective. There are several notable differences between acceptance doctrines under U.S. law and the CISG, however. For one, the “battle of the forms,” as it is formulated under the Uniform Commercial Code, does not exist under the CISG. Rather, under the CISG, a reply to an offer

that purports to be an acceptance but in fact contains new or different terms or limitations that are material is a rejection and not an acceptance. Examples of terms that would be considered material are terms relating to price, payment, quality, the extent of a party’s liability, and settlement of disputes (such as arbitration clauses). However, a reply purporting to be an acceptance that contains nonmaterial new or different terms can be an acceptance. Another major difference between U.S. law and the CISG is that, unlike the U.S. “mailbox rule,” the CISG generally holds acceptances to be effective when they are received.



Chapter Eleven The Agreement: Acceptance

But what if Marks is an honest seller merely trying to help out a customer that has placed a rush order? Must Marks expose itself to liability for breach of contract in the process? The UCC prevents such a result by providing that no contract is created if the seller notifies the buyer within a reasonable time that the shipment of nonconforming goods is intended as an accommodation (an attempt to help the buyer) [2-206(1)(b)]. In this case, the shipment is merely a counteroffer that the buyer is free to accept or reject and the seller’s notification gives the buyer the opportunity to seek the goods he needs elsewhere.

Problems and Problem Cases 1. In December 1999, Wilson applied for a Citibank credit card and signed an acceptance certificate in which she agreed to be bound by the terms and conditions of the credit card agreement. Citibank then issued a credit card to her, which Wilson began using. In July 2001, Citibank mailed Wilson her credit card statement, which informed her that it was modifying the terms of the original agreement. This revised agreement was enclosed with the credit card statement. After the July 2001 statement was made to her, Wilson continued using her credit card and made monthly payments on her account balance. Wilson made her last payment to Citibank in March 2002 and failed to make payments thereafter. Citibank then filed suit against her to collect her overdue balance, which was $12,272.84. In this action, Citibank attempted to enforce the revised agreement rather than the original agreement. Wilson argued that she never accepted the revised agreement. Is this a good argument? 2. 23andMe Inc. sold its Personal Genome Service (PGS) product on the Internet. The PGS consists of a DNA saliva collection kit and DNA test results with certain information gleaned from saliva samples that customers submit using the DNA kit. The PGS transaction is structured as a two-step process. First, a customer purchases the DNA kit, which 23andMe ships along with a pre-addressed return box. The customer collects the saliva with the kit and returns the collected saliva to 23andMe, which sends the saliva to a certified laboratory for analysis. When the laboratory returns results, 23andMe posts the results online to the customer’s personal genome profile and sends an e-mail to the customer notifying him or her that the results are available. The customer must then log on to the profile to access the information.

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Who Can Accept an Offer? As the masters of

their offers, offerors have the right to determine who can bind them to a contract. So, the only person with the legal power to accept an offer and create a contract is the original offeree. An attempt to accept by anyone other than the offeree is treated as an offer because the party attempting to accept is indicating a present intent to contract on the original offer’s terms. For example, Price offers to sell his car to Waterhouse for $5,000. Anderson learns of the offer, calls Price, and attempts to accept. Anderson has made an offer that Price is free to accept or reject.

   23andMe’s Terms of Service (TOS) are accessible by a hyperlink at the bottom of its homepage and many, though not all, of its other pages. The web page upon which a customer purchases a DNA kit is one such page with no reference to the TOS. Thus, the first step of the PGS transaction does not require the customer to view or otherwise agree to the TOS. The second step, however, requires the customer to create an account on the 23andMe site and register the DNA kit. The account creation page requires customers to check a box next to the line, “Yes, I have read and agree to the Terms of Service and Privacy Statement.” The TOS and Privacy Statement appear in blue font and are hyperlinks to the full terms. Similarly, during the registration process, customers must view a page with the title “To continue, accept our terms of service” written in large font at the top of the page. The registration page provides a hyperlink to the full TOS next to the line: “When you sign up for 23andMe’s service you agree to our Terms of Service. Click here to read our full Terms of Service.” Customers must then click a large blue icon that reads, “I ACCEPT THE TERMS OF SERVICE,” before finishing the registration process and receiving their DNA information. The TOS state that customers who use 23andMe services have manifested acceptance of the TOS by their conduct, regardless of whether they ever read the TOS. Are PGS customers bound by the TOS? What about customers who purchase the PGS as a gift for another person and that person is the one who collects the saliva sample and sets up his or her own account? 3. Belden was AEC’s longtime supplier of wire, which it used in its sensors, including the sensors that it sold to Chrysler for inclusion in its cars. In 2003, Belden began using a nonconforming insulation in its wire. Belden’s order acknowledgment, sent in response to AEC’s purchase order, contained a limitation of remedy that

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Part Three Contracts

was not in the offer. It also stated that its acceptance was expressly conditioned on AEC’s agreement to its terms. The sensors that AEC sold to Chrysler failed, due to the nonconforming wiring, and Chrysler had to recall cars in which it had been installed. AEC had to reimburse Chrysler for its losses caused by the recall. AEC sued Belden to recover the amount of money AEC paid to reimburse Chrysler, and Belden claimed that the limitation of remedies in its acknowledgment protected it from liability for these damages. Is Belden correct? 4. Standard Bent Glass wanted to buy a machine for its factory that would produce cut glass. In March 1998, it started negotiations with Glassrobots Oy, a Finnish corporation. By February 1999, negotiations had reached a critical juncture. On February 1, Standard Bent Glass faxed an offer to purchase a glass fabricating system from Glassrobots. The offer sheet began, “Please find below our terms and conditions related to ORDER #DKH2199,” and defined the items to be purchased; the quantity; the price of $1.1 million; the payment terms; and installation specifics, instructions, and warranties. The letter concluded, “Please sign this ORDER and fax to us if it is agreeable.” On February 2, Glassrobots responded with a cover letter, invoice, and standard sales agreement. The cover letter recited: “Attached you’ll find our standard sales agreement. Please read it through and let me know if there is anything you want to change. If not, I’ll send 2 originals, which will be signed.” The contract included an arbitration clause and several references to arbitration. Glassrobots did not return, nor refer to, Standard Bent Glass’s order. Later that day, Standard Bent Glass faxed a return letter that began, “Please find our changes to the Sales Agreement,” by which it meant Glassrobots’s standard sales agreement. This letter apparently accepted Glassrobots’s standard sales agreement as a template and requested five specific changes. The letter closed, “Please call me if the above is not agreeable. If it is we will start the wire today.” On February 4, Standard Bent Glass wired the down payment to Glassrobots, and on February 8, the wire transfer cleared Glassrobots’s bank account. On February 5, Glassrobots sent Standard Bent Glass a revised sales agreement that incorporated almost all of the requested changes. Glassrobots’s cover letter stated, “Attached you’ll find the revised sales agreement. . . . Please return one signed to us; the other one is for your files.” A provision of this agreement stated that “this Agreement shall come into force when signed by both parties.” Standard Bent Glass never signed the agreement.

On February 9, Standard Bent Glass sent another fax to Glassrobots in which it stated, “Just noticed on our sales agreement that the power is 440 ± 5. We must have 480 ± 5 on both pieces of equipment.” There was no further written correspondence after February 9 and no contract was ever signed by both parties. Nevertheless, both parties continued to perform. Glassrobots installed the glass fabricating system and Standard Bent Glass made its final payment to Glassrobots. Standard Bent Glass noticed defects in the equipment, and the parties disputed the cause of the defects. Standard Bent Glass sued Glassrobots. Glassrobots claimed that the contract between the parties included an arbitration clause under an appendix to the standard sales agreement. Did it? 5. Richard Davis, a South Carolina real estate broker who buys underpriced properties to renovate and sell (i.e., “flipping” homes), conceived of and developed a pilot episode of a television show documenting the flipping process. He shopped the pilot to a number of television networks, including to A & E, where he worked with the director of lifestyle programming, Charles Nordlander. Davis and Nordlander discussed turning the show into a series for A & E. Davis proposed that he would assume all of the financial risk relating to the purchase and resale of the real estate but that they would otherwise split the revenues of the show. According to Davis, Nordlander responded, “Okay, okay, I get it.” Thereafter, Nordlander arranged for Davis to meet with various A & E representatives and with a production company, Departure Films, all the while reiterating the terms Davis outlined; however, they never reduced the terms to writing. With Departure Films on board, filming began, and A & E’s senior vice president notified Davis that “the board approved the money for our series,” Flip This House. They filmed 13 episodes of the series, and the show was a commercial success. Unfortunately, there was a dispute over Davis’s compensation. A & E offered to pay Davis an appearance fee per episode and a 5 percent share of incremental revenue attributable to the show. Davis rejected that arrangement and signed a talent agreement with another network. A & E went on to produce three more seasons of Flip This House without Davis and never paid him any money, let alone half of the series’ net revenue as required by the terms Davis and Nordlander discussed. Davis sued for breach of contract, but A & E denied ever entering into a contract with Davis. Does A & E owe Davis half the net revenues for Flip This House’s first season? 6. In the summer of 2002, after several South Louisiana women had been murdered, the Multi-Agency



Chapter Eleven The Agreement: Acceptance

Homicide Task Force was established to investigate these murders, believed to have been committed by an individual referred to as the “South Louisiana Serial Killer.” In April 2003, the Baton Rouge Crime Stoppers (BRCS) began publicizing a reward offer in newspapers, television stations, and billboards around the Baton Rouge area regarding the South Louisiana Serial Killer. The offer read, in part: A $100,000 reward will be given for information leading to the arrest and indictment of the South Louisiana Serial Killer. Call today and help make Baton Rouge a safer place for you and your family. All calls remain anonymous. 334-STOP or 1-877-723-7867. Reward expires ­August 1, 2003.

   A short time later, Lafayette Crime Stoppers (LCS) also publicized a reward offer. It stated in part: In order to qualify for the reward, the tipster must provide information which leads to the arrest, DNA match, and the formal filing of charges against a suspect through grand jury indictment. . . . In addition, the qualifying tip must be received prior to midnight, August 1, 2003. . . . Tips can be submitted 24 hours a day at 232-TIPS or toll free at 1-800-TIPS.

On July 9, 2002, Alexander was attacked in her home in St. Martin Parish, Louisiana. Alexander’s son arrived home during the attack and chased the attacker from the property. Alexander reported the attack to local police and later, she and her son described the attacker to the Lafayette Sheriff’s Department. Her report led investigators to suspect that her attacker could be the South Louisiana Serial Killer. In May 2003, Alexander was interviewed by an FBI agent assisting the task force. Based on the interview, a composite sketch was drawn and released to the public. On May 25, 2003, a photo lineup was prepared and presented to Alexander, and she identified her attacker. On or about August 14, 2003, Alexander contacted LCS and sought to collect the advertised award. However, LCS informed her she was ineligible to receive the award because she did not contact LCS via the tipster hotline and did not conform to the conditions of the offer. Alexander and her son filed suit against LCS and BRCS. Assuming that the information they provided led to the arrest and prosecution of the serial killer, did they accept the offers for the rewards? 7. Cantu was hired as a special education teacher by the San Benito Consolidated Independent School District under a one-year contract for the 1990–91 school year. On August 18, 1990, shortly before the start of

11-21

the school year, Cantu hand-delivered to her supervisor a letter of resignation, effective August 17, 1990. In this letter, Cantu requested that her final paycheck be forwarded to an address in McAllen, Texas, some 50 miles from the San Benito office where she tendered the resignation. The San Benito superintendent of schools, the only official authorized to accept resignations on behalf of the school district, received Cantu’s resignation on Monday, August 20. The superintendent wrote a letter accepting Cantu’s resignation the same day and deposited the letter, properly stamped and addressed, in the mail at approximately 5:15 P.M. that afternoon. At about 8:00 A.M. the next morning, August 21, Cantu hand-delivered to the superintendent’s office a letter withdrawing her resignation. This letter contained a San Benito return address. In response, the superintendent hand-delivered that same day a copy of his letter mailed the previous day to inform Cantu that her resignation had been accepted and could not be withdrawn. The dispute was taken to the state commissioner of education, who concluded that the school district’s refusal to honor Cantu’s contract was lawful because the school district’s acceptance of Cantu’s resignation was effective when mailed, which resulted in the formation of an agreement to rescind Cantu’s employment contract. Cantu argued that the mailbox rule should not apply because her offer was made in person and the superintendent was not authorized to accept by using mail. Is this a good argument? 8. Andrew and Joyce Kay Pride owned a house in Nodaway County, Missouri, which they placed for sale in 2002. The Prides moved to a farm, so the house sat empty for some time while it was on the market. To avoid that, the Prides found a tenant to rent the house for $450 per month until such time the house sold. Larry Lewis made an offer to purchase the house for $55,000, sending the Prides and their Realtor a signed purchase agreement on April 9, 2003. The agreement indicated a closing date of May 13. The Prides changed that date on the agreement, crossing out May 13 and replacing it with June 1. They then signed the agreement on April 9 and initialed the change to the closing date. They informed their tenant that she would have to vacate by June 1. When June rolled around, though, there was a problem with closing. While the Prides and their Realtor appeared and were prepared to close, neither Lewis nor his wife nor Lewis’s Realtor showed up. The Prides’ real estate agent contacted Lewis’s Realtor and was informed that Lewis had not responded to phone calls or otherwise communicated with his Realtor. The

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Part Three Contracts

Prides thereafter sent Lewis a letter notifying him of his default and re-listed the house. They eventually sold the house the following June for $40,000. Moreover, the Prides were unable to find a new tenant after their initial tenant vacated as directed prior to the failed closing with Lewis. Do the Prides and Lewis have a contract pursuant to which the Prides could sue for breach of contract and recover the difference between the $55,000 contract price with Lewis and the $40,000 for which the house actually sold? 9. In 1985, State Farm Mutual Insurance issued Casto an automobile insurance policy on her Jaguar. Casto also insured a second car, a Porsche, with State Farm. Some time in September or early October 1987, Casto received two renewal notices for her policy on the Jaguar, indicating that the next premium was due on October 10, 1987. State Farm sent a notice of cancellation on October 15, indicating that the policy would be canceled on October 29. Casto denied having received this notice. On October 20, Casto placed two checks, one for the Jaguar and one for the Porsche, in two preaddressed envelopes that had been supplied by State Farm. She gave these envelopes to Donald Dick, who mailed them on the same day. The envelope containing the Porsche payment was timely delivered to State Farm, but State Farm never received the Jaguar payment, and that policy was canceled. Casto was involved in an accident on November 20 while driving the Jaguar. When she made a claim with State Farm, she learned that the policy had been canceled. After the accident, the envelope containing the Jaguar payment

was returned to her stamped, “Returned for postage.” The envelope did not bear any postage when returned to Casto. Casto brought a declaratory judgment action seeking a declaration that her insurance policy was in effect as of the date of the accident. Was it? 10. McGurn entered into negotiations to begin work at Bell Microproducts as a regional vice president. McGurn was eager for any employment agreement to include a termination clause that would entitle him to six months’ pay and half his commissions if he were to be fired. Bell Microproducts at first balked and presented McGurn with an agreement absent any termination clause. In response, McGurn indicated he would be satisfied with a termination clause that covered only the first two years of his employment. Bell Microproducts sent him a revised employment agreement with a termination clause; however, as written, the clause covered only the first 12 months of McGurn’s employment. McGurn signed and dated this agreement, but he also crossed out “twelve months” as the term of the termination clause and replaced it with a hand-written “twenty-four months.” He initialed that alteration, which appeared in the middle of a two-page document about five inches above his signature. No one from Bell Microproducts noticed McGurn’s edit to the agreement until McGurn’s supervisor decided to fire him for poor performance 13 months after McGurn’s start date. Did Bell Microproducts accept McGurn’s counteroffer of a 24-month termination clause based on its silence on the subject for over a year?

CHAPTER 12

Consideration

T

he Valley Area Anti-Smoking Foundation (VAAF) offered to pay any Valley Area residents $500 each if they would refrain from smoking for one year. Chad, a Valley Area resident, decided to accept this offer. He quit smoking immediately and did not smoke for a whole year. When Chad contacted VAAF to inform it of his success and collect his $500, VAAF informed him that it was able to pay only $250 because so many Valley Area residents had taken advantage of its offer. Chad reluctantly agreed to accept $250 instead of $500. • Was VAAF contractually obligated to pay Chad for refraining from smoking? • Was there consideration to support its promise to pay $500? • Are there other facts you need to know to make that determination? • Is Chad entitled to receive the entire $500 or only $250? • Was VAAF ethically required to pay the entire $500?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 12-1 Define the concept of consideration and describe its significance in the formation of a valid contract. 12-2 Explain the elements of consideration.

ONE OF THE THINGS that separates a contract from an unenforceable social promise is that a contract requires voluntary agreement by two or more parties. Not all agreements, however, are enforceable contracts. At a fairly early point in the development of classical contract law, the common law courts decided not to enforce gratuitous (free) promises. Instead, only promises supported by consideration were enforceable in a court of law. This was consistent with the notion that the purpose of contract law was to enforce freely made bargains. As one 19th-century work on contracts put it: “The common law . . . gives effect only to contracts that are founded on the mutual exigencies of men, and does not compel the performance of any merely gratuitous

12-3 Explain why illusory promises, past consideration, and promises to perform preexisting obligations are not consideration. 12-4 Determine what is required to create a valid modification of a contract under both the common law of contracts and the UCC.

agreements.”1 The concept of consideration distinguishes agreements that the law will enforce from gratuitous promises, which are normally unenforceable. This chapter focuses on the concept of consideration. LO12-1

Define the concept of consideration and describe its significance in the formation of a valid contract.

LO12-2 Explain the elements of consideration.

T. Metcalf, Principles of the Law of Contracts (1874), p. 161.

1

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Part Three Contracts

Elements of Consideration A common definition of consideration is legal value, bargained for and given in exchange for an act or a promise. Thus, a promise generally cannot be enforced against the person who made it (the promisor) unless the person to whom the promise was made (the promisee) has given up something of legal value in exchange for the promise. In effect, the requirement of consideration means that a promisee must pay the price that the promisor asked to gain the right to enforce the promisor’s promise. So, if the promisor did not ask for anything in exchange for making a promise or if what the promisor asked for did not have legal value (e.g., because it was something to which she was already entitled), the promise is not enforceable against the promisor because it is not supported by consideration. Consider the early case of Thorne v. Deas, in which the part owner of a sailing ship named the Sea Nymph promised his co-owners that he would insure the ship for an upcoming voyage.2 He failed to do so, and when the ship was lost at sea, the court found that he was not liable to his co-owners for breaching his promise to insure the ship. Why? Because his promise was purely gratuitous; he had neither asked for nor received anything in exchange for making it. Therefore, it was unenforceable because it was not supported by consideration. This early example illustrates two important aspects of the consideration requirement. First, the requirement tended to limit the scope of a promisor’s liability for his promises by insulating him from liability for gratuitous promises and by protecting him against liability for reliance on such promises. Second, the mechanical application of the requirement often produced unfair results. This potential for unfairness has produced considerable dissatisfaction with the consideration concept. As the rest of this chapter indicates, the relative importance of consideration in modern contract law has been somewhat eroded by numerous exceptions to the consideration requirement and by judicial applications of consideration principles designed to produce fair results.

Legal Value Consideration can be an act in the case

of a unilateral contract or a promise in the case of a bilateral contract. An act or a promise can have legal value in one of two ways. If, in exchange for the promisor’s promise, the promisee does, or agrees to do, something he had no prior legal duty to do, that provides legal value. If, in exchange for the promisor’s promise, the promisee refrains from doing, or agrees not to do, something she has a legal right to do, that also provides legal value. This form of consideration is known as “forbearance.” Though valid consideration can 2

4 Johns. 84 (N.Y. 1809).

result from forbearance from all sorts of otherwise legal activities, later in this chapter we discuss a specific type of forbearance common in commercial settings, namely, forbearance to sue someone else when you have a good-faith belief that you have a valid claim to do so. Note that this definition does not require that an act or a promise have monetary (economic) value to amount to consideration. Thus, in a famous 19th-century case, Hamer v. Sidway,3 an uncle’s promise to pay his nephew $5,000 if he refrained from using tobacco, drinking, swearing, and playing cards or billiards for money until his 21st birthday was held to be supported by consideration. Indeed, the nephew had refrained from doing any of these acts, even though he may have benefited from so refraining. He had a legal right to indulge in such activities, yet he had refrained from doing so at his uncle’s request and in exchange for his uncle’s promise. This was all that was required for consideration. Adequacy of Consideration The point that the legal value requirement is not concerned with actual value is further borne out by the fact that the courts generally will not concern themselves with questions regarding the adequacy of the consideration that the promisee gave. This means that as long as the promisee’s act or promise satisfies the legal value test, the courts do not ask whether that act or promise was worth what the promisor gave, or promised to give, in return for it. This rule on adequacy of consideration reflects the laissez-faire assumptions underlying classical contract law. Freedom of contract includes the freedom to make bad bargains as well as good ones, so promisors’ promises are enforceable if they got what they asked for in exchange for making their promises, even if what they asked for was not nearly so valuable in worldly terms as what they promised in return. Also, a court taking a hands-off stance concerning private contracts would be reluctant to step in and second-guess the parties by setting aside a transaction that both parties at one time considered satisfactory. Finally, the rule against judging the adequacy of consideration can promote certainty and predictability in commercial transactions by denying legal effect to what would otherwise be a possible basis for challenging the enforceability of a contract—the inequality of the exchange. Several qualifications must be made concerning the general rule on adequacy of consideration. First, if the inadequacy of consideration is apparent on the face of the agreement, most courts conclude that the agreement was a disguised gift rather than an enforceable bargain. Thus, an agreement calling for an unequal exchange of money (e.g., $500 for $1,000) or identical goods 27 N.E. 256 (N.Y. Ct. App. 1891).

3



Chapter Twelve Consideration

(20 business law textbooks for 40 identical business law textbooks) and containing no other terms would probably be unenforceable. Gross inadequacy of consideration may also give rise to an inference of fraud, duress,4 lack of capacity,5 unconscionability,6 or some other independent basis for setting aside a contract. However, inadequacy of consideration, standing alone, is never sufficient to prove lack of true consent or contractual capacity. Although gross inadequacy of consideration is not, by itself, ordinarily a sufficient reason to set aside a contract, the courts may refuse to grant specific performance or other equitable remedies to persons seeking to enforce unfair bargains. Finally, some agreements recite “$1,” or “$1 and other valuable consideration,” or some other small amount as consideration for a promise. If no other consideration is actually exchanged, this is called nominal consideration. Often, such agreements are attempts to make gratuitous promises look like true bargains by reciting a nonexistent consideration. Most courts refuse to enforce such Fraud and duress are discussed in Chapter 13. Lack of capacity is discussed in Chapter 14. 6 Chapter 15 discusses unconscionability in detail.

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agreements unless they find that the stated consideration was truly bargained for.

Bargained-For Exchange Up to this point, we

have focused on the legal value component of our consideration definition. But the fact that a promisee’s act or promise provides legal value is not, in itself, a sufficient basis for finding that it amounted to consideration. In addition, the promisee’s act or promise must have been bargained for and given in exchange for the promisor’s promise. In effect, it must be the price that the promisor asked for in exchange for making his promise. Over a hundred years ago, Oliver Wendell Holmes, one of our most renowned jurists, expressed this idea when he said, “It is the essence of a consideration that, by the terms of the agreement, it is given and accepted as the motive or inducement of the promise.”7 The following Steinberg case illustrates the concept of bargained-for legal value.

4 5

O. W. Holmes, The Common Law (1881), p. 239.

7

Steinberg v. United States   90 Fed. Cl. 435 (2009) In preparation for the January 20, 2009, inauguration ceremony for President-Elect Barack Obama, the Joint Congressional Committee on Inaugural Ceremonies (JCCIC) announced that it would distribute approximately 240,000 complimentary tickets to the general public to view the inauguration ceremonies. The tickets were available at no charge, and interested parties could obtain them by contacting the office of their congressional representatives. Michael Steinberg obtained two of the tickets from his congressman, Gus Bilirakis. Steinberg and a guest traveled to Washington, D.C., from his home in Florida and arrived several hours before the start of the ceremony at the viewing area indicated on his tickets. Eventually, however, Steinberg and his guest were refused admittance, and they were unable to view the inauguration. Steinberg claimed that the JCCIC never told ticketholders that they might not be admitted to the designated viewing section, despite the fact that they anticipated some would be turned away. He was particularly upset about incurring travel expenses without being able to accurately weigh the risk of nonadmittance, about which the JCCIC easily could have notified him. Steinberg filed a lawsuit against the United States for, among other things, breach of contract for the JCCIC’s failure to notify him about the risk of being turned away and for failing to honor the ticket. The United States moved to dismiss the claim. Hewitt, Chief Judge To recover for a breach of contract, a party must allege and ­establish: (1) a valid contract between the parties, (2) an obligation or duty arising under the contract, (3) a breach of that duty, and (4) damages caused by the breach. . . . To establish a valid

contract with the government, a party must allege and establish: (1) mutuality of intent, (2) consideration, (3) lack of ambiguity in the offer and acceptance, and (4) that the government official whose conduct the contractor relies upon has actual authority to bind the government in contract. . . . An implied-in-fact contract has the same requirements as an express contract, but an

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Part Three Contracts

implied-in-fact contract is founded upon the meeting of the minds and the mutual understanding of the parties. . . . Valid contract formation also requires consideration. “[A]ny performance which is bargained for is consideration.” [Restatement (Second) of Contracts (Restatement) § 72 (1981). “To constitute consideration, a performance or a return promise must be bargained for.” Id. § 71(1). “A performance or return promise is bargained for if it is sought by the promisor in exchange for his promise and is given by the promisee in exchange for that promise.” Id. § 71(2). * * *  Mr. Steinberg asserts that “those persons offered tickets would have to personally pick up the tickets from his or her Congressperson’s office.” More specifically, in plaintiff’s Motion, he asserts that “pick[ing] up the ticket in person was mandatory and thus acted as consideration in order to receive the ticket.” In rendering a decision on a motion to dismiss, the court must presume that undisputed factual allegations in the complaint are true. . . . Here, however, the factual allegation supporting plaintiff’s claim that such “consideration” was required is contradicted by plaintiff himself. Even if a requirement of “pick[ing] up the ticket” in person could somehow be viewed as consideration, the “mandatory” requirement on which Mr. Steinberg relies does not exist. Attached as an exhibit to the Amended Complaint was an e-mail that Mr. Steinberg received from Cristin Datch, Staff Assistant to Congressman Bilirakis, which states that “if someone will be picking up tickets on your behalf, we must have his/her name and telephone number in order to verify his/her information when he/she arrives in our office. Therefore, if that is the case, please respond to this email with his/her contact information.” Mr. Steinberg was not required to pick up his free ticket in person. Picking up the tickets in person could not serve as consideration necessary to establish a contract. Nor does the court find that Mr. Steinberg’s traveling expenses constitute consideration. Plaintiff defines consideration as “a detriment to the promisee or a benefit to the promisor,” and asserts that the cost of traveling to DC was a detriment to him and therefore constitutes consideration. A detriment to one party may serve as consideration, but only if such detriment is bargained for. See Restatement § 72. Plaintiff fails to assert that his detriment, the cost of travel, was bargained for or sought by the government in any way. Plaintiff also suggests that his attendance at the inauguration ceremonies is analogous to the activities of a plaintiff who

participated in the promotion of a casino. (“The process was similar to a contest, with winners being selected.”) (citing Gottlieb v. Tropicana Hotel & Casino, 109 F. Supp. 2d 324 (E.D. Pa. 2000)). In Gottlieb, the plaintiff was required to report information about her gambling habits to the casino and became “a part of the entertainment” at the casino. The court in Gottlieb concluded that the casino “offered the promotion in order to generate patronage of and excitement within the casino.” Id. at 330. The plaintiff in Gottlieb established bargained-for consideration and survived a motion for summary judgment. The court [is unconvinced by] plaintiff’s comparison of a presidential inauguration to a casino’s business effort to attract customers in an attempt to turn a profit. Throngs of people traveled to Washington for the inauguration. Plaintiff notes that “[p]ersons who desired the tickets exceeded the number available.” A message on plaintiff’s tickets warned the holders to “arrive early due to large crowds.” Unlike the proprietor of the casino in Gottlieb, the government did not bargain for Mr. Steinberg’s attendance. The United States did not receive a bargainedfor benefit from the spectators who attended the inauguration ceremonies. Plaintiff asserts that “the JCCIC received an intangible benefit of promoting the Inauguration by means of the complimentary tickets offered through the various mediums.” Plaintiff does not explain what such an intangible benefit might be. The government did not attempt to make money from the inauguration, nor did it need to attract participants as the casino in Gottlieb did. In determining whether there was consideration, the question is not whether one party received a benefit (tangible or otherwise), but whether the benefit was bargained for. See Restatement § 71. If the benefit was not bargained for, and here it was not, it cannot constitute consideration necessary to support a contract. The government did not bargain for the attendance of plaintiff or others at the inauguration ceremonies. Because the inauguration is unlike the business in Gottlieb, the court finds that there was no bargained-for benefit, tangible or intangible, that could serve as consideration. * * *  For the reasons set forth above, the court GRANTS defendant’s Motion. Because defendant’s Motion is GRANTED, the case is DISMISSED. . . . IT IS SO ORDERED.



Chapter Twelve Consideration

Exchanges That Fail to Meet Consideration Requirements Explain why illusory promises, past consideration, and

LO12-3 promises to perform preexisting obligations are not

consideration.

Illusory Promises For a promise to serve as con-

sideration in a bilateral contract, the promisee must have promised to do, or to refrain from doing, something at the promisor’s request. It seems obvious, therefore, that if the promisee’s promise is illusory because it really does not bind the promisee to do or refrain from doing anything, such a promise could not serve as consideration. Such agreements are often said to lack the mutuality of obligation required for an agreement to be enforceable. So, a promisee’s promise to buy “all the sugar that I want” or to “paint your house if I feel like it” would not be sufficient consideration for a promisor’s return promise to sell sugar or hire a painter. In neither case has the promisee given the promisor anything of legal value in exchange for the promisor’s promise. Remember, though: So long as the promisee has given legal value, the agreement will be enforceable even though what the promisee gave is worth substantially less than what the promisor promised in return.

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Effect of Cancellation or Termination Clauses The fact that an agreement allows one or both of the parties to cancel or terminate their contractual obligations does not necessarily mean that the party (or parties) with the power to cancel has given an illusory promise. Such provisions are a common and necessary part of many business relationships. The central issue in such cases concerns whether a promise subject to cancellation or termination actually represents a binding obligation. A right to cancel or terminate at any time, for any reason, and without any notice would clearly render illusory any other promise by the party possessing such a right. However, limits on the circumstances under which cancellation may occur (such as a dealer’s failure to live up to dealership obligations), or the time in which cancellation may occur (such as no cancellations for the first 90 days), or a requirement of advance notice of cancellation (such as a 30-day notice requirement) would all effectively remove a promise from the illusory category. This is so because in each case the party making such a promise has bound himself to do something in exchange for the other party’s promise. A party’s duty of good faith and fair dealing can also limit the right to terminate and prevent its promise from being considered illusory. The court in Day v. Fortune Hi-Tech Marketing, Inc., which follows, addresses the effect of a clause in a contract that gave one party the option to modify it at will.

Day v. Fortune Hi-Tech Marketing, Inc.   536 F. App’x 600 (6th Cir. 2013) Fortune Hi-Tech Marketing Inc. (FHTM) is a multilevel marketing company and acts as a third-party marketing firm that sells services from companies to consumers. Yvonne Day and a number of other individuals paid an enrollment fee to serve as Independent Representatives (IRs) of FHTM. They sold the services of various companies on behalf of FHTM, for which they would receive commissions. IRs also received bonuses of $100 for each new IR they recruited. When enrolling an IR, an individual completed an application and agreement that indicated he or she had read and agreed to the FHTM Policies and Procedures, which were incorporated into the agreement between the company and the IR. The FHTM Policies and Procedures included a requirement that any claim brought under the agreement would be arbitrated. Another clause in the Policies and Procedures indicated that FHTM could modify the agreement at any time without notice. Eventually, Day and others filed suit against FHTM in a federal district court in Kentucky under various federal and Kentucky state consumer protection and antiracketeering laws. They alleged that FHTM was running an illegal pyramid scheme. The plaintiffs alleged that the only way to recoup their enrollment fees and/or to make additional money was to recruit new IRs because doing that was far more lucrative than selling services on behalf of FHTM. FHTM filed a motion with the court to compel arbitration of the claims based on the arbitration clause in the Policies and Procedures. Initially, the district court found that the plaintiffs had agreed to arbitrate their claims. However, the plaintiffs moved the court to reconsider its ruling. Upon reconsideration, the district court determined that the arbitration agreement was invalid and ordered the claims to proceed to trial. Although appeals to the circuit court must usually await a final resolution of the case at the district-court level, certain issues are subject to interlocutory appeal prior to final resolution of the case. A ruling on the validity of an arbitration clause is typically one such issue, and FHTM was allowed to file an interlocutory appeal of the district court’s denial of its motion to compel arbitration.

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Part Three Contracts

Clay, Circuit Judge There is a general presumption in favor of arbitration. . . . Even if courts are meant to favor a finding that parties have agreed to submit their claims to arbitration, parties must still have a valid and enforceable agreement to resolve their claims in arbitration. Although it is a basic principle of contract law that every contract requires mutuality and consideration, an arbitration clause does not require independent consideration; so long as the contract as a whole is adequately supported by consideration, each clause is valid unless there is some other deficiency in the contract’s validity. The district court found that the arbitration clause was unenforceable because the contract between Plaintiffs and Defendant was not supported by adequate consideration, and we agree. Because Defendant retained the ability to modify any term of the contract, at any time, its promises were illusory. Defendant was not bound by any particular provision of the contract because at any point, including immediately after acceptance, Defendant could have changed any clause without any recourse sounding in contract law available to Plaintiffs. The only notice provision made changes effective upon their issuance, rather than after a fixed period of time. Had the contract permitted unilateral alteration upon thirty days’ notice, for example, there might have been consideration, because the altering party would still have been bound to the original terms for the thirty day period. See Restatement (Second) of Contracts § 77 cmt. b, illus. 5 (1981). But in

Effect of Output and Requirements Contracts Contracts in which one party to the agreement agrees to buy all of the other party’s production of a particular commodity (output contracts) or to supply all of another party’s needs for a particular commodity (requirements contracts) are common business transactions that serve legitimate business purposes. They can reduce a seller’s selling costs and provide buyers with a secure source of supply. Prior to the enactment of the UCC, however, many common law courts refused to enforce such agreements on the ground that their failure to specify the quantity of goods to be produced or purchased rendered them illusory. The courts also feared that a party to such an agreement might be tempted to exploit the other party. For example, subsequent market conditions could make it profitable for the seller in an output contract or the buyer in a requirements contract to demand that the other party buy or provide more of the particular commodity than the other party had actually intended to buy or sell. The UCC legitimizes requirements and output contracts. It addresses the concern about the potential for exploitation by limiting a party’s demands to those quantity needs that occur in good faith and are not unreasonably disproportionate to any quantity estimate contained in the contract, or to any normal prior

this case, in effect, Defendant promised to do certain things unless it decided not to, and that is by definition illusory. While some states may permit enforcement of a contract that requires only notice, rather than advance notice, for alteration of its terms, Kentucky is not one of those states. Accordingly, because the contract lacked consideration, the entire contract, including the arbitration clause, is void and unenforceable. . . . Defendant raises [several] arguments as to why the agreement was supported by consideration, or why, even if there was no consideration, the contract is still enforceable. First, [it argues that] there was no modification of the arbitration clause at any point during the relevant time period here. . . . [T]hat argument confuses performance of the terms with an obligation to perform under the contract. The fact that Defendant voluntarily continued to maintain the terms of their promise is irrelevant; the question is whether it had a legally binding obligation to continue to do so. Nothing bound Defendant to continue its agreement, or even to maintain the same terms. As the district court pointed out, Defendant could have, through any one of the various notice devices it included, changed the contract immediately upon receipt of a signed copy from any one of the Plaintiffs. Without a binding obligation, a promise is illusory, and therefore not enforceable as a contract. . . . For the foregoing reasons, the judgment of the district court is AFFIRMED.

output or requirements if no estimate is stated [2-306(1)]. Chapter 19 discusses this subject in greater detail. As the following Mid-American Salt case shows, however, parties must be careful to clearly indicate the nature of the contract is one of output or requirements. Otherwise, no obligations are contemplated, and there is no consideration to support the agreement, even under the UCC. Effect of Exclusive Dealing Contracts When a manufacturer of goods enters an agreement giving a distributor the exclusive right to sell the manufacturer’s products in a particular territory, does such an agreement impose sufficient obligations on both parties to meet the legal value test? Put another way, does the distributor have any duty to sell the manufacturer’s products and does the manufacturer have any duty to supply any particular number of products? Such agreements are commonly encountered in today’s business world, and they can serve the legitimate interests of both parties. The UCC recognizes this fact by providing that, unless the parties agree to the contrary, an exclusive dealing contract imposes a duty on the distributor to use her best efforts to sell the goods and imposes a reciprocal duty on the manufacturer to use his best efforts to supply the goods [2-306(2)].



Chapter Twelve Consideration

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Mid-American Salt, LLC v. Morris County Cooperative Pricing Council   964 F.3d 218 (3d Cir. 2020) Through a competitive bidding process, Mid-American Salt, LLC (Mid-American) agreed with the Morris County Cooperative Pricing Council (Council), a group of more than 200 New Jersey counties, municipalities, police departments, and school districts, to supply the Council with rock salt during the 2016–2017 winter. The bid specifications anticipated that the Council would require 115,000 tons of rock salt that season, and Mid-American offered to provide the salt at a particular price. The specifications, which were incorporated into the agreement between Mid-American and the Council, further stated: This is an Open-Ended contract, meaning all items are specified with an estimated quantity. There is no obligation to purchase that quantity during the contract period, and the actual quantity purchased by members of the [Council] may vary. All quantities may be more or less than estimated. No minimum order requirements are allowed, unless stated otherwise elsewhere. The only quantities stated in the contract were clearly estimates, not obligations. Following the execution of the agreement, Mid-American undertook several complex and costly steps to source from Morocco, transport by boat and tug, and properly store at a New Jersey port a quantity of rock salt sufficient to meet the estimated requirements of the Council members. During the winter, however, Council members purchased only 5% of the inventory of rock salt Mid-American acquired. Moreover, Mid-American alleged that several members purchased salt from one of its competitors at a below-market rate. In June 2017, Mid-American sued the Council and a number of its members for, among other things, breach of contract. The defendants moved to dismiss the breach of contract claim for lack of consideration. The district court granted the dismissal, finding no requirements contract existed. Mid-American appealed. Hardiman, Circuit Judge At issue in this case is a “requirements contract.” Under New Jersey law, such a contract measures quantity through “the requirements of the buyer,” instead of through a fixed number stated in the contract. N.J. Stat. Ann. § 12A:2-306(1). Requirements contracts do not need a minimum or maximum order set forth therein, but instead rely on “such actual . . . requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate . . . may be tendered or demanded.” Id. The official comment to this section further explains: If an estimate of output or requirements is included in the agreement, no quantity unreasonably disproportionate to it may be tendered or demanded. Any minimum or maximum set by the agreement shows a clear limit on the intended elasticity. In similar fashion, the agreed estimate is to be regarded as a center around which the parties intend the variation to occur. N.J. Stat. Ann. § 12A:2-306, Comment 3. Mid-American relies heavily on [a] case in New Jersey that involved a cooperative pricing agreement for asphalt paving materials signed by the Council. . . . The Council responds . . . with a contrary administrative law decision. Because [those two cases] cannot be reconciled and they include some dissimilar facts to this appeal, New Jersey caselaw does not answer the question presented. The Council members argue they entered into a valid, binding contract with Mid-American. Under the contract terms, MidAmerican was required to provide bulk road salt to the members as needed. Yet the Council members claim no corresponding

requirement existed for any of them to purchase a single pound of salt from Mid-American. In their view, the agreement is essentially an options contract. Mid-American counters that the contract must be read to require Council members who submitted estimates to purchase all their salt needs from Mid-American. On this reading, the contract’s final quantity-variation provision relieves a member with no salt needs of any obligation to purchase. But that does not mean, Mid-American says, that members remain free to purchase salt from Mid-American’s competitors at discounted prices. Neither the general terms of the contract nor the specific provision Mid-American relies on support its position. Found in bold in the bid specifications, the quantity-variation provision reads: “There is no obligation to purchase that quantity [referring to the estimates] during the contract period, and the actual quantity purchased by members of the [Council] may vary.” Citing the explicit statement “that defendants had ‘no obligation to purchase’ during the contract period,” the District Court observed that “[MidAmerican’s] own pleadings and the unambiguous language of the contract” contradicted Mid-American’s contention that there was an implicit promise to purchase certain amounts of salt. We agree. [The] contract does not clearly state that it is for “requirements.” Nor does it mention the word “exclusive,” which is another hallmark of a requirements contract. See N.J. Stat. Ann. § 12A:2-306. The absence of these fundamental attributes of a requirements contract, when combined with the Council members’ promise to buy salt in such quantities “as may be desired” or as they “may want,” compels us to hold that the contract is illusory. ***

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Part Three Contracts

Finally, we note these are sophisticated parties capable of entering into precisely the kind of contract they desire. It would have been easy to, for example, insert a simple provision stating, “This is a contract for rock salt requirements and the Council covenants to purchase (and pay for) its rock salt requirements from the Contractor.” Even merely titling this a “Requirements Contract” would have indicated to us that a requirements ­contract was, in fact, being formed. But that is not the contract we have before us and we will not rewrite the bargain for the parties. In sum, neither the Council nor its members ever promised to purchase from Mid-American all the rock salt they required.

And their promise to pay for any rock salt they might have purchased—a rather obvious proposition—does not oblige them to actually ­purchase anything. Nor can the implied covenant of good faith and fair dealing . . . supply a promise that was never made. ­Because  Mid-American promised to supply rock salt ­requirements to the Council and its members without obtaining a ­corresponding promise in return, we hold that the contract is illusory.

Preexisting Duties The legal value component of

The most important preexisting duty cases are those involving preexisting contractual duties. These cases generally occur when the parties to an existing contract agree to modify that contract. The general common law rule on contract modifications holds that an agreement to modify an existing contract requires some new (independent) consideration to be binding. For example, Turner enters into a contract with Acme Construction Company for the construction of a new office building for $3,500,000. When the construction is partially completed, Acme tells Turner that due to rising labor and materials costs it will stop construction unless Turner agrees to pay an extra $500,000. Turner, having already entered into contracts to lease office space in the new building, promises to pay the extra amount. When the construction is finished, Turner refuses to pay more than $3,500,000. Is Turner’s promise to pay the extra $500,000 enforceable against him? No. All Acme has done in exchange for Turner’s promise to pay more is build the building, something that Acme had a preexisting contractual duty to do. Therefore, Acme’s performance is not consideration for Turner’s promise to pay more. Although the result in the preceding example seems fair (why should Turner have to pay $4,000,000 for something he had a right to receive for $3,500,000?) and is consistent with consideration theory, the application of the preexisting duty rule to contract modifications has generated a great deal of criticism. Plainly, the rule can protect a party to a contract such as Turner from being pressured into paying more because the other party to the contract is trying to take advantage of his situation by demanding an additional amount for performance. However, mechanical application of the rule could also produce unfair results when the parties have freely agreed to a fair modification of their contract. Some critics argue that the purpose of contract

our consideration definition requires that promisees do, or promise to do, something that they had no prior legal duty to do in exchange for a promisor’s promise. Thus, as a general rule, performing or agreeing to perform a preexisting duty is not consideration. This seems fair because the promisor in such a case has effectively made a gratuitous promise because she was already entitled to the promisee’s performance. Preexisting Public Duties Every member of society has a duty to obey the law and refrain from committing crimes or torts. Therefore, a promisee’s promise not to commit such an act can never be consideration. So, Thomas’s promise to pay Brown $100 a year in exchange for Brown’s promise not to burn Thomas’s barn would not be enforceable against Thomas. Because Brown has a preexisting duty not to burn Thomas’s barn, his promise lacks legal value. Similarly, public officials, by virtue of their offices, have a preexisting legal duty to perform their public responsibilities. For example, Smith, the owner of a liquor store, promises to pay Fawcett, a police officer whose beat includes Smith’s store, $50 a week to keep an eye on the store while walking her beat. Smith’s promise is unenforceable because Fawcett has agreed to do something that she already has a duty to do. Preexisting Contractual Duties and Modifications of Contracts under the Common Law Determine what is required to create a valid modification

LO12-4 of a contract under both the common law of contracts

and the UCC.

*** In sum, no valid requirements contract for bulk rock salt existed here because the contract was illusory. We will affirm the orders of the District Court.



Chapter Twelve Consideration

modification law should be to enforce freely made modifications of existing contracts and to deny enforcement to coerced modifications. Such critics commonly suggest that general principles such as good faith and unconscionability, rather than technical consideration rules, should be used to police contract modifications. Other observers argue that most courts in fact apply the preexisting duty rule in a manner calculated to reach fair results because several exceptions to the rule can be used to enforce a fair modification agreement. For example, any new consideration furnished by the promisee provides sufficient consideration to support a promise to modify an existing contract. So, if Acme had promised to finish construction a week before the completion date called for in the original contract, or had promised to make some change in the original contract specifications such as to install a better grade of carpet, Acme would have done something that it had no legal duty to do in exchange for Turner’s new promise. Turner’s promise to pay more would then be enforceable because it would be supported by new consideration. Many courts also enforce an agreement to modify an existing contract if the modification resulted from unforeseen

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circumstances that a party could not reasonably be expected to have foreseen and that made that party’s performance far more difficult than the parties originally anticipated. For example, if Acme had requested the extra payment because abnormal subsurface rock formations made excavation on the construction site far more costly and time-consuming than could have been reasonably expected, many courts would enforce Turner’s promise to pay more. Courts can also enforce fair modification agreements by holding that the parties mutually agreed to terminate their original contract and then entered a new one. Because contracts are created by the will of the parties, they can be terminated in the same fashion. Each party agrees to release the other party from his contractual obligations in exchange for the other party’s promise to do the same. Because such a mutual agreement terminates all duties owed under the original agreement, any subsequent agreement by the parties would not be subject to the preexisting duty rule. A court is likely to take this approach, however, only when it is convinced that the modification agreement was fair and free from coercion. The following Welsh case illustrates the common law approach to modification of contracts.

Welsh v. Lithia Vaudm, Inc.   895 N.W.2d 487 (Iowa Ct. App. 2016) On January 14, 2015, Kent and Julie Welsh took their 2008 Volkswagen Toureg to Lithia Volkswagen of Des Moines for evaluation of possible mechanical problems, specifically complaining that the vehicle’s “oil pressure” light was activated. After Lithia evaluated the car, an employee called Kent to recommend repairs amounting to $4,336. Kent agreed. Lithia proceeded to repair the car. At no time in person or on the phone did Welsh or any representative of Lithia discuss arbitration. Lithia completed the repair, including some unanticipated work when the “check engine” light subsequently activated, but it invoiced that work at no charge to the Welshes. Julie, Kent’s spouse, picked up the car at Lithia after the repairs were completed, on March 16, 2015. She paid the expected charge of $4,336 and signed a three-page document titled “INVOICE.” Immediately above Julie’s signature, the invoice provided for the arbitration of disputes “pursuant to the Federal Arbitration Act.” Julie took the vehicle home. A few days later, however, the Welshes returned the car to Lithia, noting the “check engine” light was activated. After evaluations, Lithia proposed a costly repair, which the Welshes declined to authorize. Subsequently, the Welshes sued Lithia for damages arising from the Lithia’s alleged failure to repair the car. Lithia moved to compel arbitration in response, stating, “On or about March 16, 2015, [the parties] entered into a contractual Agreement . . . for certain repairs to the vehicle.” Based on that purported Agreement, Lithia argued that Julie had committed the Welshes to submit any disputes to arbitration. The Welshes responded that their contract was formed shortly after January 14, 2015, when Kent authorized Lithia to do the repairs during the telephone conversation with the Lithia employee. The trial court found that the arbitration clause was not part of the parties’ contract. Lithia appealed. Tabor, Judge Lithia . . . argues the district court’s ruling failed to recognize the basic principle that written agreements such as the invoice are presumed to be supported by consideration. . . . Lithia asserts: “Lithia’s work in replacing the oil pump and the timing chains and adjustors, and [the Welshes’] act of paying money and

waiting for those repairs to be completed,” constituted “independent consideration.” We are not persuaded. General principles of contract law determine the validity of an arbitration agreement. For a contract to be valid in Iowa, it must contain three elements—offer, acceptance, and consideration. The consideration element supports the fact “contract law exists

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to enforce mutual bargains, not gratuitous promises.” [Margeson v. Artis, 776 N.W.2d 652, 655 (Iowa 2009).] Generally, “when the parties modify a contract, a new contract arises.” Iowa Arboretum, Inc. v. Iowa 4-H Found., 886 N.W.2d 695, 706 (Iowa 2016). But where “the parties to a contract modify the terms, there must be some new and valid consideration.” Id. The party asserting a lack of consideration, here Welsh, must establish the defense. We look for the element of consideration in the language of the contract and by “what the parties contemplated at the time the instrument was executed.” Margeson, 776 N.W.2d at 657 (citation omitted). A promise to perform a preexisting duty generally does not constitute additional consideration. Specifically, a promise made by one party to a contract normally cannot be enforced by the other party to the contract unless the party to whom the promise was made provided some promise or performance in exchange for the promise sought to be enforced. In other words, if the promisor did not seek anything in exchange for the promise made, . . . the promise made by the promisor is unenforceable due to the absence of consideration.

Applying these principles, we conclude the district court was correct in its analysis. The document containing the arbitration language was not signed when Welsh brought his vehicle to Lithia to be repaired. After the repairs were completed, Julie did not seek anything in exchange for the promise to arbitrate; Lithia already had completed its work at the set price, making her promise to arbitrate unenforceable due to the absence of consideration. In other words, no additional consideration existed where Lithia, the promisee, had a preexisting duty under the oral contract to evaluate and repair the car for a set price, and it did so. Lithia’s alleged modification was nothing more than a post-performance, unilateral demand by it to submit any future disputes to arbitration. After Lithia completed the repairs, it asked the Welshes to give up their right to litigate in court in return for the same performance by Lithia—repairing the car at the set price. . . . Thus, Lithia cannot enforce the promise to arbitrate because there is no evidence Lithia “promised to do something more than [it] had promised to do under the [oral] agreement.” Margeson, Id. 776 N.W.2d at 658. Accordingly, we affirm the district court’s denial of Lithia’s motion to compel arbitration.

Margeson, Id. 776 N.W.2d at 655–56.

AFFIRMED.

Preexisting Duty and Contract Modification under the UCC

no new consideration is necessary, and the agreement to modify the contract is enforceable. Several things should be made clear about the operation of this UCC rule. First, XYZ had no duty to agree to a modification and could have insisted on payment of $150 per unit. Second, modification agreements under the UCC are still subject to scrutiny under the general UCC principles of good faith and unconscionability, so unfair agreements or agreements that are the product of coercion are unlikely to be enforced. Finally, the UCC contains two provisions to protect people from fictitious claims that an agreement has been modified. If the original agreement requires any modification to be in writing, an oral modification is unenforceable [2-209(2)]. Regardless of what the original agreement says, if the price of the goods in the modified contract is $500 or more, the modification is unenforceable unless the requirements of the UCC’s statute of frauds section [2-201] are satisfied [2-209(3)].8

Determine what is required to create a valid modification

LO12-4 of a contract under both the common law of contracts

and the UCC.

The drafters of the UCC sought to avoid many of the problems caused by the consideration requirement by dispensing with it in two important situations: As discussed in Chapter 10, the UCC does not require consideration for firm offers [2-205]. The UCC also provides that an agreement to modify a contract for the sale of goods needs no consideration to be binding [2-209(1)]. For example, Electronics World orders 200 XYZ televisions at $150 per unit from XYZ Corp. Electronics World later seeks to cancel its order, but XYZ refuses to agree to cancellation. Instead, XYZ seeks to mollify a valued customer by offering to reduce the price to $100 per unit. Electronics World agrees, but when the televisions arrive, XYZ bills Electronics World for $150 per unit. Under classical contract principles, XYZ’s promise to reduce the price of the goods would not be enforceable because Electronics World has furnished no new consideration in exchange for XYZ’s promise. Under the UCC,

Preexisting Duty and Agreements to Settle Debts One special variant of the preexisting duty rule that causes considerable confusion occurs when a debtor offers to pay a creditor a sum less than the creditor is demanding in Chapter 16 discusses § 2-201 of the UCC in detail.

8



Chapter Twelve Consideration

exchange for the creditor’s promise to accept the part payment as full payment of the debt. If the creditor later sues for the balance of the debt, is the creditor’s promise to take less enforceable? The answer depends on the nature of the debt and on the circumstances of the debtor’s payment. Liquidated Debts A liquidated debt is a debt that is both due and certain; that is, the parties have no good-faith dispute about either the existence or the amount of the original debt. If a debtor does nothing more than pay less than an amount he clearly owes, how could this be consideration for a creditor’s promise to take less? Such a debtor has actually done less than he had a preexisting legal duty to do—namely, to pay the full amount of the debt. For this reason, the creditor’s promise to discharge a liquidated debt for part payment of the debt at or after its due date is unenforceable for lack of consideration. For example, Connor borrows $10,000 from Friendly Finance Company, payable in one year. On the day payment is due, Connor sends Friendly a check for $9,000 marked: “Payment in full for all claims Friendly Finance has against me.” Friendly cashes Connor’s check, thus impliedly promising to accept it as full payment by cashing it, and later sues Connor for $1,000. Friendly is entitled to the $1,000 because Connor has given no consideration to support Friendly’s implied promise to accept $9,000 as full payment. However, had Connor done something he had no preexisting duty to do in exchange for Friendly’s promise to settle for part payment, he could enforce Friendly’s promise and avoid paying the $1,000. For example, if Connor had paid early, before the loan contract called for payment, or in a different medium of exchange from that called for in the loan contract (such as $4,000 in cash and a car worth $5,000), he would have given consideration for Friendly’s promise to accept early or different payment as full payment. Unliquidated Debts A good-faith dispute about either the existence or the amount of a debt makes the debt an unliquidated debt. The settlement of an unliquidated debt is called an accord and satisfaction.9 When an accord and satisfaction has occurred, the creditor cannot maintain an action to recover the remainder of the debt that he alleges is due. For example, Computer Corner, a retailer, orders 50 laptop computers and associated software from Computech for $75,000. After receiving the goods, Computer Corner refuses to pay Computech the full $75,000, arguing that some of the computers were defective and that some of the software it received did not conform to its order. Computer Corner sends Computech a check for $60,000 Accord and satisfaction is also discussed in Chapter 18.

9

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marked: “Payment in full for all goods received from Computech.” A creditor in Computech’s position obviously faces a real dilemma. If Computech cashes Computer Corner’s check, it will be held to have impliedly promised to accept $60,000 as full payment. Computech’s promise to accept part payment as full payment would be enforceable because Computer Corner has given consideration to support it: Computer Corner has given up its right to have a court determine the amount it owes Computech. This is something that Computer Corner had no duty to do; by giving up this right and the $60,000 in exchange for Computech’s implied promise, the consideration requirement is satisfied. The result in this case is supported not only by consideration theory but also by a strong public policy in favor of encouraging parties to settle their disputes out of court. Who would bother to settle disputed claims out of court if settlement agreements were unenforceable? Computech could refuse to accept Computer Corner’s settlement offer and sue for the full $75,000, but doing so involves several risks. A court may decide that Computer Corner’s arguments are valid and award Computech less than $60,000. Even if Computech is successful, it may take years to resolve the case in the courts through the expensive and time-consuming litigation process. In addition, there is always the chance that Computer Corner may file for bankruptcy before any judgment can be collected. Faced with such risks, Computech may feel that it has no practical alternative other than to cash Computer Corner’s check.10 Composition Agreements Composition agreements are agreements between a debtor and two or more creditors who agree to accept as full payment a stated percentage of their liquidated claims against the debtor at or after the date on which those claims are payable. Composition agreements are generally enforced by the courts despite the fact that enforcement appears to be contrary to the general rule on part payment of liquidated debts. Many courts have justified enforcing composition agreements on the ground that the creditors’ mutual agreement to accept less than the amount due them provides the necessary consideration. The main reason why creditors agree to compositions is that they fear that their failure to do so may force the debtor into bankruptcy proceedings, in which case they might ultimately recover a smaller percentage of their claims than that agreed to in the composition.

A provision of Article 3 of the Uniform Commercial Code, section 3-311, covers accord and satisfaction by use of an instrument such as a “full payment” check. With a few exceptions, the basic provisions of section 3-311 parallel the common law rules regarding accord and satisfaction that are described in this chapter and Chapter 18. 10

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The Global Business Environment Like the UCC, the CISG does not require new consideration to modify a contract. The CISG states that contracts can be modified by the “mere agreement” of the parties. Another similarity between the UCC and

CISG is that under the CISG, a term in a written contract stating that modifications of that contract can only be made in writing will generally preclude oral modifications.

Ethics and Compliance in Action Rex Roofing contracted with the O’Neills to install a new roof on their house for $2,500. Rex began the work and soon realized that he had underbid the job. He informed the O’Neills that he would not do the job for $2,500 after all, but that he would complete the work for $3,200. The O’Neills promised to pay him $3,200. Assuming

Forbearance to Sue An agreement by a promisee to refrain, or forbear, from pursuing a legal claim against a promisor can be valid consideration to support a return promise—usually to pay a sum of money—by a promisor. The promisee has agreed not to file suit, something that she has a legal right to do, in exchange for the promisor’s promise. The courts do not wish to sanction extortion by allowing people to threaten to file spurious claims against others in the hope that those threatened will agree to some payment to avoid the expense or embarrassment associated with defending a lawsuit. On the other hand, we have a strong public policy favoring private settlement of disputes. Therefore, it is generally said that the promisee must have a good-faith belief in the validity of his or her claim before forbearance amounts to consideration.

Past Consideration Past consideration—despite its

name—is not consideration at all. Past consideration is an act or other benefit given in the past that was not given in exchange for the promise in question. Because the past act was not given in exchange for the present promise, it cannot be consideration. Consider again the facts of the famous case of Hamer v. Sidway, discussed earlier in this chapter. There, an uncle’s promise to pay his nephew $5,000 for refraining from smoking, drinking, swearing, and other delightful pastimes until his 21st birthday was supported by consideration because the nephew had given legal value by refraining from participating in the prohibited activities. However, what if the uncle had said to his nephew on the eve of his

that there were no unforeseen conditions that affected the roof and no obvious mistakes in the bid calculations, was it ethical for Rex Roofing to refuse to do the job at the agreed-upon price? Because the O’Neills agreed to pay the higher price, are they ethically obligated to do so, even if the law does not require them to pay more than the originally agreed-upon price?

21st birthday: “Your mother tells me you’ve been a good lad and abstained from tobacco, hard drink, foul language, and gambling. Such goodness should be rewarded. Tomorrow, I’ll give you a check for $5,000.” Should the uncle’s promise be enforceable against him? Clearly not, because although his nephew’s behavior still passes the legal value test, in this case it was not bargained for and given in exchange for the uncle’s promise. Moral Obligation As a general rule, promises made to satisfy a preexisting moral obligation are unenforceable for lack of consideration. The fact that a promisor or some member of the promisor’s family, for example, has received some benefit from the promisee in the past (e.g., food and lodging, or emergency care) would not constitute consideration for a promisor’s promise to pay for that benefit, due to the absence of the bargain element. Some courts find this result distressing and enforce such promises despite the absence of consideration. In addition, a few states have passed statutes making promises to pay for past benefits enforceable if such a promise is contained in a writing that clearly expresses the promisor’s intent to be bound. In the following Doe case, the court finds that even an organization like the Roman Catholic Church has no legal obligation to fulfill its moral obligations. Note, however, that had the Archdiocese’s commitment to pay for Doe’s therapy been negotiated to avoid the Does otherwise filing a valid lawsuit against it, the outcome likely would have been different.



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Doe v. Roman Catholic Archdiocese of Indianapolis    958 N.E.2d 472 (Ind. Ct. App. 2011) Jane Doe reported that she was sexually abused by a Roman Catholic priest when she was a teenager. In 1999, Doe’s husband met with officials of the Roman Catholic Archdiocese of Indianapolis to discuss the abuse. Initially, the Does demanded a lump-sum payment from the Archdiocese as compensation for the abuse. The Archdiocese denied any legal liability to Doe and declined to make any direct payment to Doe in relation to her claim. Doe’s husband pressed on, hiring an attorney and sending a letter in August 2000 indicating that, even though the Archdiocese had “no legal responsibility at this time,” it had a moral responsibility to Doe. Consistent with its policy on dealing with victims of childhood sexual abuse by church officials, the Archdiocese offered to pay for Doe’s therapy and counseling. The Does accepted that arrangement, and the Archdiocese began paying the fees in 2001. In 2006, the Archdiocese’s chancellor became concerned that Doe’s therapy was producing no signs of recovery despite more than $100,000 it had paid for Doe’s care. In consultation with multiple health professionals (though allegedly against the advice of Doe’s psychiatrist and therapist), the chancellor concluded that the Archdiocese would reduce its commitment to pay for Doe’s psychotherapy from two sessions weekly to one session per month. Doe had no insurance. If the Archdiocese did not pay for her therapy, she had to pay for it out of pocket. Doe sued the Archdiocese for breach of contract. The trial court granted the Archdiocese’s motion for summary judgment, finding that it had no legal responsibility to continue paying all of Doe’s continuing therapy costs. Doe appealed. Baker, Judge Doe argues that the trial court erred in granting the Archdiocese’s motion for summary judgment primarily because the Archdiocese breached its obligation to continue paying for all of her therapist and counseling fees. Doe contends that the Archdiocese should have continued to pay because it was both legally and morally responsible for it to do so. At the outset, we note that the Archdiocesan “Policy on Care of Victims Sexual Misconduct” (Policy) provides for “the general courses of action that may be taken by the chancellor.” And one course of action described in the policy includes offering victims and/or the family “appropriate counseling and spiritual direction, as needed.” However, a portion of the Policy makes it clear that 4. This statement of policy does not constitute a contractual undertaking of any nature of the payment of any amount to any person, but is an exoteric statement for guidance of the resource team of the Archdiocese. In all cases, the Archdiocese expressly reserves the right to withhold or change the terms of any benefits payable pursuant to this statement of policy or any other arrangement with victims, in the sole discretion of the Archdiocese.

Exceptions to the Consideration Requirement The consideration requirement is a classic example of a traditional contract law rule. It is precise, abstract, and capable of almost mechanical application. It can also, in some instances, result in significant injustice. Modern courts and

And, as mentioned above, Doe’s husband expressly acknowledged in his letter of August 11, 2000, that the Archdiocese’s response was based upon its moral obligation. More specifically, a portion of that letter acknowledges that Doe understood that “the archdiocese has no legal responsibility at this time, but it seems to me that when the loss due to the actions of a representative of the archdiocese is so evident and measureable, a moral responsibility remains to compensate for that loss.” As the Archdiocese points out, a promise must be predicated upon adequate consideration before it can command performance. And a moral obligation to perform an agreement does not provide sufficient consideration to support the enforcement of an agreement nor does it create an enforceable contract. In this case, while the letters that the Archdiocese sent to the Does express an intent to assist them with counseling costs, that correspondence does not amount to a contract to provide them unlimited care and treatment at its expense. Therefore, the designated evidence establishes that there was no enforceable contract in this instance, and Doe’s claim fails on this basis. The judgment of the trial court is affirmed.

legislatures have responded to this potential for injustice by carving out numerous exceptions to the requirement of consideration. Some of these exceptions (for example, the UCC firm offer and contract modification rules) have already been discussed in this and preceding chapters. In the remaining portion of this chapter, we focus on several other important exceptions to the consideration requirement.

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CONCEPT REVIEW Consideration Consideration*

Not Consideration

Doing something you had no preexisting duty to do

Doing something you had a preexisting duty to do

Promising to do something you had no preexisting  duty to do

Promising to do something you had a preexisting duty to do

Paying part of a liquidated debt prior to the date the debt  is due

Nominal consideration (unless actually bargained for)

Paying a liquidated debt in a different medium of  exchange than originally agreed to

Paying part of a liquidated debt at or after the date the debt is due

Agreeing to settle an unliquidated debt

Making an illusory promise

Agreeing not to file suit when you have a good-faith  belief in your claim’s validity

Past consideration Preexisting moral obligation

Assuming bargained for.

*

Promissory Estoppel As discussed in Chapter 9,

the doctrine of promissory estoppel first emerged from attempts by courts around the turn of this century to reach just results in donative (gift) promise cases. Classical contract consideration principles did not recognize a promisee’s reliance on a donative promise as a sufficient basis for enforcing the promise against the promisor. Instead, donative promises were unenforceable because they were not supported by consideration. In fact, the essence of a donative promise is that it does not seek or require any bargained-for exchange. Yet people continued to act in reliance on donative promises, often to their considerable disadvantage. Refer to the facts of Thorne v. Deas, discussed earlier in this chapter. The co-owners of the Sea Nymph clearly relied on their fellow co-owner’s promise to get insurance for the ship. Some courts in the early 1900s began to protect such relying promisees by estopping promisors from raising the defense that their promises were not supported by consideration. In a wide variety of cases involving gratuitous agency promises (as in Thorne v. Deas), promises of bonuses or pensions made to employees, and promises of gifts of land, courts began to use a promisee’s detrimental (harmful) reliance on a donative promise as, in effect, a substitute for consideration.

In 1932, the first Restatement of Contracts legitimized these cases by expressly recognizing promissory estoppel in section 90. The elements of promissory estoppel were then essentially the same as they are today: a promise that the promisor should reasonably expect to induce reliance, reliance on the promise by the promisee, and injustice to the promisee as a result of that reliance. Promissory estoppel is now widely used as a consideration substitute, not only in donative promise cases but also in cases involving commercial promises contemplating a bargained-for exchange. The construction contract bid cases discussed in Chapter  10 are another example of this expansion of promissory ­estoppel’s reach. In fact, promissory estoppel has expanded far beyond its initial role as a consideration substitute into other areas of contract law. In McLellan v. Charly, the parties dispute whether there was sufficient consideration to support an option contract.11 In the absence of such consideration, the court must decide whether promissory estoppel applies to a promise made by an offeree to keep an offer open for a given period of time.

11

Option contracts are discussed in detail in Chapter 10.



Chapter Twelve Consideration

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McLellan v. Charly   758 N.W.2d 94 (Wis. Ct. App. 2008) Roger Charly owned a parcel of land in Madison, Wisconsin, that is situated between the University of Wisconsin’s Harlow Primate Psychology Laboratory and the Wisconsin National Primate Research Center. The University indicated an interest in buying the land in 2003 but balked at Charly’s $1 million asking price. In 2004, Rick Bogle, an animal rights activist, met with Charly to discuss purchasing the land. Bogle wanted to house the National Primate Research Center Exhibition Hall on it as a protest against the activities at the two neighboring facilities. Charly indicated he would sell the property to Bogle for $750,000, if Bogle could raise the money. Bogle accomplished the fundraising through Dr. Richard McLellan. Bogle and McLellan agreed that McLellan would borrow funds to purchase the property and Bogle would make the payments on the loan. In October 2004, Bogle notified Charly that he had the money. Bogle’s attorney drafted an agreement titled “Option to Purchase,” which Charly and McLellan signed on May 10, 2005. It indicated that McLellan could purchase the property for $675,000 within 180 days, with an opportunity to extend that option for another 90-day period. The agreement contained detailed provisions on the terms of the sale. In June 2005, Bogle held a rally at the property and posted a sign reading “Future Home of the National Primate Research Exhibition Hall,” which depicted a monkey with a device screwed into its skull. Someone from the University apparently noticed the rally and sign because, shortly thereafter, a University representative called Charly to express its consternation with the exhibition hall plan and to once again offer to buy the property. Charly maintained his million-dollar purchase price demand from the University. Around this same time, Charly took the “Option to Purchase” document to a different attorney for evaluation. The attorney concluded that the option was “voidable and void due to lack of consideration,” sending a letter to McLellan to that effect and offering to enter into an enforceable option contract with different terms. McLellan declined. On August 1, Charly received an offer from the University to purchase the property for $1 million. McLellan, then, attempted to exercise his supposed option by letter dated August 12. The letter was returned to McLellan unopened, and Charly’s attorney personally informed McLellan that there was no enforceable option and that Charly would not sell the property to him. McLellan, Bogle, and the Primate Freedom Protect (an organization formed by Bogle) sued Charly stating theories of breach of contract and promissory estoppel. The trial court found in favor of the plaintiffs on the breach of contract theory, determining that the option was supported by valid consideration. It ordered the remedy of specific performance. The trial court held, in the alternative, that there was no basis for promissory estoppel liability and dismissed the plaintiff’s promissory estoppel claims. Charly appealed the trial court’s determination that he breached the contract. The plaintiffs argued that, even if the court determined there was no breach of contract, they were entitled to relief under the promissory estoppel theory. On appeal, the appellate court first determined that a valid option contract requires consideration that is distinct from the consideration that supports the underlying contract. In this case, that means McLellan had to give something of legal value for which Charly bargained in exchange for the 180-day option that was different from and in addition to the value Charly sought for the sale of the property.

Vergeront, Judge II. Existence of Separate Consideration for this Option Charly contends there is no evidence of consideration for the option separate from the consideration for the sale. In particular, he asserts that the only consideration the circuit court found were for the sale, not for the option. The plaintiffs disagree and also assert the court erred in rejecting three additional bases for consideration. We discuss each of the four potential bases for consideration. The leaseback and repurchase provisions, like all the other terms for the sale of the property, apply only if McLellan exercises the option within the prescribed period of time. If McLellan does not do so, there is no contract for sale and thus no benefit to Charly from these provisions. The plaintiffs argue that [two

particular terms in the Option to Purchase] led to Charly’s decision to agree to the option. [E]ven if it were these two particular provisions that led Charly to agree to the option, like all the bargained-for terms of the sale that benefit the seller, these two provisions are a benefit to the seller only if the option is timely exercised and a sale occurs. In other words, they are consideration for the sale contract, but not separate consideration for the option contract. . . . Second, the plaintiffs contend there is evidence of intent to be bound by the option contract and . . . intent to be bound is sufficient in itself to constitute consideration. We [find] that it is not sufficient. . . . Third, the plaintiffs argue that the evidence of Charly’s personal satisfaction at “tweaking” the University

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constituted separate consideration for the option. The plaintiffs emphasize . . . that this satisfaction was not entirely dependent upon a sale taking place, and thus it constitutes consideration separate from that for the sale. This is so, according to the plaintiffs, because the “tweaking” occurred at least in part when the prospective sale was made public at the rally and because this publicity resulted in a higher offer from the University, which is what Charly wanted. The [trial] court found that Charly “took personal satisfaction in selling the building to Bogle for use as a primate museum . . . [either] because he was insulted by a previous offer the UW made . . . or because he didn’t like . . . the animal research facilities in that location.” In concluding this did not constitute consideration, the court reasoned that it was not bargained for: Charly did not request it and there was no requirement in the written agreement between the parties that the property be used for a museum. [W]e confine our analysis to the benefit the plaintiffs assert Charly obtained independent from the sale—Charly’s personal satisfaction at “tweaking” the University through the announcement of the prospective sale and the resulting higher offer from the University. We conclude that neither constitutes consideration for the option because neither was bargained for. As for the satisfaction Charly derived from “tweaking” the University with the public announcement of the prospective sale, there is no evidence he requested that the option be publicized or that a rally be held. As for the higher offer the University made after the publicity, that offer—to state the obvious—cannot logically be the subject of bargaining between the parties to the option. . . . Fourth, the plaintiffs contend that their efforts to obtain financing constitute consideration for the option, given the evidence that Charly knew they needed to raise money in order to purchase the property. . . . Focusing our attention on separate consideration for the option, we, like the circuit court, reject the plaintiffs’ argument. The written agreement is silent on financing. There is no evidence that Charly requested that anything be done with respect to financing and the evidence is that McLellan did nothing. The plaintiffs provide no authority for the proposition that Bogle’s efforts to raise money to repay McLellan could constitute consideration for the option Charly gave McLellan simply because Charly knew Bogle was going to do that. [I]n certain circumstances the optionee’s efforts to obtain financing may constitute the requisite separate consideration for an option contract, [but there is no support for the notion] that the efforts of a person in Bogle’s situation might do so. . . . In summary, . . . there is no evidence of consideration for the option that is separate from the consideration for the sale. Therefore, the option was not a binding and irrevocable contract and

could be withdrawn at any time before it was exercised within the prescribed time period. III. Promissory Estoppel The plaintiffs assert that, if the option is unenforceable because of lack of consideration, they are entitled to an order conveying the property based on the doctrine of promissory estoppel. They seek to enforce with this doctrine the oral promise Charly made to Bogle to sell the property to him for $750,000. They contend that, in reliance on this promise, Bogle took various actions of which Charly was aware, which included efforts to find financing, which he was ultimately able to arrange with McLellan, moving to Madison with his wife instead of continuing to look for teaching jobs, public fundraising after the agreement between McLellan and Charly was signed, which cost him approximately $15,000 for the initial mailing, and holding the rally. [T]he plaintiffs . . . tended to merge the promise Charly made to Bogle with the promise expressed in the option. We view the two promises as separate bases for two distinct theories for relief under the promissory estoppel doctrine. Accordingly, we analyze them separately. . . . A party is entitled to prevail on a claim of promissory estoppel if (1) the promise is one that the promisor should reasonably expect to induce action or forbearance of a definite and substantial character on the part of the promisee; (2) the promise induced such action or forbearance; and (3) injustice can be avoided only by enforcement of the promise. . . . In deciding that the doctrine of promissory estoppel did not support enforcement of Charly’s promise to Bogle, the court . . . found that Bogle moved to Madison and started fundraising after having only a couple brief conversations with Charly and it was not reasonable to rely on a promise “obtained by walking into a store and having a brief conversation with a stranger about a real estate transaction of three quarters of a million dollars.” Thus, the court found, Charly could not reasonably anticipate that his promise would “induce action or [inaction] of a definite and substantial character” on the part of Bogle. The court also found that the evidence did not show that Bogle’s move to Madison and fundraising efforts were to his detriment. It further found that, because of Bogle’s role in the negotiation of the agreement between McLellan and Charly, Bogle “could not possibly have believed that he still had a valid offer to sell the property to him.” Finally, the court found that the promise Charly initially made to Bogle was of a preliminary nature and was never intended as the final agreement; instead, it was the beginning of negotiations for a more formal written agreement, for which Bogle obtained an attorney. The court reasoned that the doctrine of promissory estoppel was not intended to convert contract negotiations into an enforceable promise. We accept the circuit court’s findings because they are not clearly erroneous, and we agree with the court’s policy decision



Chapter Twelve Consideration

that justice does not require enforcement of Charly’s promise to Bogle. The evidence supports a finding that, when Charly offered to sell the property for $750,000, both he and Bogle understood that they would negotiate the specific terms of the sale, and they did so. The written agreement that resulted was between Charly and McLellan, with Bogle’s involvement, agreement, and consultation with counsel. The steps Bogle took that he claims were to his detriment before the written agreement between McLellan and Charly was executed—moving to Madison and attempting to obtain financing—were in furtherance of the anticipated written agreement that did in fact occur. The steps he took after that— public fundraising and the rally—were not in reliance on Charly’s promise to him, but on the written agreement between McLellan and Charly. . . . As a policy matter, in these circumstances justice does not require the enforcement of Charly’s initial promise to sell the property to Bogle for $750,000. It is fair not to, in effect, revive that initial promise to Bogle when he was involved with and approved of the written agreement that evolved from that. We next consider the option as the promise potentially affording relief—specifically, Charly’s written promise to McLellan that he would not revoke the offer to sell the property on the specified terms to McLellan for 180 days plus an additional ninety days if McLellan chose. We have already concluded that Charly’s promise not to revoke the offer was not supported by consideration separate from that for the sale. We agree with the plaintiffs that this failure of consideration does not in itself bar enforcement of the promise under the doctrine of promissory estoppel. In adopting the doctrine in Hoffman, the court explained: Originally the doctrine of promissory estoppel was invoked as a substitute for consideration rendering a gratuitous promise enforceable as a contract. In other words, the acts of reliance by

Promises to Pay Debts Barred by Statutes of Limitations Statutes of limitations set an

express statutory time limit on a person’s ability to pursue any legal claim. A creditor who fails to file suit to collect a debt within the time prescribed by the appropriate statute of limitations loses the right to collect it. Many states, however, enforce a new promise by a debtor to pay such a debt, even though technically such promises are not supported by consideration because the creditor has given nothing in exchange for the new promise. Most states afford debtors some protection in such cases, however, by requiring that the new promise be in writing to be enforceable.

Promises to Pay Debts Barred by Bankruptcy Discharge Once a bankrupt debtor is

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the promisee to his detriment provided a substitute for consideration. . . . However, § 90 of Restatement [First of] Contracts [which the court adopted], does not impose the requirement that the promise giving rise to the cause of action must be so comprehensive in scope as to meet the requirements of an offer that would ripen into a contract if accepted by the promisee. Hoffman v. Red Owl Stores, Inc., 26 Wis. 2d 683, 697–98 (1965) (citation omitted) (emphasis added). . . . We turn, then, to the question whether Charly’s promise of the option induced McLellan to take any action or forbearance of a definite and substantial character. The circuit court, in the context of its findings on consideration, accepted McLellan’s testimony that he did nothing in connection with the project between mailing the option back and receiving notification that the option was being declared void. The plaintiffs point to McLellan’s efforts to negotiate the agreement with Charly—his consultation with real estate attorneys, his flying to Madison to meet with Charly, his “work[ing] through several versions of the parties’ written agreement,” and his signing and having the contract notarized while he was in Europe. However, these efforts—all typical steps in negotiating an agreement—preceded Charly’s promise, embodied in the option provisions of the written agreement, that he would not revoke the offer to sell on the specified terms for at least 180 days. Based on the circuit court’s findings, we conclude McLellan is not entitled to enforcement of the option under the doctrine of promissory estoppel. . . . CONCLUSION [W]e affirm the circuit court in part, reverse in part, and remand with instructions to dismiss the complaint.

granted a discharge,12 creditors no longer have the legal right to collect discharged debts. Most states enforce a new promise by the debtor to pay (reaffirm) the debt regardless of whether the creditor has given any consideration to support it. To reduce creditor attempts to pressure debtors to reaffirm, the Bankruptcy Reform Act of 1978 made it much more difficult for debtors to reaffirm debts discharged in bankruptcy proceedings. The act requires that a reaffirmation promise be made prior to the date of the discharge and gives the debtor the right to revoke his promise within 30 days after it becomes enforceable. This act also requires the Bankruptcy Court to counsel individual (as opposed to corporate) debtors about the legal effects of reaffirmation 12

Chapter 30 discusses bankruptcy in detail.

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and requires Bankruptcy Court approval of reaffirmations by individual debtors. In addition, a few states require reaffirmation promises to be in writing to be enforceable.

Charitable Subscriptions Promises

to make gifts for charitable or educational purposes are often

Problems and Problem Cases 1. William Skebba was a top sales executive for M.W. Kasch Co. The company was failing financially, and Skebba received another job offer. Jeffrey Kasch, one of the owners of the company, persuaded Skebba not to take the job and agreed to pay Skebba $250,000 if the company were sold while Skebba was still employed there. Though Skebba repeatedly asked for a written memorialization of the agreement, Kasch never provided one. The company was sold for $5.1 million; however, Kasch refused to pay Skebba the promised amount, denying ever having made the agreement. Assuming that there is no enforceable contract here, can Skebba recover by claiming promissory estoppel? What would be his recovery? 2. Rena Gottlieb was a member of the “Diamond Club” at the Tropicana casino in Atlantic City, New Jersey. To become a Diamond Club member, an individual must visit a promotional booth in the casino, obtain and fill out an application form, and show identification. There was no charge. The application form required a prospective member to list her name, address, telephone number, and e-mail address. Tropicana entered that information in the casino’s customer database. Members received a Diamond Club card with a unique identification number, which the member swiped each time she gambled on a machine. Tropicana then tracked the gambling habits of its members and used that information for marketing purposes. The card entitled members to one free spin per day on the Fun House Million Dollar Wheel Promotion, which offered participants a chance to win a grand prize of $1 million. On July 24, Gottlieb presented her Diamond Club card at the Million Dollar Wheel, a casino operator swiped it and pressed a button to activate the wheel, and the wheel began spinning. According to Gottlieb and several witnesses, the wheel landed on the $1 million grand prize. But, when it did so, the casino attendant immediately swiped another card, reactivated the wheel, and the wheel landed

enforced, despite the absence of consideration, when the institution or organization to which the promise was made has acted in reliance on the promised gift. This result is usually justified on the basis of either promissory estoppel or public policy.

on a lesser prize. Despite Gottlieb’s protests, Tropicana refused to recognize that she won the grand prize. She sued for breach of contract. Though Tropicana denied that its operator intervened, it also defended by claiming that no valid contract existed between it and Gottlieb because she had provided no consideration to support any supposed agreement. Is Tropicana correct? 3. John and Jennifer Margeson entered into a contract to sell a weight-loss franchise business called “Inches-aWeigh” to Theresa Artis. The parties signed a written “Asset Purchase Agreement” on October 1, 2004. The purchase price was $125,000, payable at closing. Later, on October 7, 2004, the parties signed a second document entitled “Sales Agreement Addendum” This addendum set the price of the business at $155,000, with $135,000 payable at closing. Of that $135,000, $125,000 was to be paid from the proceeds of a loan secured by Artis from First Bank, and $10,000 was to be paid in cash. The remaining $20,000 of the purchase price was to be paid to the Margesons in monthly installments based on sales. The closing was set for October 18. On that date, Artis tendered the $125,000 from the First Bank loan, together with $10,000 from two personal checks drawn on Artis’s bank account. Thereafter, the relationship between the Margesons and Artis soured. Artis stopped payment on one of the personal checks she presented at closing, and she stopped making the monthly payments in March 2005. The Margesons sued Artis for breach of the Addendum. Artis claimed that the Addendum was not enforceable because it was not supported by consideration. Who is correct? 4. Patricia Contreras borrowed $5,000 from Kyung-Hu Kim so that she could buy a badly needed used car. She had previously gotten around on an old Vespa scooter, but she recently learned she was pregnant and did not want to take the risk of riding the scooter while she was pregnant. Furthermore, she knew she would need a car once the baby arrived. Patricia was supposed to have paid KyungHu back on October 30, 2013. At that point, Patricia only had about $3,000. She asked Kyung-Hu if he would be willing to take that amount plus her Vespa in satisfaction



Chapter Twelve Consideration

of the debt she owed him. The Vespa was worth about $2,500 when Patricia bought it, but it was dated and now worth around $800. Kyung-Hu agreed to Patricia’s proposal. The next day, Patricia paid Kyung-Hu the $3,000 and delivered the scooter to his house. The next month Patricia’s grandmother died and left her $125,000 in her will. Kyung-Hu learned of Patricia’s inheritance and approached her requesting that Patricia make good on the balance of her $5,000 debt. He said he was willing to take $1,200 (i.e., the difference between the value of the scooter and the $2,000 in cash Patricia never paid). Will Kyung-Hu have any recourse if Patricia rebuffs his proposal? 5. Approximately four years before his death, Dr. Martin Luther King Jr. gave Boston University possession of some of his correspondence, manuscripts, and other papers. He did this pursuant to a letter, which read as follows: On this 16th day of July, 1964, I name the Boston University Library the Repository of my correspondence, manuscripts, and other papers, along with a few of my awards and other material which may come to be of interest in historical and other research. In accordance with this action I have authorized the removal of most of the above-mentioned papers and other objects to Boston University, including most correspondence through 1961, at once. It is my intention that after the end of each calendar year, similar files of materials for an additional year should be sent to Boston University. All papers and other objects which thus pass into the custody of Boston University remain my legal property until otherwise indicated, according to the statements below. However, if, despite scrupulous care, any such materials are damaged or lost while in custody of Boston University, I absolve Boston University of responsibility to me for such damage or loss. I intend each year to indicate a portion of the materials deposited with Boston University to become the absolute property of Boston University as an outright gift from me, until all shall have been thus given to the University. In the event of my death, all such materials deposited with the University shall become from that date the absolute property of Boston University.

    Sincerely,   Martin Luther King, Jr.

Acting in her capacity as administrator of Dr. King’s estate, his widow, Coretta Scott King, sued Boston University, alleging that the King Estate, not BU, owned the papers that had been housed in the BU Library’s special collection since the 1964 delivery of them. BU contended that it owned them because Dr. King had

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made an enforceable charitable pledge to give them to BU. Was Dr. King’s promise to give ownership of his papers to BU enforceable? 6. In 1999, American Golf Corporation (AGC) hired Heye for a job in the pro shop at the Paradise Hills Golf Course, a club that it managed. AGC gave Heye a number of documents, including the Co-Worker Alliance Handbook. On page 20 of the handbook was a reference to arbitration that essentially stated that binding arbitration would be the exclusive means of resolving all disputes about unlawful harassment, discrimination, wrongful discharge, and other causes of action and that the employee was agreeing to waive her right to pursue such claims in court. Page 23 of the handbook contained the following acknowledgment: My signature below indicates that I have read this AGC Co-Worker Alliance agreement and handbook and promise and agree to abide by its terms and conditions. I further understand that the Company reserves the right to amend, supplement, rescind or revise any policy, practice, or benefit described in this handbook—other than employment at-will provisions—as it deems appropriate. I acknowledge that my employment is at-will, which means that either the Company or I have the absolute right to end the employment relationship at any time with or without notice or reason. I further understand that the president of American Golf Corporation is the only authorized representative of the Company who can modify this at-will employment relationship and the contents of this handbook, and that any such modifications must be made in writing. I further acknowledge that I have read and agree to be bound by the arbitration policy set forth on page 20 of this handbook.

Heye signed the acknowledgment. Heye worked for AGC until January 2000. She later sued AGC on a variety of grounds, including sex discrimination and sexual harassment. AGC moved to compel arbitration under the acknowledgment form that Heye signed. Was the arbitration agreement supported by consideration? 7. Dr. James Taylor was employed as president of the University of the Cumberlands for 35 years beginning in August 1980. Over the course of a decade, the university entered into and reaffirmed a commitment to an agreement to provide Dr. Taylor and his wife, Dinah Taylor, with compensation for life following Dr. Taylor’s retirement from the position of president. The university further agreed to provide a number of retirement benefits to Dr. and Mrs. Taylor after his retirement from the presidency, including health insurance benefits, and the university agreed to provide the Taylors with a residence or apartment in Williamsburg, Kentucky, where the university is located. The agreement

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indicated that Dr. Taylor would serve in the newly created position of chancellor for as long as he pleased and Mrs. Taylor would continue to serve as “ambassador” for the university. They had been prolific fundraisers for the university, and they agreed to continue with those efforts even after Dr. Taylor’s retirement. When Dr. Taylor retired, the Trustees reaffirmed their commitment to the agreement, but after a while they tried to reduce the amount of benefits owed to Dr. and Mrs. Taylor by offering Dr. Taylor a one-year renewable contract that provided for a reduced salary that was significantly less than had been provided for in the disputed agreement. Dr. Taylor refused, claiming that the university was contractually bound to the agreement to provide the benefits and pay to him and Mrs. Taylor for life. The university countered that the agreement was not enforceable as a contract because the Taylors provided no legal value for it. According to the university, the agreement was entered into solely based upon the plaintiffs’ past performance, which could not serve as valid consideration. They pointed to language in the agreement and resolution that “The University of the Cumberlands and the Board of Trustees agree that the compensation and benefits contained in this agreement is/are for the past decades of duties and/or work performed by Dr. and Mrs. Taylor all for the benefit of The University of the Cumberlands.” Was the university correct to argue that it had no contractual obligation to the Taylors due to a lack of consideration? 8. Bob Acres entered into a written contract to buy 25 acres of land from Schumacher Farms for $70,000. The contract recited that Bob Acres had paid $500 earnest money, but it never did pay this money. The deal fell through when Schumacher refused to close. Bob Acres sued for breach of contract, and Schumacher asserted that the contract was not supported by consideration because Bob Acres had not paid the $500 earnest money. Did the false recital of acknowledgment of receipt of the earnest money cause the contract to be unenforceable because of lack of consideration? 9. Perry Rowan worked at Salomon North America Inc. as a glide tester for snow skis. Glide testing determines which ski waxes and structures of the ski bottom run the fastest on the snow located at the venue where the testing is being determined. Rowan was a nationalcaliber ski racer with international racing experience.

On December 1, 1994, he was killed while glide testing skis on a ski run located in Vail, Colorado, which was owned by Beaver Creek Associates. When completing a glide test, Rowan lost control and slid into unpadded support beams on a picnic deck that Beaver Creek Associates had built. The fatal run occurred on the third day of a three-day testing period on the course. On the third day, just prior to his death, Beaver Creek Associates asked Rowan to sign a form releasing it of any liability for injuries, including death, that he might suffer while engaging in the testing. Rowan’s parents as representatives of his estate sued, among others, Beaver Creek Associates for wrongful death, asserting they were negligent in constructing, placing, and failing to pad the deck. Beaver Creek Associates defended by arguing that the release was valid. Rowan’s parents countered that the release was nonbinding because it lacked consideration (i.e., Beaver Creek Associates gave nothing additional of value to change the relationship between it and Rowan on that third day of testing). Was the release valid? 10. Susannah Baxter’s mother Betty married Bazel Winstead in 1998. Susannah grew up with Betty and Bazel, and Bazel raised her as his daughter. Susannah’s siblings— John, Stephen, and Lanie—were older and not as close to Bazel. Following Betty’s death, Bazel updated his estate plan, including taking out a life insurance policy for which he named Susannah as the sole beneficiary. Bazel explained to Susannah that his will designated his estate to be divided in four equal parts going to Susannah and her siblings. In a telephone conversation, Bazel told Susannah about the life insurance policy and told her to “just share some with your brothers and sister.” When Bazel died, Susannah received the proceeds from the life insurance policy, totaling more than $200,000. Susannah purportedly told her siblings that she would share some of the proceeds, but her siblings believed that she should pay each of them a quarter of the total. Susannah, on the other hand, believed that the proceeds were hers and that Bazel’s instructions to her were to “share some” as she chose. Accordingly, when Susannah refused to commit to a particular amount to be shared with her siblings, her brother John sued. Was Susannah under a specific obligation to split the life insurance proceedings in quarters to be distributed among her and her siblings?

CHAPTER 13

Reality of Consent

I

n August 2019, Duncan went to Smith Motors to look for a used car to buy. He test-drove a 2014 Corvette with an odometer reading of 52,000. Duncan assumed that the heater worked, but he did not turn it on to test it because it was so hot outside. The salesperson assured him that the car was in “mint condition.” Duncan purchased the car. He later learned that the heater was broken, that the radio would not work, that the car would not start when the temperature dropped below 30 degrees, and that the car really had 152,000—not 52,000—miles on it. • Can Duncan get out of this contract and get his money back? • Did Smith Motors have a duty to disclose the defects in the car? • Was the statement that the car was in “mint condition” a misrepresentation? • Did Duncan have the obligation to investigate the car more thoroughly? • What are the ethical concerns involved in this situation?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 13-1 Explain what a party who claims misrepresentation, fraud, mistake, duress, or undue influence is required to do in order to rescind a contract. 13-2 Identify the conditions under which a contract can be rescinded on the basis of misrepresentation and fraud.

IN A COMPLEX ECONOMY that depends on planning for the future, it is crucial that the law can be counted on to enforce contracts. In some situations, however, there are compelling reasons for permitting people to escape or avoid their contracts. An agreement obtained by force, trickery, unfair persuasion, or error is not the product of mutual and voluntary consent. A person who has made an agreement under these circumstances will be able to avoid it because his consent was not real. This chapter discusses five doctrines that permit people to avoid their contracts because of the absence of real consent: misrepresentation, fraud, mistake, duress, and undue influence. Doctrines that involve similar considerations

13-3 Explain the elements of mistake and determine when mistake makes a contract voidable. 13-4 Explain the circumstances under which duress makes a contract voidable. 13-5 Distinguish undue influence from duress and explain the circumstances under which undue influence makes a contract voidable.

will be discussed in Chapter 14, Capacity to Contract, and Chapter 15, Illegality.

Effect of Doctrines Discussed in This Chapter Contracts induced by misrepresentation, fraud, mistake, duress, or undue influence are generally considered to be voidable. This means that the person whose consent was not real has the power to rescind (cancel) the contract. A person who rescinds a contract is entitled to the return of anything he gave the other party. By the same token,

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he must offer to return anything he has received from the other party. Explain what a party who claims misrepresentation,

LO13-1 fraud, mistake, duress, or undue influence is required

to do in order to rescind a contract.

Necessity for Prompt and Unequivocal Rescission Suppose Johnson, who recently bought

a car from Sims Motors, learns that Sims Motors made fraudulent statements to her to induce her to buy the car. She believes the contract was induced by fraud and wants to rescind it. How does she act to protect her rights? To rescind a contract based on fraud or any of the other doctrines discussed in this chapter, she must act promptly and unequivocally. She must object promptly upon learning the facts that give her the right to rescind and must clearly express her intent to cancel the contract. She must also avoid any behavior that would suggest that she affirms or ratifies the contract. (Ratification of a voidable contract means that a person who had the right to rescind has elected not to do so. Ratification ends the right to rescind.) This means that she should avoid unreasonable delay in notifying the other party of her rescission because unreasonable delay communicates that she has ratified the contract. She should also avoid any conduct that would send a “mixed message,” such as continuing to accept benefits from the other party or behaving in any other way that is inconsistent with her expressed intent to rescind.

Misrepresentation and Fraud Identify the conditions under which a contract can LO13-2 be rescinded on the basis of misrepresentation and fraud.

Relationship between Misrepresentation and Fraud A misrepresentation is an assertion that

is not in accord with the truth. When a person enters a contract because of his justifiable reliance on a misrepresentation about some important fact, the contract is voidable. It is not necessary that the misrepresentation be intentionally deceptive. Misrepresentations can be either “innocent” (not intentionally deceptive) or “fraudulent” (made with knowledge of falsity and intent to deceive). A contract may be voidable even if the person making

the misrepresentation believes in good faith that what he says is true. Either innocent misrepresentation or fraud gives the complaining party the right to rescind a contract. Fraud is the type of misrepresentation that is committed knowingly, with the intent to deceive. The legal term for this knowledge of falsity, which distinguishes fraud from innocent misrepresentation, is scienter. A person making a misrepresentation would be considered to do so “knowingly” if she knew that her statement was false, if she knew that she did not have a basis for making the statement, or even if she just made the statement without being confident that it was true. The intent to deceive can be inferred from the fact that the defendant knowingly made a misstatement of fact to a person who was likely to rely on it. As is true for innocent misrepresentation, the contract remedy for fraudulent misrepresentation is rescission. The tort liability of a person who commits fraud is different from that of a person who commits innocent misrepresentation, however. A person who commits fraud may be liable for damages, possibly including punitive damages, for the tort of deceit.1 As you will learn in the following sections, innocent misrepresentation and fraud share a common core of elements. Election of Remedies In some states, a person injured by fraud cannot rescind the contract and sue for damages for deceit; he must elect (choose) between these remedies. In other states, however, an injured party may pursue both rescission and damage remedies and does not have to elect between them.2

Requirements for Rescission on the Ground of Misrepresentation The fact

that one of the parties has made an untrue assertion does not in itself make the contract voidable. Courts do not want to permit people who have exercised poor business judgment or poor common sense to avoid their contractual obligations, nor do they want to grant rescission of a contract when there have been only minor and unintentional misstatements of relatively unimportant details. A drastic remedy such as rescission should be used only when a person has been seriously misled The tort of deceit is discussed in Chapter 6. Under every state’s law, however, a person injured by fraud in a contract for the sale of goods can both rescind the contract and sue for damages. This is made clear by Section 2-721 of the Uniform Commercial Code, which specifically states that no election of remedies is required in contracts for the sale of goods. 1 2



Chapter Thirteen Reality of Consent

about a fact important to the contract by someone he had the right to rely on. A person seeking to rescind a contract on the ground of innocent or fraudulent misrepresentation must be able to establish each of the following elements: 1. An untrue assertion of fact was made. 2. The fact asserted was material or the assertion was fraudulent. 3. The complaining party entered the contract because of his reliance on the assertion. 4. The reliance of the complaining party was reasonable. In addition, as noted earlier, establishing fraud necessitates proof that the untrue assertion was made with scienter. In tort actions in which the plaintiff is seeking to recover damages for deceit, the plaintiff would have to establish another element: injury. He would have to prove that he had suffered actual economic injury because of his reliance on the fraudulent assertion. In cases in which the injured person seeks only rescission of the contract, however, proof of economic injury usually is not required. Untrue Assertion of Fact To have misrepresentation or fraud, one of the parties must have made an untrue assertion of fact or engaged in some conduct that is the equivalent of an untrue assertion of fact. The fact asserted must be a past or existing fact, as distinguished from an opinion or a promise or prediction about some future happening. Consider, for instance, a contract under which a franchisor, Able, issues a franchise for a children’s daycare business to a franchisee, Baker. During the negotiations leading up to the contract, Able provides Baker an income and earnings statement purportedly based on the actual incomes and expenses of others who had acquired daycare franchises from Able and had operated their businesses for at least three years. According to the statement, a new daycare franchisee would have approximately $260,000 in net income after one year of operation of the business and approximately $440,000 in net income after each of the next two years of operation. Baker enters into the contract for acquisition of the daycare franchise, opens the daycare business, loses money the first year, and makes very little income the second year. Would the income and earnings statement provided by Able to Baker during the negotiations phase be merely a prediction about a possible future happening (and thus not the sort of thing on which Baker could base a misrepresentation or fraud claim)? Instead, would the numbers in the income and earnings

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statement furnish a potential basis on which Baker could obtain legal relief? Assuming that the numbers are not consistent with the actual experience of other franchisees even though Able represented them as such, an untrue assertion of past or existing fact would be present. Baker, therefore, could seek an appropriate remedy on misrepresentation grounds and possibly on fraud grounds.3  The concealment of a fact through some active conduct intended to prevent the other party from discovering the fact is considered to be the equivalent of an assertion. Like a false statement of fact, concealment can be the basis for a claim of misrepresentation or fraud. For example, if Summers is offering her house for sale and paints the ceilings to conceal the fact that the roof leaks, her active concealment may be considered an assertion of fact. Nondisclosure can also be the equivalent of an assertion of fact. Nondisclosure differs from concealment in that concealment involves the active hiding of a fact, whereas nondisclosure is the failure to volunteer information. Disclosure of a fact—even a fact that will harm the speaker’s bargaining position—is required in a number of situations, such as when the person has already offered some information, but further information is needed to give the other party an accurate picture, or when there is a relationship of trust and confidence between the parties. In recent years, courts and legislatures have tended to impose a duty to disclose when a party has access to information that is not readily available to the other party. This is consistent with modern contract law’s emphasis on influencing ethical standards of conduct and achieving fair results. Transactions involving the sale of real estate are among the most common situations in which this duty to disclose arises. Most states now hold that a seller who knows about a latent (hidden) defect that materially affects the value of the property he is selling has the obligation to speak up about this defect. In Stephen A. Wheat Trust v. Sparks, which follows, the court addresses nondisclosure and concealment issues in ruling on the plaintiffs’ claim that the defendants committed fraud in connection with their sale of real estate to the plaintiffs. Materiality If the misrepresentation was innocent, the person seeking to rescind the contract must establish that the fact asserted was material. A fact will be considered This illustration was drawn from Legacy Academy v. Mamilove, LLC, 761 S.E.2d 880 (Ga. App. 2014), which was ultimately reversed by  the Georgia Supreme Court in Legacy Academy v. Mamilove, LLC,  771 S.E.2d 868 (Ga. 2015), due to a merger clause. Merger clauses are discussed in more detail in Chapter 16. 3

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Part Three Contracts

Stephen A. Wheat Trust v. Sparks   754 S.E.2d 640 (Ga. Ct. App. 2014) Robert and Louise Sparks (the Sparkses) sold a house in Decatur, Georgia, to Stephen A. Wheat and Teresa M. McCrerey-Wheat (the Wheats). The parties’ contract, dated August 14, 2009, incorporated a Seller’s Property Disclosure Statement (Disclosure) dated March 5, 2009. The Sparkses conveyed the property to the Wheats at a September 14, 2009, closing of the transaction. At the closing, the Sparkses also signed an Owners’ Affidavit. Upon taking title to the house, Mr. Wheat deeded his interest in the property to Ms. McCrerey-Wheat and the Stephen A. Wheat Trust (Wheat Trust), which had just been created. In the Disclosure, the Sparkses represented that there were no “encroachments (known or recorded), leases, unrecorded easements, or boundary line disputes” regarding the property. In an addendum attached to the Disclosure, the Sparkses stated that the “[e]xterior sewer line [was] replaced with PVC in 2005. All waterlines, including service line, were replaced with copper plumbing in 2006.” The Owners’ Affidavit reiterated that “there are no disputes . . . concerning the encroachment of any improvements including fences, driveways, structures, [etc.] onto the property of neighbors or vice versa.” Approximately 18 months after taking possession of the property, the Wheats experienced a problem with the sewer lateral servicing the property. (A sewer lateral is an underground pipe that connects a house or business to a city or county sewer line.) During the process of repairing the problem, they learned that the sewer lateral extended approximately 133 feet beyond the property and included a portion that lay under both the property of their neighbors (the Gransdens) and a piece of heavily wooded land owned by the City of Decatur. The Wheats contacted the Sparkses’ real estate agent about the sewer problem. In response, she forwarded the Wheats an e-mail from Robert Sparks regarding the Sparkses’ past troubles with the sewer lateral. The e-mail stated that the “only small hurdle in making the replacement was the fact that the lateral crosses the Grandsen’s [sic] property.” In other e-mails to the real estate agent, Robert Sparks noted that one of the sewer line’s “clean-outs” is on “the back corner of the Gransden property (quite near the city’s tap)” and confirmed that when the Sparkses replaced the sewer lateral line in 2005, they “had to get permission from the next-door neighbor, Joe Gransden, to trench across the corner of his yard.” The Wheats eventually reached an easement agreement with the Gransdens and the city to resolve the encroachments between the property and the public sewer connection. In another section of the Disclosure, the Sparkses affirmed that there had been water leakage, water accumulation, or dampness within the house’s basement. The addendum attached to the Disclosure further explained, “During very heavy rains the front corner of the basement occasionally became damp. Installed French drains down sides of house to draw water downhill and away from house.” Evidence adduced in the litigation referred to below indicated that the Sparkses became aware of three major leaks and a minor leak that occurred during the months after they completed their Disclosure (while the property was on the market). During that time, Louise Sparks set up fans (including some that were borrowed) in the basement to dry the leaks before showing the property. Although their real estate agent advised the Sparkses to update their Disclosure to acknowledge the continued leaks, they did not do so. On April 2, 2009, Ms. Sparks stated in an e-mail to the agent: I think Rob or my parents mentioned the leak in the basement—we have a piece of masonry missing in the basement, causing water to come in the front right corner, Rob has found someone to fix on Monday. We’ve had a water issue in the basement too, near the window facing the driveway, water is coming in off the deck. Rob has asked someone else to come over on Saturday to address—hopefully we’ll have this one done before the open house, and it doesn’t rain any time soon! Thanks again for your fans (I set them up this A.M. at 6:30). However, Ms. Sparks later stated in a deposition that she did not believe they ultimately made any repairs to correct the leaks identified in her e-mail. The Wheats visited the property during an open house in April 2009 and viewed the basement after it had been dried by the fans. After purchasing the property, the Wheats experienced water leaks in the basement, which they undertook to repair. Subsequently, the Wheats, the Wheat Trust, and Stephen A. Wheat in his role as trustee filed suit against the Sparkses. The plaintiffs asserted a fraud claim based on false representations about the sewer lateral and misleading failures to disclose important particulars regarding the lateral. In addition, they asserted a fraud claim based on misleading nondisclosure, or active concealment, of the water intrusions in the basement. The plaintiffs sought compensatory and punitive damages. Following discovery, the Sparkses filed a motion for summary judgment, which the trial court granted. The plaintiffs (referred to collectively, for easeof-reference purposes, as “the Wheats” except where clarity dictates otherwise) appealed.



Chapter Thirteen Reality of Consent

McMillian, Judge Summary judgment is proper when there is no genuine issue of material fact and the movant is entitled to judgment as a matter of law. [In reviewing a grant of summary judgment], we view the evidence, and all reasonable conclusions and inferences drawn from it, in the light most favorable to the nonmovant. A purchaser claiming he was fraudulently induced to enter into a sales contract has an election of remedies: (1) promptly after discovering the fraud he may rescind the contract . . . ; or (2) he may affirm the contract and sue for damages resulting from the fraud. The Wheats have elected to [pursue] the second [option]. Fraud requires proof of five elements: (i) false representation made by the defendant, (ii) knowledge by the defendant that the representation was false when made, (iii) intent to induce the plaintiff to act or refrain from acting, (iv) justifiable reliance by the plaintiff, and (v) damage to the plaintiff. “Fraud in the sale of real estate may be predicated upon a willful misrepresentation, i.e., the seller tells a lie.” [Citation omitted.] In addition, fraudulent inducement of a sale may be based on claims of fraudulent concealment where the seller, who knows of the defect, either (1) takes active steps to conceal it and prevent the buyer from discovering it or (2) passively conceals the defect by simply keeping quiet about it. Here, the Wheats assert fraud [mainly] on the latter theory—that the Sparkses concealed the fact that the sewer lateral servicing the property encroached onto the neighboring property and the fact that the basement had multiple, continued leaks. As evidence of fraud regarding the encroachment of the sewer lateral, the Wheats point to the Sparkses’ statement in the Disclosure that there were no known encroachments, their reiteration of this fact in their Owners’ Affidavit, and their silence as to the subterranean encroachment. The Sparkses, on the other hand, although not disputing that the sewer lateral does run underneath the neighboring properties for approximately 133 feet, argue that because they made their disclosures based upon their understanding and personal knowledge, there was no actionable misrepresentation. Moreover, Mr. Sparks [stated in his deposition] that he did not disclose the encroachment to the Wheats because he “did not believe it to be material.” Based on our review of the record, we find that whether the Sparkses had knowledge as to the falsity of their representation and their intention to induce the Wheats to purchase the property are issues of fact best left to a jury. We have frequently cautioned that “[q]uestions of fraud, the truth and materiality of representations made by a seller, and whether the buyer could have protected himself by the exercise of proper diligence are, except in plain and indisputable cases, questions for the jury.” [Citation omitted.] In support of their motion for summary judgment, Mr. Sparks submitted an affidavit showing that when the Sparkses purchased the property in 2004 from the previous owners, the seller’s

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disclosure statement likewise did not disclose any encroachment. However, we are not persuaded that the Sparkses’ knowledge in 2004 regarding the sewer lateral encroachment is relevant to whether they knowingly made a false representation at the time that they induced the Wheats to purchase the property in 2009. “For purposes of summary judgment, scienter and intent to deceive are determined on the basis of the seller’s knowledge of the falsity of his representations at the time made to the prospective purchaser.” [Citation omitted.] More significantly, there is evidence in the record to support the Wheats’ assertion that the Sparkses did in fact know of the encroachment as early as 2005, including admissions from Mr. Sparks that when they replaced the sewer lateral line in 2005, they had to get permission from their neighbors to trench across the corner of their yard. The Sparkses also argue that the Wheats were put on notice as to the previous problems with the sewer system, yet failed to exercise due diligence and therefore cannot prove justifiable reliance. The Wheats, however, point out that the sewer line servicing the property was subterranean and the encroachment of that line onto the neighboring properties was not something that they could have discovered through their own investigation until they were forced to excavate in 2011. Because the Wheats have established that genuine issues of material fact remain with respect to their fraud claim regarding the sewer lateral encroachment, the trial court erred in granting summary judgment to the Sparkses on that claim. We likewise find that genuine issues of material fact exist regarding the Wheats’ fraud claim based on the basement water intrusion. The Sparkses argue [in their brief] that they satisfied their duty of disclosure by acknowledging the past problem and disclosing “an attempted repair to the water leaks they experienced,” and that the Wheats were therefore on notice of the defect and cannot show justifiable reliance. We disagree with the Sparkses’ characterization of the additional information provided in the addendum to their Disclosure. A jury would be authorized to find that the Sparkses’ explanation—that “[d]uring very heavy rains the front corner of the basement occasionally became damp. Installed French drains down sides of house to draw water downhill and away from house”—was stated in such a way as to induce a purchaser to believe that the problem was in the past and had been resolved, not that it was an “attempted” repair. Moreover, there is evidence, namely the e-mail communications between the Sparkses and their real estate agent, that the Sparkses were experiencing additional leaks at the time they were marketing the property and that those current leaks were never disclosed. In this case, although the conclusion that the Wheats should have realized there may be additional water-related defects was authorized by the evidence, this conclusion was not demanded by the evidence. As discussed above, questions of fraud, including materiality of representations made by a seller and whether

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Part Three Contracts

the buyer could have protected himself by the exercise of proper diligence, are generally questions for the jury. Because the Wheats have established a genuine issue of material fact as to their fraud claim regarding the basement water intrusions, the trial court erred in granting summary judgment to the Sparkses on that claim. The Wheats further assert that the trial court erred in ruling that the Wheat Trust did not have standing [to bring a claim for fraud]. In order for a fraud claim to be actionable, the fraud must be based upon a misrepresentation made to a defrauded party and relied upon by the defrauded party. Here, as the Sparkses have noted, the Wheat Trust was not even in existence at the time the alleged misrepresentations (or fraudulent concealments) were made. Therefore, no evidence exists that the Wheat Trust relied on the alleged misstatements. Accordingly, we find that the trial court did not err in granting summary judgment as to the claims made by the Wheat Trust. The Wheats (Stephen Wheat individually and Teresa McCrerey-Wheat) next challenge the trial court’s holding that Mr. Wheat was not damaged. [T]he trial court [concluded] that because Mr. Wheat conveyed his interest in the property to the

Wheat Trust, he was no longer an owner of the property, and therefore, was not damaged by any alleged fraud. The Wheats, however, each averred that they individually expended time and money in securing an easement from the neighbors and the City of Decatur. They further averred that they each individually spent time and money in making the necessary repairs to the basement to prevent further leaks. Mr. Wheat also averred that the money expended in solving these two problems was paid for out of the Wheats’ joint checking account. “General damages awarded on a fraud claim may cover a broader range of damages than those awarded on contract claims.” [Citation omitted.] Because there is sufficient evidence in the record to allow a jury to find that Mr. Wheat was individually damaged, we find that the trial court incorrectly held that Mr. Wheat’s lack of ownership in the property precluded his proof of damages. [In addition, the trial court erred in ruling that the Wheats could not seek punitive damages.] Fraud is an intentional tort for which punitive damages may be awarded.

to be material if it is likely to play a significant role in inducing a reasonable person to enter the contract or if the person asserting the fact knows that the other person is likely to rely on the fact. For example, Rogers, who is trying to sell his car to Ferguson and knows that Ferguson idolizes professional bowlers, tells Ferguson that a professional bowler once rode in the car. Relying on that representation, Ferguson buys the car. Although the fact Rogers asserted might not be important to most people, it would be material here because Rogers knew that his representation would be likely to induce Ferguson to enter the contract. Even if the fact asserted was not material, the contract may be rescinded if the misrepresentation was fraudulent. The rationale for this rule is that a person who fraudulently misrepresents a fact, even one that is not material under the standards previously discussed, should not be able to profit from his intentionally deceptive conduct.

assertion was false or was not aware that an assertion had been made, there has been no reliance.

Actual Reliance Reliance means that a person pursues some course of action because of his faith in an assertion made to him. For misrepresentation for fraud to exist, there must have been a causal connection between the assertion and the complaining party’s decision to enter the contract. If the complaining party knew that the

Grant of summary judgment to the Sparkses reversed in favor of the Wheats individually; case remanded for further proceedings.

Justifiable Reliance Courts also scrutinize the reasonableness of the behavior of the complaining party by requiring that his reliance be justifiable. A person does not act justifiably if he relies on an assertion that is obviously false or not to be taken seriously. One problem involving the justifiable reliance element is determining the extent to which the relying party is responsible for investigating the accuracy of the statement on which he relies. Classical contract law held that a person who did not attempt to discover readily discoverable facts generally was not justified in relying on the other party’s statements about them. For example, under traditional law, a person would not be entitled to rely on the other party’s assertions about facts that are a matter of public record or that could be discovered through a reasonable inspection of available documents or records. The extent of the responsibility placed on a relying party to conduct an independent investigation has declined in modern contract law, however. Today, a court might be more likely to follow the approach of section 172 of the Restatement, which provides that a relying party’s failure to discover facts before entering the contract does not make his reliance unjustifiable



Chapter Thirteen Reality of Consent

unless the degree of his fault was so extreme as to amount to a failure to act in good faith and in accordance with reasonable standards of fair dealing. Thus, today’s courts tend to place a greater degree of accountability on the person

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who makes the assertion than on the person who relies on the assertion. You will see an example of this approach to justifiable reliance in the Timothy case, which follows.

Timothy v. Keetch   251 P.3d 848 (Utah Ct. App. 2011) Teri and Thomas Keetch wanted to establish a therapeutic horse ranch as a business venture. Their concept for the ranch was that it would be a place where children who were victims of abuse could ride and care for horses as a means of healing. The Keetches lacked sufficient funds to start the ranch, however. In the summer of 2000, they sought to buy a stallion for breeding purposes, and they turned to MSF Properties for financing. The Keetches eventually borrowed $102,000 from MSF and pledged the stallion—a quarterhorse named Hesa Son of a Dun—as collateral for the loan. This transaction was memorialized in a security agreement. A financing statement was filed with Utah’s Division of Corporations and Commercial Code, which maintains an online database for Uniform Commercial Code filings. A month or two later, Rebecca Mendenhall, a broker representing the Keetches, contacted Paul and Janice Timothy and suggested that they make a “bridge loan” (a short-term loan used as a means of interim financing) to the Keetches for funding the therapeutic horse ranch. The Keetches and the Timothys met at a fast-food restaurant to discuss the transaction. The Keetches offered to pledge Hesa Son of a Dun as security for the loan. Following the meeting, Teri showed the horse to Paul. Teri said that she owned the horse and that it was worth between $125,000 and $175,000. Paul asked Teri if the horse was encumbered in any way—that is, if ownership of the horse was subject to any debts or obligations—and Teri responded that the horse was not encumbered. In September 2001, Paul met with Thomas and asked several questions about his financial status. Thomas gave false answers to a number of questions, including the purposes for the loan and whether the Keetches owned the horse “free and clear.” After the meeting, Paul asked the horse’s trainer if the horse was encumbered. He also inquired of the American Quarter Horse Association, which maintains ownership, lien, and breeding records for quarterhorses. Neither had any knowledge of any prior encumbrances. The Timothys did not check Uniform Commercial Code filings to see if a financing statement had been filed on the horse. Had they done so, they would have discovered that, contrary to the Keetches’ representations, the horse was already serving as collateral on the loan MSF made to the Keetches. Oblivious to the horse’s true status, the Timothys made the bridge loan to the Keetches, secured—or so they thought—by the full value of the horse. The Keetches defaulted on their loan from MSF, and MSF seized the horse in October 2001. The Keetches later defaulted on the bridge loan from the Timothys as well. At this point, the Timothys learned that their collateral had been lost to MSF. The Timothys sued the Keetches for breach of contract and fraud, among other claims. A bench trial was held and the court found in favor of the Timothys. The Keetches appealed. Orme, Judge In general, Utah law does not require one to inspect the public record to verify the truthfulness of statements made to him or her. In Christiansen v. Commonwealth Land Title Ins. Co., 666 P.2d 302, 307 (Utah 1983), an escrow company represented that a land development company held an interest in property that it actually did not have. The injured party sued because the escrow company’s representations that certain properties held in escrow had unencumbered equity values available as security for the plaintiff were not true. On appeal, the Utah Supreme Court held in favor of the plaintiff, noting that a defendant who makes misrepresentations, even negligently, can be held liable. As to reasonable reliance, the Court differentiated between available documents that are part of a transaction and documents contained in public records, and stated that “failure to examine public records does not defeat an action for a false representation because in most cases there is no duty to make such an examination.”

We considered the doctrine of reasonable reliance in Conder v. A. L. Williams & Associates, Inc., 739 P.2d 634 (Utah Ct. App. 1987), and held that a plaintiff may justifiably rely on positive assertions of fact without independent investigation. It is only where, under the circumstances, the facts should make it apparent to one of his knowledge and intelligence, or he has discovered something which should serve as a warning that he is being deceived, that a plaintiff is required to make his own investigation. Applying these principles to the facts, the Timothys were not required to check for prior UCC filings on the horse. The Keetches unqualifiedly represented that they owned the horse free of prior encumbrances. Nothing in the transaction, in the Keetches’ representations, in Paul’s visit to the ranch, or in the inquiries the Timothys made suggested anything that would “serve as a warning” that they were being deceived. Affirmed in favor of the Timothys.

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Part Three Contracts

CONCEPT REVIEW Misrepresentation and Fraud Remedy Elements

Innocent Misrepresentation

Fraud

Rescission 1. Untrue assertion of fact (or equivalent) 2. Assertion relates to material fact 3. Actual reliance 4. Justifiable reliance

Rescission and/or tort action for damages 1. Untrue assertion of fact (or equivalent) 2. Assertion made with knowledge of falsity (scienter) and intent to deceive 3. Justifiable reliance 4. Economic loss (in a tort action for damages)

LOG ON A number of useful sites provide information about the nature of Internet fraud and how to reduce the chances of being victimized. Some even provide a method of reporting Internet fraud. An example is the National Fraud Information Center, www.fraud.org/. For a good resource on identity theft and identity fraud, see the U.S. Department of Justice’s web page on the topic at www.usdoj.gov/criminal/ fraud/websites/idtheft.html.

Mistake Nature of Mistake LO13-3

Explain the elements of mistake and determine when mistake makes a contract voidable.

Anyone who enters into a contract does so on the basis of her understanding of the facts that are relevant to the contract. Her decision about what she is willing to exchange with the other party is based on this understanding. If the parties are wrong about an important fact, the exchange that they make is likely to be quite different from what they contemplated when they entered into the contract. This difference is due to simple error rather than to any external events such as an increase in market price. For example, Fox contracts to sell to Ward a half-carat stone, which both believe to be a tourmaline, at a price of $65. If they are wrong and the stone is actually a diamond worth at least $2,500, Fox will have suffered an unexpected loss and Ward will have reaped an unexpected gain. The contract would not have been made at a price of $65 if the parties’ belief about the nature of the stone had been in accord with the facts. In such cases, the person adversely affected

by the mistake can avoid the contract under the doctrine of mistake. The purpose of the doctrine of mistake is to prevent unexpected and unbargained for losses that result when the parties are mistaken about a fact central to their contract. What Is a Mistake? In ordinary conversation, we may use the term mistake to mean an error in judgment or an unfortunate act. In contract law, however, a mistake is a belief about a fact that is not in accord with the truth.4 The mistake must relate to facts as they exist at the time the contract is created. An erroneous belief or prediction about facts that might occur in the future would not qualify as a mistake. As in misrepresentation cases, the complaining party in a mistake case enters into a contract because of a belief that is at variance with the actual facts. Mistake is unlike misrepresentation, however, in that the erroneous belief is not the result of the other party’s untrue statements. Mistakes of Law A number of the older mistake cases state that mistake about a principle of law will not justify rescission. The rationale for this view was that everyone was presumed to know the law. More modern cases, however, have granted relief even when the mistake is an erroneous belief about some aspect of law. Negligence and the Right to Avoid for Mistake Although courts sometimes state that relief will not be granted when a person’s mistake was caused by his own negligence, they often have granted rescission even when the mistaken party was somewhat negligent. Section 157 of the Restatement (Second) of Contracts focuses on the degree of a party’s negligence in making Restatement (Second) of Contracts § 151.

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Chapter Thirteen Reality of Consent

the mistake. It states that a person’s fault in failing to know or discover facts before entering the contract will not bar relief unless his fault amounted to a failure to act in good faith. Effect of Mistake The mere fact that the contracting parties have made a mistake is not, standing alone, a sufficient ground for avoidance of the contract. The right to avoid a contract because of mistake depends on several factors that are discussed in later sections. One important factor that affects the right to avoid is whether the mistake was made by just one of the parties (unilateral mistake) or by both parties (mutual mistake). Mutual Mistakes in Drafting Writings Sometimes, mutual mistake takes the form of erroneous expression of an agreement, frequently caused by a clerical error in drafting or typing a contract, deed, or other document. In such cases, the remedy is reformation of the writing rather than avoidance of the contract. Reformation means modification of the written instrument to express the agreement that the parties made but failed to express correctly. Suppose Arnold agrees to sell Barber a vacant lot next to Arnold’s home. The vacant lot is “Lot 3, block 1”; Arnold’s home is on “Lot 2, block 1.” The person typing the contract strikes the wrong key, and the contract reads, “Lot 2, block 1.” Neither Arnold nor Barber notices this error when reading and signing the contract, yet clearly they did not intend to have Arnold sell the lot on which his house stands. In such a case, a court will reform the contract to conform to Arnold and Baker’s true agreement.

Requirements for Mutual Mistake A

mutual mistake exists when both parties to the contract have erroneous assumptions about the same fact. When both parties are mistaken, the resulting contract can be avoided if the three following elements are present: 1. The mistake relates to a basic assumption on which the contract was made. 2. The mistake has a material effect on the agreed-upon exchange. 3. The party adversely affected by the mistake does not bear the risk of the mistake.5 Mistake about a Basic Assumption Even if the mistake is mutual, the adversely affected party will not have the right to avoid the contract unless the mistake concerns a basic assumption on which the contract was based. Restatement (Second) of Contracts § 152.

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Assumptions about the identity, existence, quality, or quantity of the subject matter of the contract are among the basic assumptions on which contracts typically are founded. It is not necessary that the parties be consciously aware of the assumption; an assumption may be so basic that they take it for granted. For example, if Peterson contracts to buy a house from Tharp, it is likely that both of them assume at the time of contracting that the house is in existence and that it is legally permissible for the house to be used as a residence. An assumption would not be considered a basic assumption if it concerns a matter that bears an indirect or collateral relationship to the subject matter of the contract. For example, mistakes about matters such as a party’s financial ability or market conditions usually would not give rise to avoidance of the contract. Material Effect on Agreed-Upon Exchange It is not enough for a person claiming mistake to show that the exchange is something different from what he expected. He must show that the imbalance caused by the mistake is so severe that it would be unfair for the law to require him to perform the contract. He will have a better chance of establishing this element if he can show not only that the contract is less desirable for him because of the mistake but also that the other party has received an unbargained-for advantage. Party Harmed by Mistake Did Not Bear the Risk of Mistake Even if the first two elements are present, the person who is harmed by the mistake cannot avoid the contract if he is considered to bear the risk of mistake.6 Courts have the power to allocate the risk of a mistake to the adversely affected person whenever it is reasonable under the circumstances to do so. One situation in which an adversely affected person would bear the risk of mistake is when he has expressly contracted to do so. For example, if Buyer contracted to accept property “as is,” he may be considered to have accepted the risk that his assumption about the quality of the property may be erroneous. The adversely affected party also bears the risk of mistake when he contracts with conscious awareness that he is ignorant or has limited information about a fact—in other words, he knows that he does not know the true state of affairs about a particular fact, but he binds himself to perform anyway. Suppose someone gives you an old, locked safe. Without trying to open it, you sell it and “all of its contents” to one of your friends for $25. When your friend succeeds in opening Restatement (Second) of Contracts § 154.

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Part Three Contracts

the safe, he finds $10,000 in cash. In this case, you would not be able to rescind the contract because, in essence, you gambled on your limited knowledge—and lost.

Hicks v. Sparks, which follows, illustrates the mutual mistake issues discussed above, including whether the party seeking relief bore the risk of mistake.

Hicks v. Sparks   2014 Del. LEXIS 142 (Del. Mar. 25, 2014) In March 2011, 72-year-old Patricia Hicks was a passenger in a motor vehicle that was rear-ended by a car driven by Debra Sparks. Hicks went to the local hospital’s emergency room and followed up with her family physician a few days later with complaints of neck pain and headaches. During approximately 15 visits, she received medical treatment and physical therapy for neck pain and headaches. In April 2011, Hicks presented a claim regarding her injuries to Progressive Northern Insurance Co., Sparks’s liability carrier. Adjuster Sharon O’Connell handled the claim. Hicks spoke with O’Connell, explaining that she had stopped physical therapy. She also told O’Connell that she was still having some problems but was satisfied with her progress and was ready to negotiate a settlement. O’Connell offered Hicks $2,000 in resolution of the claim, but Hicks did not accept. Hicks spoke with O’Connell a second time in May 2011 and told O’Connell that she was still having headaches. Hicks made a settlement demand of $7,000. O’Connell countered with a $2,500 offer. Hicks stated that she wanted more time to consider the counteroffer. More than three months after the accident, Hicks contacted O’Connell again. Hicks made a settlement demand for $5,000. She explained that two attorneys to whom she had spoken had advised her to wait at least a year before settling, in order to ensure that her injuries were resolved. O’Connell explained that she respected Hicks’s right to wait for settlement but offered her $3,000. In October 2011, Hicks reiterated her demand of $5,000. O’Connell responded with an offer of $4,000, which Hicks accepted. She later went to the Progressive office, obtained a settlement check, and executed a full and final release (the Release). Nearly a year after the accident, Hicks began to experience pain in both of her arms and tingling and numbness in her hands. An MRI revealed a cervical disc herniation. She later underwent disc surgery. In 2013, Hicks filed suit in the Delaware Superior Court, alleging that Sparks’s negligence had caused the March 2011 accident and Hicks’s resulting injuries. The court granted Sparks’s motion for summary judgment, largely because of the above-referred-to Release. Hicks appealed to the Delaware Supreme Court.

Ridgely, Justice Hicks contends that . . . a mutual mistake of fact between the parties . . . should have allowed for rescission of the Release. [She alleges that her] post-Release injuries are materially different from those contemplated in the Release, [thus] amounting to a mistake of fact, [that she] did not assume the risk of mistake, [and that] the Superior Court therefore erred by granting Sparks’s motion for summary judgment. A release is a device by which parties seek to control the risk of the potential outcomes of litigation. Releases are executed to resolve the claims the parties know about as well as those that are unknown or uncertain. Because litigation is inherently risky, a general release avoids the uncertainty, expenses, and delay of a potential trial. Delaware courts will generally uphold a release and will only set aside a clear and unambiguous release where it was the product of fraud, duress, coercion, or mutual mistake. To establish a mutual mistake of fact, the plaintiff must show by clear and convincing evidence that (1) both parties were mistaken as to a basic assumption, (2) the mistake materially affects the agreed-upon exchange of performances, and (3) the party adversely affected did not assume the risk of the mistake. Under principles of contract law, a contract is voidable on the grounds

of mutual mistake existing at the time of contract formation. But the mutual mistake “must relate to a past or present fact material to the contract and not to an opinion respecting future conditions as a result of present facts.” [Citation omitted.] Nevertheless, mutuality of mistake in the insurance context can “exist[] only where neither the claimant nor the insurance carrier is aware of the existence of personal injuries.” [Citation omitted.] A release will bar suit for a plaintiff’s subsequently discovered injuries unless the injuries are materially different from the parties’ expectations at the time the release was signed. Mutual mistake will invalidate the release where both parties are mistaken as to the presence or extent of the plaintiff’s injuries at the time they executed the release. If the plaintiff knew that “an indicia of injuries exist[ed] at the time [she] signed the release,” the release will bar suit and a court will not invalidate it by mutual mistake. [Citation omitted.] Even though the plaintiff might be unaware of “the exact degree of injuries with medical certainty,” knowledge of the existence of an injury will preclude a finding of mutual mistake. [Citation omitted.] Finally, mutual mistake does not exist if the party adversely affected assumed the risk of the mistake. As the Restatement (Second) of Contracts explains in § 154(a–b), a party assumes the risk



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of a mistake where the contract assigns the risk to the party or where the mistaken party consciously performed under a contract aware of his or her limited knowledge with respect to the facts to which the mistake relates. Hicks argues that the Release is voidable by mutual mistake because her injuries are materially different from the injuries that both parties believed she sustained at the time the Release was signed. Hicks explains that she and O’Connell were aware that Hicks suffered a cervical sprain requiring treatment before signing the Release. Hicks contends that surgery for a herniated disc is materially different from the minor head and neck injuries contemplated at the time of release. Hicks further argues that this mistake adversely affected the parties’ agreed-upon performance because the herniated disc was a new, undiscovered injury for which Hicks did not assume the risk of mistake. The record shows that Hicks has failed to demonstrate a mutual mistake of fact held by both parties at the time of the release. Hicks concedes that she told O’Connell that she had not made a full recovery and continued to experience headaches and neck pain. Although Hicks may have been mistaken as to the future effect of her injury, both parties were aware that Hicks

injured her neck in the accident. This can reasonably be considered an “indicia of injuries” existing at the time of the Release. Hicks had ample opportunity to consult additional physicians and obtain further diagnoses to discover the herniated disc. Her later diagnosis is not a materially different fact but an injury of which Hicks and O’Connell had some awareness. Therefore, there was no mutual mistake. The record also shows that Hicks assumed the risk of mistake. She executed a clear and unambiguous Release in exchange for a settlement payment. This release specifically provided that Hicks “declares and represents that the injuries are or may be permanent and that recovery therefrom is uncertain and indefinite.” Hicks assumed the risk of mistake when she signed the Release without obtaining a more thorough medical examination to fully discover the extent of her injuries related to her neck pain. She assumed the risk that her injuries were more serious than she believed and that her symptoms could worsen and require further treatment. Because Hicks assumed this risk, she cannot now claim mutual mistake.

Requirements for Unilateral Mistake A

avoid on the ground of unilateral mistake must show either one of the following:

unilateral mistake exists when only one of the parties makes a mistake about a basic assumption on which he made the contract. For example, Plummer contracts to buy 25 shares of Worthwright Enterprises Inc. from Taylor, mistakenly believing that he is buying 25 shares of the much more valuable Worthwrite Industries. Taylor knows that the contract is for the sale of shares of Worthwright. Taylor (the “nonmistaken party”) is correct in his belief about the identity of the stock he is selling; only Plummer (the “mistaken party”) is mistaken in his assumption about the identity of the stock. Does Plummer’s unilateral mistake give him the right to avoid the contract? Courts are more likely to allow avoidance of a contract when both parties are mistaken than when only one is mistaken. The rationale for this tendency is that in cases of unilateral mistake, at least one party’s assumption about the facts was correct, and allowing avoidance disappoints the reasonable expectations of that nonmistaken party. It is possible to avoid contracts for unilateral mistake, but to do so, proving the elements necessary for mutual mistake is just a starting point. In addition to proving the elements of mistake discussed earlier, a person trying to

Grant of summary judgment to Sparks affirmed.

1. The nonmistaken party caused or had reason to know of the mistake. Courts permit avoidance in cases of unilateral mistake if the nonmistaken party caused or knew of the mistake, or if the mistake was so obvious that the nonmistaken party had reason to realize that a mistake had been made.7 For example, Ace Electrical Company makes an error when preparing a bid that it submits to Gorge General Contracting. If the mistake in Ace’s bid was so obvious that Gorge knew about it when it accepted Ace’s offer, Ace could avoid the contract even though Ace is the only mistaken party. The reasoning behind this rule is that the nonmistaken person could have prevented the loss by acting in good faith and informing the person in error that he had made a mistake. It also reflects the judgment that people should not take advantage of the mistakes of others. Or 2. It would be unconscionable to enforce the contract. A court could also permit avoidance because of unilateral Restatement (Second) of Contracts § 153.

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mistake when the effect of the mistake was such that it would be unconscionable to enforce the contract. To show unconscionability in this context, the mistaken party would have to convince the court that the consequences of the mistake would be severe enough to make the contract unreasonably harsh or oppressive if it were enforced.8 In the example above, Ace Electrical Company made an error when preparing a bid that it submits The concept of unconscionability is developed more fully in Chapter 15.

8

to Gorge General Contracting. Suppose that Gorge had no reason to realize that a mistake had been made, and accepted the bid. Ace might show that it would be unconscionable to enforce the contract by showing that not only will its profit margin not be what Ace contemplated when it made its offer, but also that it would suffer a grave loss by having to perform at the mistaken price. The Patterson case, which follows, deals with a situation in which a party is unable to bind a unilaterally mistaken party to a contractual obligation.

Patterson v. CitiMortgage, Inc.   820 F.3d 1273 (11th Cir. 2016) In 2008, Toby Breedlove fell behind on his mortgage payments to CitiMortgage. Hoping to avoid foreclosure, he sought to sell his home to Victor Patterson through a short sale. (A short sale occurs when the mortgage company will not recoup all the money that it is owed by the mortgagor through a sale of the house but agrees to the sale nonetheless because it likely nets the mortgage company more than a foreclosure sale would. In a short sale, the mortgagor is released from his debt to the mortgage company.) Patterson communicated directly with CitiMortgage to negotiate the sale. During those negotiations, CitiMortgage emphasized that it would not agree to a deal unless the short sale would generate a net payout greater than the expected proceeds from a foreclosure sale. In pursuit of a deal, Patterson made a series of escalating offers to CitiMortgage over the course of several months. In succession, Patterson offered $371,000, $412,000, and $444,000. CitiMortgage rejected the first two offers outright, as the net payout for each would have been insufficient, namely, $350,000 and $391,940, respectively. As to the third offer, CitiMortgage decided to accept it on the condition that Patterson reduce certain fees associated with the sale so that the net payout would be $423,940. CitiMortgage intended to convey that counteroffer in a letter dated September 19, 2008, which it sent to Patterson. Due to a clerical error, however, the letter actually indicated that CitiMortgage sought a net payout amount of $113,968.45. The letter set a closing deadline for October 24, 2008. CitiMortgage faxed the letter to Patterson with a subject line reading, “Toby Breedlove Shortsale approval.” Patterson received the letter and immediately notified CitiMortgage that he wanted to move forward with the short sale. The parties, though, never explicitly discussed the payoff amount. Thereafter, Patterson scheduled a closing, revised the sale agreement to reflect a sale price that would produce a net payout amount to CitiMortgage of $113,968.45, and obtained a $130,000 loan to finance the purchase of Breedlove’s house. On October 23, 2008—the date of the closing—the closing attorney sent the payout funds to CitiMortgage by wire transfer. Only then did CitiMortgage realize its mistake and immediately attempted to contact the closing attorney to let him know that it would be rejecting the funds. CitiMortgage left a voicemail message for the closing attorney and faxed a letter to him explaining that the net payout amount was based on a clerical error in the September 19 letter and that the “corrected” amount was $423,940. The next day CitiMortgage received a letter from Patterson demanding that it accept the $113,968.45 payment. He insisted that was the amount CitiMortgage had agreed to accept for the house and that they had a binding contract. Eventually, CitiMortgage commenced foreclosure proceedings on the Breedlove property, which prompted Patterson to file a complaint in state court against CitiMortgage for breach of contract. CitiMortgage removed the case to federal court based on diversity and filed a motion for summary judgment, based in part on the theory that the contract for the sale of Breedlove’s house to Patterson was voidable due to unilateral mistake. The district court granted the motion. Patterson appealed.

Carnes, Chief Judge The dispositive issue is whether CitiMortgage’s unilateral mistake, the clerical error in its September 19, 2008 letter about the amount of the net payout it was seeking, prevented the parties from forming a valid contract. . . .

[Patterson] argue[s] that, under Georgia law, a court may not rescind a contract based on a unilateral mistake. It is true that Georgia courts will often refuse to save contracting parties from their own unilateral mistakes that could have been avoided through the exercise of due diligence. But it



Chapter Thirteen Reality of Consent

is equally true, if not more so, that Georgia courts will not permit a party to take unfair advantage of an offer that contains an obvious, unilateral mistake. As the Georgia Supreme Court explained more than a century ago, “There is no disposition in the law to let one ‘snap up’ another, or take an advantage of mistakes.” Singer v. Grand Rapids Match Co., 43 S.E. 755, 757 (Ga. 1903). Georgia courts will rescind or refuse to enforce a contract when “one of the parties has, without gross fault . . . on his part, made a mistake,” the mistake “was known, or ought to have been known, to the opposite party,” and “the mistake can be relieved against without injustice.” Id. Under those circumstances, a unilateral mistake “may be a ground for rescinding a contract, or for refusing to enforce its specific performance.” Werner v. Rawson, 15 S.E. 813, 814 (Ga. 1892). If Patterson was unaware that CitiMortgage’s September 19 offer was a mistake, then CitiMortgage should suffer the loss. “On the other hand if [CitiMortgage] inadvertently (though negligently) made an obvious mistake and this mistake was apparent on the face of the offer and was known to [Patterson], then relief should [be] granted to [CitiMortgage]. . . .” [Frazier Assocs. Mfrs. Representatives, Inc. v. Dabbs & Stewart, 325 S.E.2d 914, 916 (Ga. 1985).]

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Given the parties’ negotiations and Patterson’s series of escalating offers, CitiMortgage’s mistake was obvious and Patterson knew or should have known it was a mistake. Patterson made successive offers of $371,000 and $412,000, which would have generated net payouts to CitiMortgage in the amounts of $350,000 and $391,940, respectively. CitiMortgage rejected both of those offers without making a counteroffer. Then Patterson offered $444,000, which would have generated a net payout of $412,620. In response to that highest offer from Patterson, CitiMortgage sent the September 19 letter counteroffering for a net payout to it of $113,968.45. No rational person would believe that was anything but a mistake because rational persons and mortgage companies do not counteroffer for less—in this case nearly $300,000 less—than the latest and highest and still outstanding offer. Patterson . . . will not suffer an injustice under Georgia law because [he] will only be deprived of what Georgia law does not allow [him] to have—the opportunity to take advantage of another’s obvious unilateral mistake. . . .  *** AFFIRMED.

CONCEPT REVIEW Avoidance on the Ground of Mistake Description Needed for Avoidance of Contract

Mutual Mistake

Unilateral Mistake

Both parties mistaken about same fact  Elements of mistake: 1. Mistake about basic assumption on  which contract was made

Only one party mistaken about a fact  Same elements as mutual mistake Plus a. Nonmistaken party caused mistake or had reason to know of mistake Or b. Effect of mistake is to make it uncon- scionable to enforce contract

2. Material effect on agreed exchange 3. Person adversely affected by mistake  does not bear the risk of the mistake

Duress Nature of Duress Duress is wrongful coercion that

induces a person to enter or modify a contract. One kind of duress is physical compulsion to enter a contract. For example, Thorp overpowers Grimes, grasps his hand, and forces him to sign a contract. This kind of duress is rare, but when it occurs, a court would find that the contract was void. A far more common type of duress occurs when a

person is induced to enter a contract by a threat of physical, emotional, or economic harm. In these cases, the contract is considered voidable at the option of the victimized person. This is the form of duress addressed in this chapter. The elements of duress have undergone dramatic changes. Classical contract law took a very narrow view of the type of coercion that constituted duress, limiting duress to threats of imprisonment or serious physical harm. Today, however, courts take a much broader view of the types of

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coercion that will constitute duress. For example, modern courts recognize that threats to a person’s economic interests can be duress under some circumstances.

Requirements for Duress LO13-4

Explain the circumstances under which duress makes a contract voidable.

To rescind a contract because of duress, one must be able to establish both of the following elements: 1. The contract was induced by an improper threat. 2. The victim had no reasonable alternative but to enter into the contract. Improper Threat It would not be desirable for courts to hold that every kind of threat constituted duress. If they did, the enforceability of contracts in general would be in question because every contract negotiation involves at least the implied threat that a person will not enter into the transaction unless her demands are met. What degree of wrongfulness, then, is required for a threat to constitute duress? Traditionally, a person would have to threaten to do something she was not legally entitled to do—such as threaten to commit a crime or a tort—for that threat to be duress. Some courts still follow that rule. Other courts today

follow the Restatement position that, to be duress, the threat need not be wrongful or illegal but must be improper—that is, improper to use as leverage to induce a contract. Under some circumstances, threats to institute legal actions can be considered improper threats that will constitute duress. A threat to file either a civil or a criminal suit without a legal basis for doing so would clearly be improper. What of a threat to file a well-founded lawsuit or prosecution? Generally, if there is a good-faith dispute over a matter, a person’s threat to file a lawsuit to resolve that dispute is not considered to be improper. Otherwise, every person who settled a case out of court could later claim duress. However, if the threat to sue is made in bad faith and for a purpose unrelated to the issues in the lawsuit, the threat can be considered improper. In one case, for example, duress was found when a husband who was in the process of divorcing his wife threatened to sue for custody of their children—something he had the right to do—unless the wife transferred to him stock that she owned in his company.9 Victim Had No Reasonable Alternative The person complaining of duress must be able to prove that the coercive nature of the improper threat was such that he had no reasonable alternative but to enter or modify the contract. Classical contract law applied an objective standard of coercion, which required that the degree of coercion Link v. Link, 179 S.E.2d 697 (N.C. 1971).

9

CYBERLAW IN ACTION Pricing Glitches on the Web: Legal, Ethical, and Marketing Issues The accidental advertisement of a mistaken price for a product or service occurs sometimes in bricksand-mortar businesses. But when e-tailers make price glitches, the impact is likely to be far greater because news of extremely low prices travels fast on the web through various bargain hunter websites and online bulletin boards. By the time the company learns of and repairs the error, it may have confirmed hundreds of orders for the product or service. Amazon.com, United Airlines, and Staples.com are a few of the e-commerce leaders that have experienced pricing glitches. In one widely reported incident, for example, United Airlines’s website accidentally listed mistaken fares to Paris and various other cities—$24.98 for a flight from San Francisco to Paris—for five hours on one day. In that time, more than 140 people had booked trips based on the mistaken fares.10 Legally, the doctrine of mistake presents at least a possible avenue for avoidance of contracts that are formed based on a

mistaken price, but this would depend on factors such as the size and obviousness of the discrepancy between the mistaken price and the intended price. Of equal or greater concern to the e-tailer is likely to be the issue of how to maintain good customer relations. Should it sell the product at the advertised price and absorb the loss? Refuse to honor the mistaken deal and perhaps offer the customer something else of value to preserve goodwill? Some commercial websites have a provision in their “Terms and Conditions” link that notifies customers of the possibility of pricing mistakes and purports to protect the company in cases of price glitches. Ethical issues are also present in these situations. Is it ethical for an e-tailer to refuse to honor a contract that is based on a mistaken price? Is it ethical for a customer to insist on a contract that is based on a mistaken price? Frank Hayes, “A Deal’s a Deal: Should Pricing Glitches Be  Honored?,” Computerworld, February 26, 2001, www.itworld.com /Tech/2403/CWSTO58053. 10



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Ethics and Compliance in Action Ashton Development’s general contractor, Britton, hired Rich & Whillock to do grading and excavation on one of Ashton’s construction projects for $112,990. After a month’s work, Rich & Whillock encountered rock on the project site. Ashton and Britton agreed that the rock would have to be blasted and that this would involve extra costs because the original contract between Ashton and Rich & Whillock specified that any rock encountered would be considered an extra. Britton directed Rich & Whillock to go ahead with the blasting and bill for the extra cost. Rich & Whillock did so, submitting separate invoices for the regular contract work and the extra blasting work and receiving payment every two weeks. After completing the work and

exercised had to be sufficient to overcome the will of a person of ordinary courage. The more modern standard for coercion focuses on the alternatives open to the complaining party. For example, Barry, a traveling salesman, takes his car to Cheatum Motors for repair. Barry pays Cheatum the full amount previously agreed upon for the repair, but Cheatum refuses to return Barry’s car to him unless Barry agrees to pay substantially more than the contract price for the repairs. Because of his urgent need for the return of his car, Barry agrees to do this. In this case, Barry technically had the alternative of filing a legal

receiving payments totaling over $190,000, Rich & Whillock submitted a final billing for an additional $72,286.45. This time, Britton refused to pay, stating that he and Ashton had no money left to pay the final billing. In response to Whillock’s statement that Rich & Whillock would “go broke” without this final payment because it was a new business with rented equipment and numerous subcontractors waiting to be paid, Britton stated that he and Ashton would pay $50,000 or nothing, and Rich & Whillock could sue for the full amount if they were not satisfied with this compromise. Ultimately, Rich & Whillock signed a compromise agreement and took the $50,000. What is your legal and ethical analysis of this situation?

action to recover his car. However, this would not be a reasonable alternative for someone who needs the car urgently because the time, expense, and uncertainty involved in pursuing a lawsuit would be considerable. Thus, Barry could avoid his agreement to pay more money under a theory of duress. The following Olmsted case illustrates that the class of threats that can give rise to a valid claim of duress is quite limited and that what might constitute a reasonable alternative is not necessarily what one might consider a “good” alternative.

Olmsted v. Saint Paul Public Schools   830 F.3d 824 (8th Cir. 2016) Timothy Olmsted worked for the Saint Paul Public School District (“District”) from 1995 until his resignation in 2012. During the 2011 school year, families of several students alleged that Olmsted racially discriminated against certain students and acted inappropriately toward students. The District commenced an investigation and, on January 12, 2012, placed Olmsted on paid administrative leave “pending further investigation of allegations of serious misconduct.” Olmsted contacted Margaret Luger-Nikoli (Luger), a union attorney, and asked her to represent him in the investigation and any subsequent proceedings. Thus, Luger corresponded with the District on his behalf, primarily communicating with Jeff Lalla, the District’s attorney. On March 8, 2012, Lalla informed Luger that the District “would propose termination [of Olmsted’s employment] at a school board meeting.” When Luger asked Lalla for the basis for that decision, Lalla reported that the investigation had uncovered “additional issues” and provided some examples from the District’s written investigation report. He did not detail specific charges the District would bring, but he did tell Luger that he had begun drafting formal charges to present to the school board and the Minnesota Board of Teaching. Lalla suggested to Luger that if Olmsted resigned, the District would not issue the report or present the charges. Luger requested that Lalla delay drafting the formal charges until she had the chance to discuss the situation with Olmsted. Luger relayed the information to Olmsted and outlined three possible responses Olmsted could pursue: (1) acquiesce in the termination, (2) negotiate a separation or severance, or (3) go to a hearing. Later, Olmsted testified that he only “vaguely” remembered Luger going through these options with him, but he did remember Luger telling him that he had a statutory right to a hearing if the District

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brought termination charges against him. Olmsted did not feel like he was left with a real choice; instead, he felt like the District had a “gun to [his] head” forcing him to resign. On March 11, 2012, Olmsted e-mailed Luger a draft resignation letter, which requested that the District allow him to exhaust his sick days, leave him with a “clean file,” provide a letter of recommendation, and allow him to continue to teach driver’s education. Luger relayed Olmsted’s terms to Lalla, and the District agreed to permit him to exhaust his accumulated sick days. It would not allow him to continue to teach driver’s education, though. When Luger conveyed the District’s counteroffer to Olmsted, he agreed to go on sick leave and resign in October 2012, when his bank of sick days would run out. Thus, on March 16, 2012, Olmsted submitted his notice of resignation to the District, with an effective date of October 8, 2012. The school board accepted and approved Olmsted’s offer of resignation and never pursued termination charges nor initiated any disciplinary action against him. Three months after submitting his resignation, on June 12, 2012, Olmsted wrote the District purporting to rescind his resignation and requesting to resume his duties as a driver’s education teacher. The District sent him a letter, dated June 18, 2012, declining to accept Olmsted’s withdrawal of his resignation or to grant his request to resume his teaching duties. Olmsted sued the District for, among other things, breach of his employment contract. The District moved for summary judgment, which the district court granted over Olmsted’s claims that his resignation was voidable due to duress. Olmsted appealed.

Smith, Circuit Judge On appeal, Olmsted argues that the district court erred in granting summary judgment on his breach-of-contract claim. Olmsted contends that his resignation was revocable because when he resigned he . . . was under duress. Olmsted asserts that the District threatened to file termination charges against him when it had no intention or grounds to do so. Olmsted further asserts that in light of Minnesota law that requires “[a] school board [to] report to the Board of Teaching . . . when a teacher or administrator is suspended or resigns while an investigation is pending,” the District illegally promised not to report him if he resigned. According to Olmsted, this threat and promise placed him under legal duress and compelled him to resign. As such, Olmsted argues that his resignation is revocable. Under Minnesota law, it is “undisputed that duress is coercion by means of physical force or unlawful threats which destroys the victim’s free will and compels him to comply with some demand of the party exerting the coercion.” Wise v. Midtown Motors, 42 N.W.2d 404, 407 (Minn. 1950). “As a rule, duress will not prevail to invalidate a contract entered into with full knowledge of all the facts, with ample time and opportunity for investigation, consideration, consultation and reflection.” Am. Nat’l. Bank of Lake Crystal v. Helling, 202 N.W. 20, 23 (Minn. 1925). . . .  Olmsted cannot demonstrate that his free will was overcome. No evidence supports the allegation that the District made an unlawful threat. Olmsted claims that the District unlawfully threatened him “[b]y pitting [his] property interest in his job against his property interest in his [teaching] license.” Olmsted avers that the District had no grounds to file termination charges against him, thus it used its investigation only to intimidate. The District initiated an investigation of the claims made against Olmsted.

Olmsted’s resignation obviated the need for the District to seek his termination. The District’s decision not to pursue termination charges against Olmsted after his resignation did not mean it lacked grounds to do so. When Olmsted learned of the District’s proposed intention to file termination charges, he had already been placed on administrative leave “pending further investigation of allegations of serious misconduct,” and he knew the nature of the allegations against him. Olmsted has not pointed to any evidence to support his contention that the District had no grounds to file termination charges against him. Instead, Olmsted posits that the District has a statutory duty to report teachers that are under investigation. Assuming this statutory duty, Olmsted infers that the District had no basis to file any charges against him because it did not report him to the Board of Teaching. But the District presented evidence that it did not make a report every time a teacher was suspended, so the absence of a report neither proves nor disproves the validity of any charges under investigation at time of his resignation. Olmsted has not pointed to any record evidence that would support his claim that the District unlawfully threatened him. Even if Olmsted could demonstrate that the District unlawfully threatened him, the threat was cured. . . . Olmsted had full knowledge of all the facts, advice from an attorney, and ample time for reflection. Olmsted did not know the specific charges, if any, that the District planned to bring against him, but he was aware of the nature of the allegations against him based on his conversations with the District’s investigative team. Olmsted claims that he felt like the District had a gun to his head, but he also “vaguely” remembers Luger informing him of his options. Further, the record demonstrates that throughout the investigation and his separation from the District, Olmsted was



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represented by and received counsel from Luger, a union attorney skilled in the relevant matters. Finally, approximately eight days elapsed between the time that Olmsted first learned of the District’s plan and when Olmsted ultimately, without prompting by the District, submitted his notice of resignation. This period

of time provided Olmsted with ample opportunity to reflect on his options.

Economic Duress Today, the doctrine of duress

Determining Undue Influence All contracts

is often applied in a business context. Economic duress, or business compulsion, are terms commonly used to describe situations in which one person induces the formation or modification of a contract by threatening another person’s economic interests. A common coercive strategy is to threaten to breach the contract unless the other party agrees to modify its terms. For example, Moore, who has contracted to sell goods to Stephens, knows that Stephens needs timely delivery of the goods. Moore threatens to withhold delivery unless Stephens agrees to pay a higher price. Another common situation involving economic duress occurs when one of the parties offers a disproportionately small amount of money in settlement of a debt and refuses to pay more. Such a strategy can exert great economic pressure on a creditor who is in a desperate financial situation to accept the settlement because he cannot afford the time and expense of bringing a lawsuit.

Undue Influence Distinguish undue influence from duress and explain the

LO13-5 circumstances under which undue influence makes a

contract voidable.

Nature of Undue Influence Undue influence

is unfair persuasion. Like duress, undue influence involves wrongful pressure exerted on a person during the bargaining process. In undue influence, however, the pressure is exerted through persuasion rather than through coercion. The doctrine of undue influence was developed to give relief to persons who are unfairly persuaded to enter into a contract while in a position of weakness that makes them particularly vulnerable to being preyed upon by those they trust or fear. A large proportion of undue influence cases arise after the death of the person who has been the subject of undue influence, when her relatives seek to set aside that person’s contracts or wills.

*** Accordingly, we affirm the judgment of the district court.

are based on persuasion. There is no precise dividing line between permissible persuasion and impermissible persuasion. Nevertheless, several hallmarks of undue influence cases can be identified. Undue influence cases normally involve both of the following elements: 1. The relationship between the parties is either one of trust and confidence or one in which the person exercising the persuasion dominates the person being persuaded. 2. The persuasion is unfair.11 Relation between the Parties Undue influence cases involve people who, though they have capacity to enter a contract, are in a position of particular vulnerability in relationship to the other party to the contract. This relationship can be one of trust and confidence, in which the person being influenced justifiably believes that the other party is looking out for his interests, or at least that he would not do anything contrary to his welfare. Examples of such relationships would include parent and child, husband and wife, or lawyer and client. The relationship also can be one in which one of the parties holds dominant psychological power that is not derived from a confidential relationship. For example, Royce, an elderly man, is dependent on his housekeeper, Smith, to care for him. Smith persuades Royce to withdraw most of his life savings from the bank and make an interest-free loan to her. If the persuasion Smith used was unfair, the transaction could be voided because of undue influence. Unfair Persuasion The mere existence of a close or dependent relationship between the parties that results in economic advantage to one of them is not sufficient for undue influence. It must also appear that the weaker person entered into the contract because he was subjected to unfair methods of persuasion. In determining this, a court will look at all of the surrounding facts and circumstances. 11

Restatement (Second) of Contracts § 177.

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Part Three Contracts

Was the person isolated and rushed into the contract, or did he have access to outsiders for advice and time to consider his alternatives? Was the contract discussed and consummated in the usual time and place that would be expected for such a transaction, or was it discussed or consummated at an unusual time or in an unusual place? Was the contract a reasonably fair one that a person might have

entered into voluntarily, or was it so lopsided and unfair that one could infer that he probably would not have “agreed” to it unless he had been unduly influenced by the other party? The answers to these and similar questions help determine whether the line between permissible and impermissible persuasion has been crossed.

CONCEPT REVIEW Wrongful Pressure in the Bargaining Process Nature of Pressure Elements

Duress

Undue Influence

Coercion 1. Contract induced by improper threat 2. Threat leaves party no reasonable alternative but to enter or modify contract

Unfair persuasion of susceptible individual 1. Relationship of trust and confidence  or dominance 2. Unfair persuasion

Problems and Problem Cases 1. Nelson died in 1996 and Newman and Franz were appointed co-personal representatives of her estate. Newman and Franz hired McKenzie-Larson to appraise the estate’s personal property in preparation for an estate sale. McKenzie-Larson told them that she did not appraise fine art, and that if she saw any, they would need to hire an additional appraiser. McKenzieLarson did not report finding any fine art, and relying on her silence and her appraisal, Newman and Franz priced the personal property and held an estate sale. Rice responded to the newspaper advertisement for the sale and attended it. At the sale, Rice bought two oil paintings for $60. Rice had bought and sold some art, but he was no expert. He had never made more than $55 on any single piece, and he had bought many that turned out to be frauds, forgeries, or the work of lesser artists. He assumed that the paintings at the estate sale were not originals, given their price and the fact that the sale was being managed by professionals. Subsequently, Rice learned that the paintings were original works of Martin Johnson Heade. Rice sold the paintings on consignment at Christie’s in New York for $1,072,000. After subtracting the buyer’s premium and the commission, Rice realized $911,780 from the sale. Newman and Franz sued Rice, claiming that the sale contract should be rescinded on the basis of mistake. Will Newman and Franz win?

2. In November 2006, Lopez was working for The G-Man Inc. as a “thrower” on one of its garbage trucks. Lopez was injured when a garbage can fell on his left hand. Lopez was treated for his injuries; spent approximately eight days in the hospital; and, ultimately, had a majority of his left ring finger amputated. Lopez returned to work in February 2007. At about this time, Lopez and The G-Man began a series of negotiations about compensation for Lopez’s injury and the resulting medical treatment. During the period of negotiations, a number of people assisted Lopez with translation and interpretation of the proposed agreement because Lopez could not read or understand English. Following the parties’ first meeting, Lopez was provided with a copy of the proposed agreement for his further review. The parties later reconvened, but parted ways without reaching an agreement. Lopez again took the proposed release agreement with him. Upon the parties’ third meeting, Lopez was assisted by a certified interpreter who translated the agreement for Lopez from English to Spanish and sought to assure that Lopez understood the terms of the agreement. Thereafter, in May 2007, Lopez signed the agreement. Under the terms of the agreement, The G-Man agreed to pay Lopez $5,000 in $100 monthly increments. The parties further agreed to “carve out” of the release Lopez’s past medical expenses and reasonable and necessary future medical expenses. In exchange, Lopez agreed to release The G-Man from all claims, including claims



Chapter Thirteen Reality of Consent

for negligence and gross negligence. The G-Man terminated Lopez’s employment in July 2007. Lopez then sued The G-Man, alleging that it was liable for his previous injury under theories of negligence and negligence per se. The G-Man claimed that Lopez had validly released it from all liability, but Lopez asserted that he signed the release under duress. He claimed that Hawley, the owner of The G-Man, had told him at some time during the three-month period after he returned to work that he would not be permitted to return to work or to go on vacation until he signed the agreement. The interpreter testified that no statement of any kind was made to indicate that Lopez’s job was in jeopardy if he did not sign the agreement. Was the release voidable because of duress? 3. Rodi was recruited to the defendant law school, which had provisional accreditation, by statements indicating that accreditation would be forthcoming. (However, the school’s catalog, which was sent to Rodi, stated that it made no representations about accreditation.) After his first year, the school was still unaccredited and he considered transfer. Accreditation was essential for him to sit for the New Jersey bar. The acting dean of the school learned of Rodi’s intentions and wrote him that there was “no cause for pessimism” about accreditation. In fact, however, the school had strayed farther away from accreditation standards. The school was not accredited by the time Rodi graduated, and he was unable to sit for the New Jersey bar. He sued the acting dean and the law school for fraud. Should his complaint be dismissed? 4. A group of golf caddies for professional golfers on the PGA Tour sued the Tour for violations of their right of publicity, as well as antitrust and trademark violations. Their claim was based on a requirement that caddies wear  “bibs” during golf tournaments sponsored by the Tour. These bibs display the name of the golf tournament; the name of the golfer for whom the caddie works (on the back); and, often, corporate logos. The caddies are not compensated for the publicity they provided or the advertising revenues generated by the logos on the bibs, and because of the bibs they are not able to seek endorsements from companies who might otherwise pay them to wear patches or the like on their shirts. The caddies, however, have been required to wear the bibs for decades by the contracts they all sign with the Tour. Part of the caddies’ suit was on a claim that the contracts were voidable due to duress.  They alleged that the Tour “threatened to and attempted to interfere with [the caddies’] business relationships

13-19

with their respective players and individual sponsors” if they would not agree to wear the bibs. The Tour also allegedly “threatened to or did in fact preclude caddies from working for their golfers [at Tour events] if they refused to” wear the bibs. The caddies assert that, because they “lack viable alternative employment,” they had no choice but to agree to wear the bibs at the Tour’s insistence. Should the caddies be able to avoid the contractual requirement to wear the bibs? 5. In February 2005, Dandey Corporation and Nick’s Hideaway Inc. entered into a 10-year lease of property for use as a restaurant. The property had been operated as a restaurant for decades and had a certificate of occupancy as an existing nonconforming use. Immediately after signing the lease, Nick’s began extensive renovations of the premises, without first seeking a permit for such work. Nick’s later submitted an application for a permit. During the town’s review of that application, it was discovered that, approximately 20 years earlier, Dandey had expanded the original building, in violation of a zoning rule that a nonconforming use may not be enlarged, and that the extensions did not have a certificate of occupancy. Upon discovering that the premises could not be used as intended, Nick’s stopped paying rent. In January 2007, Dandey sued Nick’s for nonpayment of rent. Nick’s seeks rescission of the lease. Will it win? 6. Boskett, a part-time coin dealer, paid $450 for a dime purportedly minted in 1916 and two additional coins of relatively small value. After carefully examining the dime, Beachcomber Coins, a retail coin dealer, bought the coin from Boskett for $500. Beachcomber then received an offer from a third party to purchase the dime for $700, subject to certification of its genuineness from the American Numismatic Society. The organization labeled the coin a counterfeit. Can Beachcomber rescind the contract with Boskett on the ground of mistake? 7. Retailer opened a baseball card store in vacant premises next to an existing store. The card shop was very busy on opening day, so Retailer got a clerk from the adjacent store to help out. The clerk knew nothing about baseball cards. A boy who had a large baseball card collection asked to see an Ernie Banks rookie card, which was in a plastic case with an adhesive dot attached that read “1200.” The boy asked the salesclerk, “Is it really worth $12?” The salesclerk responded, “I guess so,” or “I’m sure it is.” The boy bought the card for $12. In fact, the true price intended by Retailer was $1,200. Can Retailer get the card back from the boy?

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8. Keith contracted to build a house for Radford. Shortly before the closing, he met with Radford, accused her of fraud, and threatened to prevent the deal from closing. During the meeting, Keith’s associate stood outside the door for two hours to prevent her from leaving. He gave her the choice of signing a Note and Deed of Trust promising to pay him more money or of going to court to settle the matter. Radford signed the agreement, but later sought to rescind it. Should she be able to rescind the agreement? 9. In February 2006, Konstantinos Koumboulis shot and killed his wife and himself inside his house in a Pennsylvania community. The murder/suicide was highly publicized in the local media and on the Internet. At a September 2006 auction, Kathleen and Joseph Jacono purchased the property from the Koumboulis estate for $450,000. After completing renovations of the home, the Jaconos listed the property for sale in June 2007. They informed their listing real estate agents about the murder/suicide. They also consulted their attorney, their agents, and representatives of the Pennsylvania Real Estate Commission, asking whether the murder/suicide was a “material defect” requiring disclosure under Pennsylvania’s Real Estate Seller Disclosure Law (RESDL). The persons consulted informed the Jaconos that they did not consider the murder/suicide a material defect for purposes of the RESDL because it would not adversely affect the value of the property. Although the real estate agents did not think that disclosure of the murder/suicide was required by the statute, they suggested that disclosure would be a good idea “just to get it out there” (quoting the deposition of one of the agents). The Jaconos replied that they had investigated the issue and did not wish to disclose the murder/suicide.

   Thereafter, the Jaconos signed a Seller’s Property Disclosure Statement of the sort called for by the RESDL. Their statement contained numerous specific disclosures concerning the property, indicated when the house was last occupied, and showed that the Jaconos had owned the property for seven months. However, the statement did not disclose the murder/ suicide. Later in June 2007, Janet Milliken, who lived in California, viewed the property and received a copy of the disclosure statement. Milliken then entered into a contract to purchase the house from the Jaconos for $610,000. After the closing took place and Milliken moved into the house, she learned of the murder/ suicide from her neighbor. Contending that she would not have gone ahead with the purchase of the house if she had known about the murder/suicide prior to closing, Milliken sued the Jaconos over the nondisclosure. She brought her case on common law misrepresentation and common law fraud grounds (rather than on the theory that the RESDL had been violated). Did the Jaconos have a duty, under common law principles, to disclose the murder/suicide? In not disclosing this information, did they commit either misrepresentation or fraud? 10. Stambovky, a resident of New York City, contracted to buy a house in the Village of Nyack, New York, from Ackley. The house was widely reputed to be possessed by poltergeists, which Ackley and members of her family had reportedly seen and reported to both Reader’s Digest and the local press. In 1989, the house was included in a five-home walking tour of Nyack and described in a newspaper article as a “riverfront Victorian (with ghost).” Ackley did not tell Stambovsky about the poltergeists before he bought the house. When Stambovsky learned of the house’s reputation, however, he promptly sued for rescission. Will he be successful?

C H A P T E R 14

Capacity to Contract

I

n a state in which the age of majority for contracting purposes is 18, 17-year-old Daniel was married, employed, and living with his wife in their own apartment. Daniel and his wife went to Mattox Motors, a used car dealership, and purchased a used car for $500 cash. After driving the car for several months, Daniel was involved in a serious collision and damaged the car. He was one week over the age of 18 at this time. The next day, Daniel sent a letter to Mattox Motors stating that he was disaffirming the sales contract because he was underage at the time he entered the contract and that he wanted his money back. • Does Daniel have the right to get out of his contract? • Does Mattox Motors have to give him his money back? • Would it make a difference if Daniel had used the car to earn a living? • If, instead of being a minor at the time the contract was made, Daniel had been mentally disabled or intoxicated, would he have the right to get out of the contract? • Is it ethical for Daniel to disaffirm the contract after having wrecked the car?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 14-1 Explain the concept of capacity to contract. 14-2 List and describe the categories of persons who lack capacity to contract. 14-3 Describe the effect of lack of capacity to contract.

ONE OF THE MAJOR justifications for enforcing a contract is that the parties voluntarily consented to be bound by it. It follows, then, that a person must have the ability to give consent before he can be legally bound to a contract. This ability to give consent must involve more than the mere physical ability to say yes, shake hands, sign one’s name. Rather, the person’s maturity and mental ability must be such that it is fair to presume that he is capable of representing his own interests effectively. This concept is embodied in the legal term capacity.

14-4 Explain the rights and duties of the parties to a contract when there has been disaffirmance because of lack of capacity.

What Is Capacity? LO14-1 Explain the concept of capacity to contract.

Capacity means the ability to incur legal obligations and acquire legal rights. Today, the primary classes of people who are considered to lack capacity are minors (who, in legal terms, are often seen as infants), persons suffering

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Part Three Contracts

from mental illnesses or defects, and intoxicated persons.1 Contract law gives them the right to avoid (escape the legal consequences of) contracts that they enter during incapacity. This rule provides a means of protecting people who, because of mental impairment, intoxication, or youth and inexperience, are disadvantaged in the normal give-andtake of the bargaining process. LO14-2

List and describe the categories of persons who lack capacity to contract.

Usually, lack of capacity to contract comes up in court in one of two ways. In some cases, it is asserted by a plaintiff as the basis of a lawsuit for the money or other benefits that he gave the other party under their contract. In others, it arises as a defense to the enforcement of a contract when the defendant is the party who lacked capacity. The responsibility for alleging and proving incapacity is placed on the person who bases his claim or defense on his lack of capacity.

Effect of Lack of Capacity LO14-3 Describe the effect of lack of capacity to contract.

Normally, a contract in which one or both parties lack capacity because of infancy, mental impairment, or intoxication is considered to be voidable. People whose capacity is impaired in any of these ways are able to enter a contract and enforce it if they wish, but they also have the right to In times past, married women, convicts, and aliens were also among the classes of persons who lacked capacity to contract. These limitations on capacity have been removed by statute and court rule, however. 1

avoid the contract. There are, however, some individuals whose capacity is so impaired that they do not have the ability to form even a voidable contract. A bargain is considered to be void if, at the time of formation of the bargain, a court had already adjudicated (adjudged or decreed) one or more of the parties to be mentally incompetent or one or more of the parties was so impaired that he could not even manifest assent (e.g., he was comatose or unconscious).

Capacity of Minors Minors’ Right to Disaffirm Courts have long

recognized that minors are in a vulnerable position in their dealings with adults. As a result, minors are considered to lack capacity to contract. You will see the implications of this principle in the following J.T. ex rel. Thode v. Monster Mountain case. Minors have the right to avoid contracts as a means of protecting against their own improvidence and against overreaching by adults. The exercise of this right to avoid a contract is called disaffirmance. The right to disaffirm is personal to the minor. That is, only the minor or a legal representative such as a guardian may disaffirm the contract. No formal act or written statement is required to make a valid disaffirmance. Any words or acts that effectively communicate the minor’s desire to cancel the contract can constitute disaffirmance. If, on the other hand, the minor wishes to enforce the contract instead of disaffirming it, the adult party must perform. You can see that the minor’s right to disaffirm puts any adult contracting with a minor in an undesirable position: She is bound on the contract unless it is to the minor’s advantage to disaffirm it. The right to disaffirm has the effect of discouraging adults from dealing with minors.

J.T. ex rel. Thode v. Monster Mountain, LLC    754 F. Supp. 2d 1323 (M.D. Ala. 2010)

In late January of 2009, J.T.—a minor from Indiana and a competitive motocross rider—traveled to Monster Mountain MX Park in Alabama. Prior to departing, J.T.’s parents signed a notarized authorization for James Thompson (J.T.’s coach) to act as their son’s legal guardian for the purpose of signing all release of liability and registration forms. To ride at Monster Mountain, all riders are required to pay an entry fee and execute a “Release and Waiver of Liability and Indemnity Agreement” (the “Release”) that reads: IN CONSIDERATION of being permitted to enter . . . EACH OF THE UNDERSIGNED, for himself, his personal representatives, heirs, and next of kin, acknowledges, agrees, and represents that he has or will immediately upon entering . . . [inspect the premises] . . . [and] HEREBY RELEASES, WAIVES, DISCHARGES, AND COVENANTS NOT TO SUE the . . . track operator [or] track owner . . . from all liability to the undersigned, his personal representatives, assigns, heirs, and next of kin for any and all loss or damage . . . whether caused by the negligence of the releasees or otherwise while the undersigned is



Chapter Fourteen Capacity to Contract

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in or upon the restricted area . . . [and] HEREBY AGREES TO INDEMNIFY AND SAVE AND HOLD HARMLESS the releasees and each of them from any loss, liability, damage, or cost they may incur due to the presence of the undersigned in or upon the restricted area . . . [and] HEREBY ASSUMES FULL RESPONSIBILITY FOR AND RISK OF BODILY INJURY, DEATH OR PROPERTY DAMAGE due to the negligence of releasees or otherwise. . . . THE UNDERSIGNED HAS READ AND VOLUNTARILY SIGNS THE RELEASE AND WAIVER . . . and further agrees that no oral representations, statements or inducements apart from the foregoing written agreement have been made. Each day that J.T. rode the track at Monster Mountain, J.T. and Thompson signed the Release on J.T.’s behalf and paid J.T.’s entry fee. During his first three days of riding, J.T. rode without incident, but on the morning of February 1, 2009, J.T. rode over a blind jump, became airborne, and crashed into a tractor on the track that he did not see until he was airborne. J.T. sued Monster Mountain alleging negligence, premises liability, and wantonness for its failure to remove the tractor from the track. Monster Mountain moved for summary judgment on the basis that the Release barred J.T.’s claim. Albritton, Senior District Judge  The issue before the court is whether J.T.’s negligence claims against the Monster Mountain Defendants are barred by the Release. The Monster Mountain Defendants contend that they are entitled to summary judgment because J.T. signed the Release and Thompson “signed [the Release] on [J.T.’s] behalf,” thus binding J.T. to a contract that exculpates the Monster Mountain Defendants from liability for J.T.’s injuries. J.T. responds that, under Alabama law, a contract made with a minor is voidable. [Case citation omitted] J.T. argues that because the Release is effectively a contract with a minor, whether signed on his behalf or not, the Release is not binding on him. The Monster Mountain Defendants concede that J.T.’s signature on the contract cannot make it binding, due to the rule that a contract with a minor is voidable. However, they attempt to overcome J.T.’s argument by asserting that Thompson, an adult who was acting on behalf of J.T.’s parents, signed the Release on J.T.’s behalf. Thus, the Monster Mountain Defendants contend that if a child’s parents, acting through an agent, sign an exculpatory contract on their child’s behalf, the contract is binding on the child and not voidable. As the following discussion indicates, the court agrees with J.T., and therefore, summary judgment is due to be denied. A. Alabama Law The parties agree that Alabama law applies in this case. They also agree that Alabama courts have not addressed the specific factual situation presented by this case. However, Alabama courts have dealt with three relevant legal principles. First, Alabama, like virtually all jurisdictions, applies the longstanding common law rule that, except for a contract for necessaries, “a minor is not liable on any contract he makes and that he may disaffirm the same.” [Case citation omitted] This rule exists to protect minors from being taken advantage of by others due to minors’ “improvidence and incapacity.” [Case citation omitted] This rule is firmly entrenched in the common law and has existed at least since the year 1292. [Citation omitted]

Second, while Alabama courts have noted an exception to this rule, that exception is narrow. [Discussion of the narrow exception in Alabama pertaining to medical insurance and public policy considerations] Third, Alabama courts have restricted the right of a parent or guardian to release a minor’s post-injury claims. [Case citation omitted] Specifically, a parent or guardian cannot bind a minor to a settlement that releases the minor’s post-injury claims without express court approval. The rationale behind the need for express court approval, similar to the voidable contract rule for minors, is to protect the minor’s “best interest[s].” The teaching of these cases is that, in Alabama, the default rule is that contracts with minors are voidable. . . . B. Law from Other Jurisdictions Because no Alabama case or statute directly addresses the issue of the case at bar, the court turns to the law of other jurisdictions for persuasive guidance. There are three important conclusions to be drawn from the law of other jurisdictions. First, the majority rule in the United States is that parents may not bind their children to pre-injury liability waivers by signing the waivers on their children’s behalf. See, e.g., Galloway v. Iowa, 790 N.W.2d 252, 256 (Iowa 2010) (listing cases and stating that “the majority of state courts who have examined the issue . . . have concluded public policy precludes enforcement of a parent’s preinjury waiver of her child’s cause of action for injuries caused by negligence”); Kirton v. Fields, 997 So. 2d 349, 356 (Fla. 2008) (listing cases, and stating that “[i]n holding that preinjury releases executed by parents on behalf of minor children are unenforceable for participation in commercial activities, we are in agreement with the majority of other jurisdictions.”). Second, many courts rejecting parents’ right to bind children to pre-injury releases have relied on legal principles recognized by Alabama, as discussed above. For example, courts have relied in part on the principle that parents may not bind a child to a settlement releasing post-injury claims without court approval. Galloway, 790 N.W.2d at 257 (“As the Washington Supreme Court has noted, if a parent lacks authority without court

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Part Three Contracts

approval to compromise and settle her minor child’s personal injury claim after an injury has occurred, ‘it makes little, if any, sense to conclude a parent has the authority to release a child’s cause of action prior to an injury.’ ”) [Additional case citations omitted] Courts have also relied on the policy, also recognized in Alabama, of the state’s role of protecting minors from harm. [Case citations omitted] Third, the only published decisions from other jurisdictions that have bound children to pre-injury releases executed by a parent or guardian on the child’s behalf have done so in the context of a “minor’s participation in school-run or community-sponsored activities.” [Case citations omitted] By contrast, this court is not aware of a single case, that has not been overturned, that has held these clauses to be binding in the context of a for-profit activity. C. Application to the Case at Bar The court concludes, based on the law of Alabama as well as persuasive authority from other jurisdictions, that the Release signed by Thompson on J.T.’s behalf is not binding on J.T. Children tend to be vulnerable in such situations, however, in ways adults are not. The parent who reads, understands, and executes a waiver of liability for her child is not the person who will participate in the activity. First, J.T. is a minor, so the applicable default rule under Alabama law is that any contract made with J.T. is voidable. Second, there is no exception under current Alabama law that requires that this court apply a different rule under the facts of this case. . . .

Third, under Alabama law, a parent may not bind a child to a settlement releasing the child’s post-injury claims without express court approval. This court agrees with the rationale of other jurisdictions that it would be completely illogical if, despite this rule, a parent could bind a child, before any injury occurs, to an exculpatory clause releasing parties from any liability for injuries which might be caused in the future, simply by signing a contract on the child’s behalf. Fourth, the weight of authority in other jurisdictions suggests that the release in this case is not binding. The majority rule in jurisdictions throughout the United States is that a parent may not bind a child to a liability waiver. Moreover, and more significantly, no published decision that has not been overturned holds that a parent may bind a child to a liability waiver in favor of a for-profit entity, such as the Monster Mountain Defendants in this case. The few cases that have upheld a pre-injury waiver have made a point of emphasizing that the policy reasons for doing so are based on the fact of the defendant being a non-profit sponsor of the activity involved, such as with school extra-curriculars. Based on all of the above considerations, the court concludes that, under Alabama law, a parent may not bind a child to a preinjury liability waiver in favor of a for-profit activity sponsor by signing the liability waiver on the child’s behalf. Accordingly, the Release Thompson signed on J.T.’s behalf, based on authority given by J.T.’s parents, does not bar J.T. from asserting a negligence claim against the Monster Mountain Defendants. Summary judgment on this issue in favor of the Monster Mountain Defendants, therefore, is due to be DENIED.

Ethics and Compliance in Action Joseph Dodson, age 16, bought a 1984 Chevrolet truck from Burns and Mary Shrader, owners of Shrader’s Auto Sales, for $4,900 cash. At the time, Burns Shrader, believing Dodson to be 18 or 19, did not ask Dodson’s age and Dodson did not volunteer it. Dodson drove the truck for about eight months, when he learned from an auto mechanic that there was a burned valve in the engine. Dodson did not have the money for the repairs, so he continued to drive the truck without repair for another month until the engine “blew up” and stopped operating. He parked the car in the front yard of his parents’ house. He then contacted the Shraders, rescinding the purchase of the truck and requesting a full refund. The Shraders refused to accept the truck or to give Dodson a refund. Dodson then filed an action seeking

to rescind the contract and recover the amount paid for the truck. Before the court could hear the case, a hit-and-run driver struck Dodson’s parked truck, damaging its left front fender. At the time of the circuit court trial, the truck was worth only $500. The Shraders argued that Dodson should be responsible for paying the difference between the present value of the truck and the $4,900 purchase price. The trial court found in Dodson’s favor, ordering the Shraders to refund the $4,900 purchase price upon delivery of the truck.

• What ethical issues are raised in this case? • What is your ethical analysis of Dodson’s conduct, Shrader’s conduct, and the trial court’s decision?

• If you were the parent of a child in Dodson’s situation, how would you advise him or her and why?



Chapter Fourteen Capacity to Contract

Exceptions to the Minor’s Right to Disaffirm Not every contract involving a minor is voidable, however. State law often creates statutory exceptions to the minor’s right to disaffirm. These statutes prevent minors from disaffirming such transactions as marriage, agreements to support their children, educational loans, life and medical insurance contracts, contracts for transportation by common carriers, and certain types of contracts approved by a court (such as contracts to employ a child actor).

Period of Minority At

common law, the age of majority was 21. However, the ratification in 1971 of the Twenty-Sixth Amendment to the Constitution giving 18-year-olds the right to vote stimulated a trend toward reducing the age of majority. The age of majority has been lowered by 49 states. In almost all of these states, the age of majority for contracting purposes is now 18.

Emancipation Emancipation

is the termination of a parent’s right to control a child and receive services and wages from him. There are no formal requirements for emancipation. It can occur by the parent’s express or implied consent or by the occurrence of some events such as the marriage of the child. In most states, the mere fact that a minor is emancipated does not give him capacity to contract. A person younger than the legal age of majority is generally held to lack capacity to enter a contract, even if he is married and employed full time.

Time of Disaffirmance Contracts entered during

minority that affect title to real estate cannot be disaffirmed until majority. This rule is apparently based on the special importance of real estate and on the need to protect a minor from improvidently disaffirming a transaction (such as a mortgage or conveyance) involving real estate. All other contracts entered during minority may be disaffirmed as soon as the contract is formed. The minor’s power to avoid her contracts does not end on the day she reaches the age of majority. It continues for a period of time after she reaches majority. How long after reaching majority does a person retain the right to disaffirm the contracts she made while a minor? A few states have statutes that prescribe a definite time limit on the power of avoidance. In Oklahoma, for example, a person who wishes to disaffirm a contract must do so within one year after reaching majority.2 In most Okla. Stat. Ann. tit. 15, § 18 (1983).

2

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states, however, there is no set limit on the time during which a person may disaffirm after reaching majority. In determining whether a person has the right to disaffirm, a major factor that courts consider is whether the adult has rendered performance under the contract or relied on the contract. If the adult has relied on the contract or has given something of value to the minor, the minor must disaffirm within a reasonable time after reaching majority. If she delays longer than a period of time that is considered to be reasonable under the circumstances, she will run the risk of ratifying (affirming) the contract. (The concept and consequences of ratification are discussed in the next section.) If the adult has neither performed nor relied on the contract, however, the former minor is likely to be accorded a longer period of time in which to disaffirm, sometimes even years after she has reached majority.

Ratification Though

a person has the right to disaffirm contracts made during minority, this right can be given up after the person reaches the age of majority. When a person who has reached majority indicates that he intends to be bound by a contract that he made while still a minor, he surrenders his right to disaffirm. This act of affirming the contract and surrendering the right to avoid the contract is known as ratification. Ratification makes a contract valid from its inception. Because ratification represents the former minor’s election to be bound by the contract, he cannot later disaffirm. Ratification can be done effectively only after the minor reaches majority. Otherwise, it would be as voidable as the initial contract. There are no formal requirements for ratification. Any of the former minor’s words or acts after reaching majority that indicate with reasonable clarity his intent to be bound by the contract are sufficient. Ratification can be expressed in an oral or written statement, or, as is more often the case, it can be implied by conduct on the part of the former minor. Naturally, ratification is clearest when the former minor has made some express statement of his intent to be bound. Predicting whether a court will determine that a contract has been ratified is a bit more difficult when the only evidence of the alleged ratification is the conduct of the minor. A former minor’s acceptance or retention of benefits given by the other party for an unreasonable time after he has reached majority can constitute implied ratification. Also, a former minor’s continued performance of his part of the contract after reaching majority has been held to imply his intent to ratify the contract.

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Part Three Contracts

Duties upon Disaffirmance Explain the rights and duties of the parties to a contract

LO14-4 when there has been disaffirmance because of lack of

capacity.

Duty to Return Consideration If neither party has performed her part of the contract, the parties’ relationship will simply be canceled by the disaffirmance. Because neither party has given anything to the other party, no further adjustments are necessary. But what about the situation where, as is often the case, the minor has paid money to the adult and the adult has given property to the minor? Upon disaffirmance, each party has the duty to return to the other any consideration that the other has given. This means that the minor must return any consideration given to her by the adult that remains in her possession. However, if the minor is unable to return the consideration, most states will still permit her to disaffirm the contract. The duty to return consideration also means that the minor has the right to recover any consideration she has given to the adult party. She even has the right to recover some property that has been transferred to third parties. One exception to the minor’s right to recover property from third parties is found in section 2-403 of the Uniform Commercial Code, however. Under this section, a minor cannot recover goods that have been transferred to a goodfaith purchaser. For example, Simpson, a minor, sells a used Ford to Mort’s Car Lot. Mort’s then sells the car to Vane, a good-faith purchaser. If Simpson disaffirmed the contract with Mort’s, he would not have the right to recover the Ford from Vane. Must the Disaffirming Minor Make Restitution? A Split of Authority If the consideration given by the adult party has been lost, damaged, or destroyed, or simply has depreciated in value, is the minor required to make restitution to the adult for the loss? The traditional rule is that the minor who cannot fully return the consideration that was given to her is not obligated to pay the adult for the benefits she has received or to compensate the adult for loss or depreciation of the consideration. Some states still follow this traditional rule. (As you will read in the next section, however, a minor’s misrepresentation of age can, even in some of these states, make her responsible for reimbursing the other party upon disaffirmance.) The rule that restitution is not required is designed to protect minors by discouraging adults from dealing with them. After all, if an adult knew that he might be able to demand

the return of anything that he transferred to a minor, he would have little incentive to refrain from entering into contracts with minors. The traditional rule, however, can work harsh results for innocent adults who have dealt fairly with minors. It strikes many people as unprincipled that a doctrine intended to protect against unfair exploitation of one class of people can be used to unfairly exploit another class of people. As courts sometimes say, the minor’s right to disaffirm was designed to be used as a “shield rather than as a sword.” For these reasons, a growing number of states have rejected the traditional rule. The courts and legislatures of these states have adopted rules that require minors who disaffirm their contracts and seek refunds of purchase price to reimburse adults for the use or depreciation of their property. Minors’ Obligation to Pay Reasonable Value of Necessaries Though the law regarding minors’ contracts is designed to discourage adults from dealing with (and possibly taking advantage of) minors, it would be undesirable for the law to discourage adults from selling minors the items that they need for basic survival. For this reason, disaffirming minors are required to pay the reasonable value of items that have been furnished to them that are classified as necessaries. A necessary is something that is essential for the minor’s continued existence and general welfare that has not been provided by the minor’s parents or guardian. Examples of necessaries include food, clothing, shelter, medical care, tools of the minor’s trade, and basic educational or vocational training. A minor’s liability for necessaries supplied to him is quasi-contractual. That is, the minor is liable for the reasonable value of the necessaries that she actually receives. She is not liable for the entire price agreed on if that price exceeds the actual value of the necessaries, and she is not liable for necessaries that she contracted for but did not receive. For example, Joy Jones, a minor, signs a oneyear lease for an apartment in Mountain Park at a rent of $300  per month. After living in the apartment for three months, Joy breaks her lease and moves out. Because she is a minor, Joy has the right to disaffirm the lease. If shelter is a necessary in this case, however, she must pay the reasonable value of what she has actually received—three months’ rent. If she can establish that the actual value of what she has received is less than $300 per month, she will be bound to pay only that lesser amount. Furthermore, she will not be obligated to pay for the remaining nine months’ rent because she has not received any benefits from the remainder of the lease. Whether a given item is considered a necessary depends on the facts of a particular case. The minor’s age, station



Chapter Fourteen Capacity to Contract

in life, and personal circumstances are all relevant to this issue. An item sold to a minor is not considered a necessary if the minor’s parent or guardian has already supplied him with similar items. For this reason, the range of items that will be considered necessaries is broader for

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married minors and other emancipated minors than it is for unemancipated minors. The following Zelnick case involves a situation in which the court is challenged to determine whether a minor has been provided with a necessary.

Zelnick v. Adams   606 S.E.2d 843 (Va. 2005) The trust beneficiary filed a bill of complaint against his attorney for a declaration that the contract for legal services, entered into when beneficiary was a minor, was void. The Circuit Court, Prince William County, Thomas A. Fortkort, J., granted summary judgment voiding the contract, but the court awarded quantum meruit damages to the attorney. Both parties appealed. Agee, Justice “A contract with an infant is not void, only voidable by the infant upon attaining the age of majority.” [Zelnick v. Adams, 263 Va. 601,] at 608, 561 S.E.2d [711,] at 715 [(2002)]. When a plea of infancy is timely raised, as in this case, the trial court makes a mixed inquiry of law and fact to ascertain whether the defense applies to the case at hand. As we described in Zelnick I, the initial inquiry of the trial court is a matter of law: “whether the ‘things supplied’ to the infant under a contract may fall within the general class of necessaries.” Id. If this first query is answered in the affirmative, then the trial court proceeds to a second inquiry on a matter of fact: “whether there is sufficient evidence to allow the finder of fact to determine whether the things supplied were in fact necessary in the instant case.” Id. Should this second inquiry also be answered in the affirmative, then the trial court must resolve a third query, also one of fact, which is “whether the ‘things supplied’ were actually necessary to the ‘position and condition’ of the infant”? Id. Should all three inquiries be answered in the affirmative, then the plea of infancy is defeated and the infant is bound “under an implied contract to pay what the goods or services furnished were reasonably worth.” Id. In Zelnick I, the trial court erroneously answered the first inquiry in the negative because “a contract for legal services is within the ‘general classes of necessaries’ that may defeat a plea of infancy.” Id. at 611, 561 S.E.2d at 717. Although our decision definitively answered the first inquiry as a matter of law, the prior record was without evidence upon which the trial court could answer the remaining questions of fact. See Id. at 612, 561 S.E.2d at 717–18. We, therefore, remanded the case for the taking of such evidence as necessary to answer those questions. Id., 561 S.E.2d at 718. Upon remand, Jonathan Ray Adams (Jonathan) contended the legal services provided for him by Robert J. Zelnick (Zelnick), under the contract executed for Jonathan by his mother, Mildred A. Adams (Adams) were not “in fact necessary.” Alternatively, even if Zelnick’s legal services were necessary, Jonathan argued they were not “actually necessary to the ‘position and condition of the infant’ ” at the time rendered.

Jonathan introduced evidence that he was living a comfortable lifestyle in a middle class home and was not “necessitous.” He further argued that the suit filed by Zelnick was not necessary because his status as issue for purposes of distributions from the trusts of Jonathan’s grandfather, Cecil D. Hylton, Sr. (Mr. Hylton) was settled by a Florida court’s paternity order establishing Cecil D. Hylton, Jr. (Sonny) as his biological father. In addition, Jonathan contended no legal action was necessary during his minority because distributions under the trusts would not be made until 2014 and 2021, long after he was an adult. Accordingly, Jonathan averred no prejudice could have occurred to him had Zelnick waited until Jonathan was 18 and obtained his consent before proceeding with legal action against the trusts. Further, Jonathan testified the legal proceedings prosecuted by Zelnick had harmed Jonathan because it exacerbated tensions between Adams and Sonny thus adversely affecting him. In response, Zelnick contended the Florida court’s paternity order was not determinative of Jonathan’s status under the trusts. Moreover, Zelnick directed the trial court’s attention to the fact that Mr. Hylton’s will placed the decision as to Jonathan’s status as issue for purposes of trust distributions within the purview of the trustees. Adams also communicated to Zelnick that she feared payments were being made to some of Mr. Hylton’s grandchildren through the trusts. The trial court found that Zelnick’s legal services were “in fact necessary” because Jonathan’s status as issue of Mr. Hylton for purposes of trust distributions would not have been resolved without legal proceedings to compel a resolution. Our inquiry, therefore, goes only to the final question of whether Zelnick’s legal services were “actually necessary” to Jonathan’s “position and condition.” As we indicated in Zelnick I, the answer to this inquiry “must be determined by consideration of the circumstances at the time of rendering the services or providing the things in issue.” Zelnick I, 263 Va. at 611, 561 S.E.2d at 717. The record amply supports the trial court’s determination. Zelnick filed suit on Jonathan’s behalf on May 15, 1997, when

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Part Three Contracts

Jonathan was less than a year from attaining status as an adult. The consent decree establishing Jonathan as Mr. Hylton’s grandchild and issue was entered on January 23, 1998, less than three months before Jonathan’s eighteenth birthday. Before Zelnick executed the retainer agreement, he obtained a copy of Mr. Hylton’s probated will and reviewed the trust accountings. Zelnick knew that the distribution dates for the grandchildren’s trusts would be in 2014 and 2021. Zelnick testified that he “read the will over many times” in order to “make sure [he] had a full understanding of the terms and conditions and how the will would work.” Even though any interest Jonathan might have had in the trusts would not be realized for at least 17 years, Zelnick began writing to the trustees, asking them to acknowledge Jonathan as Mr. Hylton’s grandson and issue for the purposes of trust distributions. However, trustees’ counsel did confirm by letter of December 13, 1996, that the triggering events for any distributions from Mr. Hylton’s trust were “many years in the future.” Trustees’ counsel also informed Zelnick that the trustees had been advised to “carefully evaluate the merits of [Jonathan’s] claim” “as soon as any amount is to be paid to Mr. Hylton’s grandchildren. . . .” Trustees’ counsel also confirmed distributions of the trusts would be made in 2014 and 2021 respectively. On February 19, 1997, trustees’ counsel

again replied to Zelnick indicating that the trust was “still in the process of conducting a due diligence analysis of [Jonathan’s] claim.” Nonetheless, Zelnick filed suit on Jonathan’s behalf on May 15, 1997, 11 months before Jonathan became an adult. “By consideration of the circumstances at the time of rendering the services,” Zelnick I, 263 Va. at 611, 561 S.E.2d at 717, we agree with the trial court’s judgment that delaying the suit until Jonathan became 18 “would not have compromised Jonathan’s position.” The record does not reflect any advantage to the legal proceedings before Jonathan turned 18 or that he would have been disadvantaged by waiting. Zelnick’s legal action on Jonathan’s behalf was not a necessity to his “position and condition” at the time this service was rendered. The trial court thus did not err in so finding because its decision is supported by the record. We find sufficient support in the record for the trial court’s judgment that Zelnick’s legal services were not necessary for Jonathan’s position and condition under all the circumstances. The trial court was thus correct in sustaining Jonathan’s plea of infancy and denying any fee award to Zelnick. We will accordingly affirm the judgment of the trial court.

Effect of Misrepresentation of Age It

courts—at least in those cases in which the adult has dealt with the minor fairly and in good faith—because it creates severe hardship for innocent adults who have relied on minors’ misrepresentations of age. State law today is fairly evenly divided among those states that take the position that the minor who misrepresents his age will be estopped (prevented) from asserting his infancy as a defense and those states that will allow a minor to disaffirm regardless of his misrepresentation of age. Among the states that allow disaffirmance despite the minor’s misrepresentation, most hold the disaffirming minor responsible for the losses suffered by the adult, either by allowing the adult to counterclaim against the minor for the tort of deceit or by requiring the minor to reimburse the adult for use or depreciation of his property.

is not unheard of for a minor to occasionally pretend to be older than he is. The normal rules dealing with the minor’s right to disaffirm and his duties upon disaffirmance can be affected by a minor’s misrepresentation of his age.3 Suppose, for example, that Jones, age 17, wants to lease a car from Acme Auto Rentals but knows that Acme rents only to people who are at least 18. Jones induces Acme to lease a car to him by showing a false identification that represents his age to be 18. Acme relies on the misrepresentation. Jones wrecks the car, attempts to disaffirm the contract, and asks for the return of his money. What is the effect of Jones’s misrepresentation? State law is not uniform on this point. The traditional rule was that a minor’s misrepresentation about his age did not affect his right to disaffirm and did not create any obligation to reimburse the adult for damages or pay for benefits received. The theory behind this rule is that one who lacks capacity cannot acquire it merely by claiming to be of legal age. As you can imagine, this traditional approach does not “sit well” with modern You might want to refer back to Chapter 13 to review the elements of misrepresentation. 3

Affirmed.

Capacity of Mentally Impaired Persons Theory of Incapacity Like

minors, people who suffer from a mental illness or defect are at a disadvantage in their ability to protect their own interests in the bargaining process. Contract law makes their contracts either void



Chapter Fourteen Capacity to Contract

or voidable to protect them from the results of their own impaired perceptions and judgment and also from others who might take advantage of them.

Test for Mental Incapacity Incapacity

on grounds of mental illness or defect, which is often referred to in cases and texts as “insanity,” encompasses a broad range of causes of impaired mental functioning, such as mental illness, brain damage, mental retardation, or senility. The mere fact that a person suffers from some mental illness or defect does not necessarily mean that she lacks capacity to contract, however. She could still have full capacity unless the defect or illness affects the particular transaction in question. The usual test for mental incapacity is a cognitive one; that is, courts ask whether the person had sufficient mental capacity to understand the nature and effect of the contract. Some courts have criticized the traditional test as unscientific because it does not take into account the fact that a person suffering from a mental illness or defect might be unable to control her conduct. Section 15 of the Restatement (Second) of Contracts provides that a person’s contracts are voidable if she is unable to act in a reasonable manner in relation to the transaction and the other party has reason to know of her condition. Where the other party has reason to know of the condition of the mentally impaired person, the Restatement (Second) standard would provide protection to people who understood the transaction but, because of some mental defect or illness, were

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unable to exercise appropriate judgment or to control their conduct effectively.

The Effect of Incapacity Caused by Mental Impairment The contracts of people who are suf-

fering from a mental defect at the time of contracting are usually considered to be voidable. In some situations, however, severe mental or physical impairment may prevent a person from even being able to manifest consent. In such a case, no contract could be formed. As mentioned at the beginning of this chapter, contract law makes a distinction between a contract involving a person who has been adjudicated (judged by a court) incompetent at the time the contract was made and a contract involving a person who was suffering from some mental impairment at the time the contract was entered but whose incompetency was not established until after the contract was formed. If a person is under guardianship at the time the contract is formed—that is, if a court has found a person mentally incompetent after holding a hearing on his mental competency and has appointed a guardian for him—the contract is considered void. You will see an example of this in the following Rogers case. On the other hand, if after a contract has been formed, a court finds that the person who manifested consent lacked capacity on grounds of mental illness or defect, the contract is usually considered voidable at the election of the party who lacked capacity (or her guardian or personal representative).

Rogers v. Household Life Insurance Co.    2011 Idaho LEXIS 53 (Idaho Mar. 18, 2011)

Alan Rogers was diagnosed with Alzheimer’s and dementia in 2003. Soon after, Alan’s son, Jason, sought an adjudication that Alan was incapacitated. An order to that effect was entered in 2004. The letters appointing Jason as guardian and conservator for his father did not place any limitations on Jason’s powers. On May 15, 2007, Jason helped his father complete and submit an online application for life insurance offered by Household Life Insurance Company (HLIC). The application requested information regarding Alan’s health but did not specifically inquire as to whether Alan suffered from Alzheimer’s or dementia. The completed application did not reveal that Alan had been adjudicated to be incapacitated, nor did it reveal that Jason had been appointed as his father’s guardian and conservator. That day, HLIC approved the application, the initial $447.20 premium was paid, and Alan Rogers’s term life insurance policy with a face value of $250,000 took effect. Jason was the sole beneficiary of the policy. Alan passed away on June 7, 2007. His death certificate lists the sole cause of his death as “dementia of the Alzheimer’s type.” Jason submitted a notice of claim to HLIC, seeking the $250,000 policy proceeds. HLIC conducted a medical-history verification, a routine procedure for claims arising within two years of a policy’s inception. Several months later, HLIC informed Jason that, because Alan had been adjudicated mentally incompetent prior to the May 15, 2007, application and effective date, the policy was void from its inception. Jason brought suit against HLIC, alleging breach of contract and bad faith. HLIC moved for summary judgment on the grounds that Alan Rogers was adjudicated mentally incapacitated prior to entering into the insurance contract and therefore the contract was

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Part Three Contracts

void. Jason took the position that the contract was merely voidable at the election of the incompetent’s guardian, and that a guardian may ratify such a contract. The district court granted HLIC’s motion for summary judgment and dismissed Jason’s complaint. Jason appealed. Horton, Justice Idaho Code § 32-108 provides as follows: After his incapacity has been judicially determined, a person of unsound mind can make no conveyance or other contract, nor delegate any power or waive any right until his restoration to capacity. . . . Jason asserts that the statute’s language that one adjudicated to be incapacitated “can make no conveyance or other contract” means that although such a person should not contract, if he or she does, the contract is merely voidable. HLIC responds that under the statute’s plain language, the contracts of one who is adjudicated incompetent are void because the individual lacks all capacity to contract. The language of I.C. § 32-108 does not, upon preliminary consideration, support Jason’s position. Effectively, Jason argues that the statutory language that a person adjudicated to be incapacitated “can make no . . . contract” means that such a person may enter into a contract, while simultaneously retaining the ability to avoid the obligations imposed by the agreement. Nevertheless, when considering Jason’s claim that the insurance contract in this case was merely voidable, rather than void ab initio, we consider the statutory framework relating to persons who suffer from impaired capacity and their ability to make decisions regarding the conduct of their lives. Idaho Code §§ 32-106 through 32-108 address the enforceability of contracts involving persons of unsound mind. If a person is “entirely without understanding,” he “has no power to make a contract of any kind, but he is liable for the reasonable value of things furnished to him necessary for his support or the support of his family.” I.C. § 32-106. A contract involving a party who is “not entirely without understanding” and has not been adjudicated to be incapacitated “is subject to rescission.” I.C. § 32-107.

The Right to Disaffirm If a contract is found to be voidable on the ground of mental impairment, the person who lacked capacity at the time the contract was made has the right to disaffirm the contract. A person formerly incapacitated by mental impairment can ratify a contract if he regains his capacity. Thus, if he regains capacity, he must disaffirm the contract unequivocally within a reasonable time, or he will be deemed to have ratified it. As is true of a disaffirming minor, a person disaffirming on the ground of mental impairment must return any consideration given by the other party that remains in his

In other words, prior to a judicial determination of incapacity, such contracts are voidable. However, after a judicial determination of incapacity, “a person of unsound mind can make no conveyance or other contract, nor delegate any power or waive any right until his restoration to capacity.” Comparing I.C. § 32-107 and I.C. § 32-108, it is evident that the legislature intended that contracts involving persons not adjudicated to be incapacitated are to be voidable and to declare that a person adjudicated to be incompetent is without the legal capacity to contract until that person has been “restored to reason.” Guardianship proceedings fall directly within the scope of those the legislature intended to be conclusive judicial determinations of incapacity. In a guardianship proceeding, the trial court assesses whether an individual’s acts and statements during the twelve preceding months strongly indicate the inability to maintain his or her self or property. If the individual has some ability to care for himself or herself, the court may craft a guardianship that corresponds with his or her capacity. This “limited guardianship” is accomplished by noting limitations within the letters of guardianship. A finding that one is incapacitated and a grant of unrestricted guardianship powers represents [sic] a finding that the ward lacks all capacity to make decisions and take actions that protect his or her well-being. Thus, we conclude that the appointment of a guardian with full powers represents a finding that the ward lacks the capacity to contract as a matter of law. According to the plain language of Idaho Code § 32-108, an adjudication that one is incapacitated is a determination that one lacks the capacity to contract as a matter of law. Thus, agreements entered into by such a person do not give rise to enforceable contracts.

Affirmed in favor of HLIC.

possession. A person under this type of mental incapacity is liable for the reasonable value of necessaries in the same manner as are minors. Must the incapacitated party reimburse the other party for loss, damage, or depreciation of non-necessaries given to him? Generally, this depends on whether the contract was basically fair and on whether the other party had reason to be aware of his impairment. If the contract is fair and was bargained for in good faith, and the other party had no reasonable cause to know of the incapacity, the contract cannot be disaffirmed unless the other party is placed in status quo (the position she



Chapter Fourteen Capacity to Contract

was in before the creation of the contract). However, if the other party had reason to know of the incapacity, the incapacitated party is allowed to disaffirm without placing the other party in status quo. This distinction discourages people from attempting to take advantage of mentally impaired people, but it spares those who are dealing in good faith and have no such intent.

Contracts of Intoxicated Persons Intoxication and Capacity Intoxication (either

from alcohol or the use of drugs) can deprive a person of capacity to contract. The mere fact that a party to a contract had been drinking when the contract was formed would not normally affect his or her capacity to contract, however. Intoxication is a ground for lack of capacity only when it is so extreme that the person is unable to understand the nature of the business at hand. Section 16 of the

Problems and Problem Cases 1. Williams was 18 years old when she was admitted to Baptist Health Systems for treatment of serious health conditions. The age of majority for contracting in Williams’s state was 19. Williams was hospitalized for two days, during which she had a variety of medical procedures and tests. At this time, Williams had been admitted to college and was awaiting enrollment, did not work, had no source of income, and was dependent on her mother to provide support. According to her, she believed that she was covered by her mother’s health insurance, and that is what she told the hospital, but in fact, she was not covered. Williams’s mother was listed in the hospital records as “guarantor.” The hospital bill was $12,144. Williams’s mother did not pay the bill. The hospital sued both Williams and her mother for the principal amount plus interest. Was Williams legally obligated to pay the bill, despite the fact that she was a minor when the contract was formed? 2. Robertson, while a minor, contracted to borrow money from his father for a college education. His father mortgaged his home and took out loans against his life insurance policies to get some of the money he lent to Robertson, who ultimately graduated from dental school. Two years after Robertson’s graduation,

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Restatement (Second) of Contracts further provides that intoxication is a ground for lack of capacity only if the other party has reason to know that the affected person is so intoxicated that he or she cannot understand or act reasonably in relation to the transaction. The rules governing the capacity of intoxicated persons are very similar to those applied to the capacity of people who are mentally impaired. The basic right to disaffirm contracts made during incapacity, the duties upon disaffirmance, and the possibility of ratification upon regaining capacity are the same for an intoxicated person as for a person under a mental impairment. In practice, however, courts traditionally have been less sympathetic with a person who was intoxicated at the time of contracting than with minors or those suffering from a mental impairment. It is rare for a person to actually escape his contractual obligations on the ground of intoxication. A person incapacitated by intoxication at the time of contracting might nevertheless be bound to his or her contract if he or she fails to disaffirm in a timely manner.

his father asked him to begin paying back the amount of $30,000 at $400 per month. Robertson agreed to pay $24,000 at $100 per month. He did this for three years before stopping the payments. His father sued for the balance of the debt. Could Robertson disaffirm the contract? 3. In the fall of 2001, Kim Young, who at the time was 18 years old and had been living with her parents all of her life, decided that she “wanted to move out and get away from [her] parents and be on [her] own.” Young and a friend, Ashley Springer, also a minor at the time, signed a contract for the lease of an apartment with Phillip Weaver on September 20, 2001. No adult signed the lease as a guarantor. Young was employed on a fulltime basis at a Lowe’s hardware store at the time she entered into the lease agreement. Young paid a security deposit in the amount of $300; the rent for the apartment was $550 per month, and the lease was set to expire on July 31, 2002. Young and Springer moved into the apartment in late September and, together, paid rent at the agreed-upon rate for the portion of that month in which they lived in the apartment. Young and Springer continued to live in the apartment during October and most of November 2001. Young moved out near the end of November and returned to live with her parents. Young paid the full amount of her portion of the rent for October and November, but she

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Part Three Contracts

stopped making any rent payments after she moved out of the apartment. Young had a dog that stayed in the apartment, and the dog damaged part of the floor and the bathroom door in the apartment, causing $270 in damage. Young did not pay for this damage before vacating the apartment. Weaver managed to rent the apartment to someone else in June 2002. Weaver filed a claim against Young in Small Claims, seeking damages for the unpaid rent and the damage done by Young’s dog to the apartment. The court ruled in favor of Weaver and awarded $1,370 in damages. Young appealed the decision to the Tuscaloosa Circuit Court, which tried the case and also entered a judgment in favor of Weaver and awarded him $1,095, the amount of Young’s share of the unpaid rent for December 2001 and January and February 2002, as well as the $270 in damage caused by Young’s dog. Young appealed. How did the appellate court rule? 4. In 2002, the State charged Bishop, who was 16 at the time, with a misdemeanor DUI. Bishop entered into a diversion agreement with the State to avoid prosecution. In 2004, the City of Pratt charged Bishop with another DUI and disobeying a stop sign. Again, Bishop entered into a diversion agreement with the City to avoid prosecution for the charges. In 2007, Bishop was again arrested under suspicion of driving under the influence. Her blood alcohol test revealed a blood alcohol concentration of .24 gram per 100 milliliters, in excess of the legal limit. The State charged Bishop in the alternative with driving under the influence of alcohol to a degree that rendered her incapable of safely driving a vehicle (third offense), and with driving under the influence of alcohol while having a blood alcohol content greater than .08 (third offense). A third DUI is a felony. Bishop moved to dismiss the charges, asserting it was not her third offense. She claimed that the State could not rely on the 2002 diversion agreement as a prior conviction because Bishop was 16 when she entered into it and, therefore, it was not a legally binding contract due to her lack of capacity to contract. Is this a good argument under these facts? 5. At a time when the age of majority in Ohio was 21, Lee, age 20, contracted to buy a 1964 Plymouth Fury for $1,552 from Haydocy Pontiac. Lee represented herself to be 21 when entering the contract. She paid for the car by trading in another car worth $150 and financing the balance. Immediately following delivery of the car to her, Lee permitted one John Roberts to take possession of it. Roberts delivered the car to someone

else, and it was never recovered. Lee failed to make payments on the car, and Haydocy Pontiac sued her to recover the car or the amount due on the contract. Lee repudiated the contract on the ground that she was a minor at the time of purchase. Can Lee disaffirm the contract without reimbursing Haydocy Pontiac for the value of the car? 6. Five-year-old Trent Woodman’s parents had his birthday party at Bounce Party, which is operated by Kera LLC. Bounce Party is an indoor play area that contains inflatable play equipment. Before the party, Trent’s father, Jeffrey Woodman, signed a liability waiver on Trent’s behalf. The waiver provided that the undersigned acknowledged the risk and waived claims against Bounce Party. THE UNDERSIGNED, by his/her signature herein affixed does acknowledge that any physical activities involve some element of personal risk and that, accordingly, in consideration for the undersigned waiving his/her claim against BOUNCE PARTY, and their agents, the undersigned will be allowed to participate in any of the physical activities. By engaging in this activity, the undersigned acknowledges that he/she assumes the element of inherent risk, in consideration for being allowed to engage in the activity, agrees to indemnify and hold BOUNCE PARTY, and their agents, harmless from any liability. Further, the undersigned agrees to indemnify and hold BOUNCE PARTY, and their agents, harmless from any and all costs incurred including, but not limited to, actual attorney’s fees that BOUNCE PARTY, and their agents, may suffer by an action or claim brought against it by anyone as a result of the undersigned’s use of such facility.

   During the party, Trent Woodman jumped off a slide and broke his leg. Trent’s mother filed suit on Trent’s behalf. Kera filed a motion for summary judgment, arguing that Trent’s claims were barred by the liability waiver. The Woodmans filed a cross-motion for summary judgment, arguing that the waiver was invalid as a matter of law. The trial court ruled that the waiver barred Trent’s negligence claim but not his gross negligence claim. Both parties appealed. The court of appeals reversed and held that the waiver was invalid to bar the negligence claim. Kera appealed.     A parental preinjury waiver is a contract. Mr. Woodman purportedly signed the contract on behalf of his son. Consequently, Kera necessarily asserts that  the contract is enforceable against Trent because Mr. Woodman had authority to bind his son to the contract. The well-established Michigan common law rule is that a minor lacks the capacity to contract.



Chapter Fourteen Capacity to Contract

It is undisputed that if five-year-old Trent had signed the waiver, defendant could not enforce the waiver against him unless Trent confirmed it after he reached the age of majority. Can a parent bind his child by contract if the child could not otherwise be bound? 7. David Denison is a developmentally disabled young man who has been under the legal guardianship of his parents since 1999, when he turned 18. In October 2002, David was living in his own apartment, but his parents strictly controlled his finances. They visited him at least once each week to make sure he had a clean and safe place to live and was budgeting his food money properly. They also visited him socially several times every week and spoke with him nearly every day. The Denisons first learned that David wanted to buy a car when David called his father, Michael, from Kenai Chrysler and asked him to cosign for a used car; Michael refused. The next day, David again tried to purchase a car from Kenai Chrysler. This time, he was trying to buy a new car, which he could finance without a cosigner. David called his mother, Dorothy, to ask for money for a down payment. Dorothy refused and told him not to buy a car. She assumed her word would be final because she did not realize that David could obtain any appreciable amount of money with his debit card. David used his debit card and bought a Dodge Neon. Kenai Chrysler charged a total price of $17,802, including taxes, fees, and extended service plan. One or two days after David signed the contract, Dorothy came to Kenai Chrysler with David and informed the salesman who had sold the car to David and a Kenai Chrysler manager that David was under the legal guardianship of his parents and had no legal authority to enter into a contract to buy the Neon. Dorothy showed the manager David’s guardianship papers and asked him to take back the car. The manager refused; according to Dorothy, he told her that Kenai Chrysler would not take back the car and that the company sold cars to “a lot of people who aren’t

14-13

very smart.” Dorothy insisted that the contract was void, but the Kenai Chrysler manager ignored her and handed the keys to David over Dorothy’s objection. David drove off in the new car. Dorothy contacted Bannock, the general manager of Kenai Chrysler, the next day; he told her that he had seen the guardianship papers, but he still thought that the contract was valid and that David was bound by it. Is the general manager correct? 8. In October 1995, Mitchell, a 17-year-old married minor, was injured in an auto accident while riding in a car owned by her father and driven by her husband. Subsequently, while Mitchell was still 17, she signed a release with State Farm Mutual Automobile Insurance Co. to settle her bodily injury claims for $2,500. No guardian or conservator was appointed at the time Mitchell signed this release. Mitchell then claimed that the release was voidable because she lacked capacity at the time she signed it. State Farm argued that the release was enforceable because she was married at the time she signed it. Will Mitchell be able to disaffirm the contract? 9. A boy bought an Ernie Banks rookie card for $12 from an inexperienced clerk in a baseball card store owned by Johnson. The card had been marked “1200,” and Johnson, who had been away from the store at the time of the sale, had intended the card to be sold for $1,200, not $12. Can Johnson get the card back by asserting the boy’s lack of capacity? 10. Fourteen-year-old Taneia Galloway attended a field trip to Milwaukee with Upward Bound, a youth outreach program. On the field trip, Galloway was injured when she was struck by a car as she attempted to cross the street. Before going on the field trip, her mother signed two documents titled “Field Trip Permission Form” and “Release and Medical Authorization.” If Galloway sues Upward Bound, will she prevail or will the release signed by her mother protect Upward Bound from liability?

CHAPTER 15

Illegality

W

ilson had been licensed to practice architecture in Hawaii, but his license lapsed in 1971 because he had failed to pay a required $15 renewal fee. A Hawaii statute provides that any person who practices architecture without having been registered and “without having a valid unexpired certificate of registration . . . shall be fined not more than $500 or imprisoned not more than one year, or both.” In 1972, Wilson performed architectural and engineering services for Kealakekua Ranch and billed the Ranch more than $33,000 for the work. • Is this a legal contract? • Would it matter if Wilson had never met the licensing requirements to be licensed in Hawaii? • Is Kealakekua Ranch required to pay Wilson anything for his work? • Is it ethical for the Ranch to refuse to pay Wilson, even if he is unlicensed?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 15-1 Explain the concept of illegality as it is used in contract law. 15-2 Determine when a contract that violates the language or policy of a statute is likely to be illegal. 15-3 Analyze whether a given noncompete clause is likely to be enforceable.

ALTHOUGH THE PUBLIC INTEREST normally favors the enforcement of contracts, there are times when the interests that usually favor the enforcement of an agreement are subordinated to conflicting social concerns. As you read in Chapter 13, Reality of Consent, and Chapter 14, Capacity to Contract, for example, people who did not truly consent to a contract or who lacked the capacity to contract have the power to cancel their contracts. In these situations, concerns about protecting disadvantaged persons and preserving the integrity of the bargaining process outweigh the usual public interest in enforcing private agreements. Similarly, when an agreement involves an act or promise that violates some legislative or courtmade rule, the public interests threatened by the agreement

15-4 Analyze whether a given exculpatory clause is likely to be enforceable. 15-5 Explain the concept of unconscionability and identify the circumstances that make a contract unconscionable. 15-6 Determine the effect of illegality in a given scenario.

outweigh the interests that favor its enforcement. Such an agreement will not be enforced on the ground of illegality, even if there is voluntary consent between two parties who have capacity to contract.

Meaning of Illegality LO15-1

Explain the concept of illegality as it is used in contract law.

When a court says that an agreement is illegal, it does not necessarily mean that the agreement violates a criminal law, although an agreement to commit a crime is one type

15-2

Part Three Contracts

of illegal agreement. Rather, an agreement is illegal either because the legislature has declared that particular type of contract to be unenforceable or void or because the agreement violates a public policy that has been developed by courts or that has been manifested in constitutions, statutes, administrative regulations, or other sources of law. The term public policy is impossible to define precisely. Generally, it is taken to mean a widely shared view about what ideas, interests, institutions, or freedoms promote public welfare. For example, in our society there are strong public policies favoring the protection of human life and health, free competition, and private property. Judicial and legislative perceptions of desirable public policy influence the decisions they make about the resolution of cases or the enactment of statutes. Public policy may be based on a prevailing moral code, on an economic philosophy, or on the need to protect a valued social institution such as the family or the judicial system. If the enforcement of an agreement would create a threat to a public policy, a court may determine that it is illegal.

Determining Whether an Agreement Is Illegal If a statute states that a particular type of agree-

ment is unenforceable or void, courts will apply the statute and refuse to enforce the agreement. Relatively few such statutes exist, however. More frequently, a legislature will forbid certain conduct but will not address the enforceability of contracts that involve the forbidden conduct. In such cases, courts must determine whether the importance of the public policy that underlies the statute in question and the degree of interference with that policy are sufficiently great to outweigh any interests that favor enforcement of the agreement. In some cases, it is relatively easy to predict that an agreement will be held to be illegal. For example, an

agreement to commit a serious crime is certain to be illegal. However, the many laws enacted by legislatures are of differing degrees of importance to the public welfare. The determination of illegality would not be so clear if the agreement violated a statute that was of relatively small importance to the public welfare. For example, in one Illinois case,1 a seller of fertilizer failed to comply with an Illinois statute requiring that a descriptive statement accompany the delivery of the fertilizer. The sellers prepared the statements and offered them to the buyers but did not give them to the buyers at the time of delivery. The court enforced the contract despite the sellers’ technical violation of the law because the contract was not seriously injurious to public welfare. Similarly, the public policies developed by courts are rarely absolute; they, too, depend on a balancing of several factors. In determining whether to hold an agreement illegal, a court will consider the importance of the public policy involved and the extent to which enforcement of the agreement would interfere with that policy. They will also consider the seriousness of any wrongdoing involved in the agreement and how directly that wrongdoing was connected with the agreement. For purposes of our discussion, illegal agreements will be classified into three main categories: (1) agreements that violate statutes, (2) agreements that violate public policy developed by courts, and (3) unconscionable agreements and contracts of adhesion. You will see the court grapple with conflicting public policies in deciding the following Coma Corporation case.

Amoco Oil Co. v. Toppert, 56 Ill. App. 3d 1294 (1978).

1

Coma Corporation v. Kansas Department of Labor    154 P.3d 1080 (Kan. 2007) Cesar Martinez Corral was an undocumented worker who was not legally permitted to work in the United States. He was nevertheless employed by Coma Corporation, which did business as Burrito Express. Corral stated that Coma’s manager, Luis Calderon, had agreed to pay him $6 per hour, with payment made weekly. Corral maintained that he worked 50 to 60 hours per week, 6 or 7 days per week, but that he was paid “$50 or $60 bucks a week.” Coma fired Corral, and Corral filed a claim with the Kansas Department of Labor for earned but unpaid wages under the Kansas Wage Payment Act. He was awarded a total of $7,657 against Coma and its president. Coma filed a petition for judicial review of final order. The district court held that the employment contract was illegal due to Corral’s status as an undocumented worker and remanded to the Kansas Department of Labor for recalculation at the applicable minimum wage. The Kansas Department of Labor appealed.



Chapter Fifteen Illegality

Nuss, Judge Coma argues that Corral’s employment contract was illegal and unenforceable because he is an illegal alien. Intertwined with this argument is another: Coma claims that federal immigration law preempts the Kansas Wage Payment Act. Coma’s purported trumping argument is based upon [The Immigration Reform and Control Act (IRCA)], which makes employment of unauthorized aliens illegal. Preemption, however is not presumed. It is well established that the states enjoy broad authority under their police powers to regulate employment relationships to protect workers within the state. Minimum and other wage laws and workmen’s compensation law are only a few examples of the exercise of this broad authority. We conclude that under this case’s facts, Coma has not overridden the presumption against federal preemption. Finally, we agree with the rationale set forth in Flores v. Amigon, 233 F. Supp. 2d 462 (E.D.N.Y. 2002), where the court granted Fair Labor Standards Act protections to an undocumented worker and determined that payment of unpaid wages for work actually performed furthers the federal immigration policy: Indeed, it is arguable that enforcing the FLSA’s provisions requiring employers to pay proper wages to undocumented aliens when the work had been performed actually furthers the goal of the IRCA, which requires the employer to discharge any worker upon discovery of the worker’s undocumented alien status. If employers know that they will not only be subject to civil penalties when they hire illegal aliens, but they will also be required to pay them at the same rates as legal workers for work actually performed, there are virtually no incentives left for an employer to hire an undocumented alien in the first instance. Whatever benefit an employer might have gained by paying less than the minimum wage is eliminated and the employer’s incentive would be to investigate and obtain proper documentation from each of his workers. Coma also asserts that Corral’s employment contract is illegal under state law. Specifically, it argues that Kansas Department of Labor regulations require that a contract of employment contain lawful provisions in order to be enforceable. Coma reasons that because Corral does not have a legal right to be or to work in the United States, his contract violates IRCA and is unenforceable under Kansas Department of Labor regulations and state law. Prior to IRCA’s enactment, the Alaska Supreme Court confronted the issue of whether a contract of employment entered into by a Canadian alien was barred by illegality. Gates v. Rivers Construction Co., Inc., 515 P.3d 1020 (Alaska 1973). The court first discussed the nature of illegal contracts: Generally, a party to an illegal contract cannot recover damages for its breach. But as in the case of many such simplifications, the exceptions and qualifications to the general rule are numerous and complex. Thus, when a statute imposes sanctions but does not specifically declare a contract to be invalid, it is

15-3

necessary to ascertain whether the legislature intended to make unenforceable contracts entered into in violation of the statute. The Gates court then concluded that enforcement of the employment contract with the Canadian alien was not barred. It looked at the statutory language: [I]t is clear that the contract involved here should be enforced. First, it is apparent that the statute itself does not specifically declare the labor or service contracts of aliens seeking to enter the United States for the purpose of performing such labor or services to be void. The statute only specifies that aliens who enter this country for such purpose, without having received the necessary certification, “shall be ineligible to receive visas and shall be excluded from admission into the United States.” The court next advanced the concept of equity and fairness to the employee: Second, that the employer, who knowingly participated in an illegal transaction, should be permitted to profit thereby at the expense of the employee is a harsh and undesirable consequence of the doctrine that illegal contracts are not to be enforced. This result, so contrary to general considerations of equity and fairness, should be countenanced only when clearly demonstrated to have been intended by the legislature. Finally, in a general foreshadowing of the benefit described in Flores, that is, of reducing employer incentives to violate the law, the Gates court stated: Third, since the purpose of this section would appear to be the safeguarding of American labor from unwanted competition, the appellant’s contract should be enforced, because such an objective would not be furthered by permitting employers knowingly to employ excludable aliens and then, with impunity, to refuse to pay them for their services. Indeed, to so hold could well have the opposite effect from the one intended, by encouraging employers to enter into the very type of contracts sought to be prevented. We agree with Kansas Department of Labor’s position concerning the strong and longtime Kansas public policy of protecting wages and wage earners. As we stated in Burriss v. Northern Assurance Co. of America, 236 Kan. 326 (1984): “[t]hroughout the history of this state, the protection of wages and wage earners has been a principal objective of many of our laws in order that they and the families dependent upon them are not destitute.” Accordingly, we conclude that to deny or to dilute an action for wages earned but not paid on the ground that such employment contracts are “illegal,” would thus directly contravene the public policy of the State of Kansas. We hold for the above reasons that the district court erred in concluding that Corral’s employment contract was illegal and therefore not enforceable. Reversed in favor of Kansas Department of Labor.

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Agreements in Violation of Statute

Part Three Contracts

depends on whether Davis knew of the illegal purpose and whether he intended the sale to further that illegal purpose. Generally speaking, such agreements will be legal unless there is a direct connection between the illegal conduct and Determine when a contract that violates the language or the agreement in the form of active, intentional participaLO15-2 policy of a statute is likely to be illegal. tion in or facilitation of the illegal act. Knowledge of the other party’s illegal purpose, standing alone, is generally Agreements Declared Illegal by Statute  not sufficient to render an agreement illegal. When a person is aware of the other’s illegal purpose and actively helps State legislatures occasionally enact statutes that declare to accomplish that purpose, an otherwise legal agreement— certain types of agreements unenforceable, void, or voidsuch as a sale of goods—might be labeled illegal. able. In a case in which a legislature has specifically stated that a particular type of contract is void, a court need only Licensing Laws: Agreement to Perform an Act for interpret and apply the statute. These statutes differ from Which a Party Is Not Properly Licensed Congress and state to state. Some are relatively uncommon. For example, the state legislatures have enacted a variety of statutes that an Indiana statute declares surrogate birth contracts to be 2 regulate professions and businesses. A common type of void. Others are common, such as statutes setting limits regulatory statute is one that requires a person to obtain on the amount of interest that can be charged for a loan a license, permit, or registration before engaging in a ceror forbearance (usury statutes) and statutes prohibiting or tain business or profession. For example, state statutes regulating wagering or gambling. require lawyers, physicians, dentists, teachers, and other Agreements That Violate the Public Policy professionals to be licensed to practice their professions. of a Statute As stated earlier, an agreement can be In order to obtain the required license, they must meet specified requirements such as attaining a certain educaillegal even if no statute specifically states that that particutional degree and passing an examination. Real estate brolar sort of agreement is illegal. Legislatures enact statutes kers, stockbrokers, insurance agents, sellers of liquor and in an effort to resolve some particular problem. If courts tobacco, pawnbrokers, electricians, barbers, and others too enforced agreements that involve the violation of a statute, numerous to mention are also often required by state statthey would frustrate the purpose for which the legislature ute to meet licensing requirements to perform services or passed the statute. They would also promote disobedience sell regulated commodities to members of the public. of the law and disrespect for the courts. What is the status of an agreement in which one of the Agreements to Commit a Crime For the reasons stated parties agrees to perform an act regulated by state law for above, contracts that require the violation of a criminal statwhich she is not properly licensed? This will often be deterute are illegal. If Grimes promises to pay Judge John Doe a mined by looking at the purpose of the legislation that the bribe of $5,000 to dismiss a criminal case against Grimes, unlicensed party has violated. If the statute is regulatory—that for example, the agreement is illegal. Sometimes the very is, the purpose of the legislation is to protect the public against formation of a certain type of contract is a crime, even if dishonest or incompetent practitioners—an agreement by an the acts agreed on are never carried out. An example of unlicensed person is generally held to be unenforceable. For this is an agreement to murder another person. Naturally, example, if Spencer, a first-year law student, agrees to draft a such agreements are considered illegal under contract law will for Rowen for a fee of $150, Spencer could not enforce the as well as under criminal law. agreement and collect a fee from Rowen for drafting the will because she is not licensed to practice law. This result makes Agreements That Promote Violations of Statutes  sense, even though it imposes a hardship on Spencer. The Sometimes a contract of a type that is usually perfectly public interest in ensuring that people on whose legal advice legal—say, a contract to sell goods—is deemed to be illegal others rely have an appropriate educational background and under the circumstances of the case because it promotes proficiency in the subject matter outweighs any interest in seeor facilitates the violation of a statute. Suppose Davis sells ing that Spencer receives what she bargained for. Sims goods on credit. Sims uses the goods in some illegal On the other hand, where the licensing statute was manner and then refuses to pay Davis for the goods. Can intended primarily as a revenue-raising measure—that is, Davis recover the price of the goods from Sims? The answer as a means of collecting money rather than as a means of protecting the public—an agreement to pay a person 2 for performing an act for which she is not licensed will Ind. Code §§31-20-1-1 and 31-20-1-2.



Chapter Fifteen Illegality

generally be enforced. For example, suppose that in the example used above, Spencer is a lawyer who is licensed to practice law in her state and who met all of her state’s educational, testing, and character requirements but neglected to pay her annual registration fee. In this situation, there is no compelling public interest that would justify the harsh measure of refusing enforcement and possibly inflicting forfeiture on the unlicensed person. Whether a statute is a regulatory statute or a revenueraising statute depends on the intent of the legislature, which may not always be expressed clearly. Generally, statutes that require proof of character and skill and impose penalties for violation are considered to be regulatory in nature. Their requirements indicate that they were intended for the protection of the public. Those that impose a significant license fee and allow anyone who pays the fee to obtain a license are usually classified as revenue raising. The fact that no requirement other than the payment of the fee is imposed indicates that the purpose of the law is to raise money rather than to protect the public. Because such a statute is not designed for the protection of the public, a violation of the statute is not as threatening to the public interest as is a violation of a regulatory statute. It would be misleading to imply that cases involving unlicensed parties always follow such a mechanical test. In some cases, courts may grant recovery to an unlicensed party even where a regulatory statute is violated. If the public policy promoted by the statute is relatively trivial in relation to the amount that would be forfeited by the unlicensed person and the unlicensed person is neither dishonest nor incompetent, a court may conclude that the statutory penalty for violation of the regulatory statute is sufficient to protect the public interest and that enforcement of the agreement is appropriate.

Agreements That May Be in Violation of Public Policy Articulated by Courts Courts have broad discretion to articulate public policy and to decline to lend their powers of enforcement to an agreement that would contravene what they deem to be in the best interests of society. There is no simple rule for determining when a particular agreement is contrary to public policy. Public policy may change with the times; changing social and economic conditions may make behavior that was acceptable in an earlier time unacceptable today, or vice versa. The following are examples of agreements that are frequently considered vulnerable to attack on public policy grounds.

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Agreements in Restraint of Competition  LO15-3

Analyze whether a given noncompete clause is likely to be enforceable.

The policy against restrictions on competition is one of the oldest public policies declared by the common law. This same policy is also the basis of federal and state antitrust statutes. The policy against restraints on competition is based on the economic judgment that the public interest is best served by free competition. Nevertheless, courts have long recognized that some contractual restrictions on competition serve legitimate business interests and should be enforced. Therefore, agreements that limit competition are scrutinized very closely by the courts to determine whether the restraint imposed is in violation of public policy. If the sole purpose of an agreement is to restrain competition, it violates public policy and is illegal. For example, if Martin and Bloom, who own competing businesses, enter an agreement whereby each agrees not to solicit or sell to the other’s customers, such an agreement would be unenforceable. Where the restriction on competition was part of (ancillary to) an otherwise legal contract, the result may be different because the parties may have a legitimate interest to be protected by the restriction on competition. For example, if Martin had purchased Bloom’s business, the goodwill of the business was part of what she paid for. She has a legitimate interest in making sure that Bloom does not open a competing business soon after the sale and attract away the very customers whose goodwill she paid for. Or suppose that Martin hired Walker to work as a salesperson in her business. She wants to assure herself that she does not disclose trade secrets, confidential information, or lists of regular customers to Walker only to have Walker quit and enter a competing business. To protect herself, the buyer or the employer in the above examples might bargain for a contractual clause that would provide that the seller or employee agrees not to engage in a particular competing activity in a specified geographic area for a specified time after the sale of the business or the termination of employment. This type of clause is called an ancillary covenant not to compete, or, as it is more commonly known, a noncompetition clause or “noncompete.” Such clauses most frequently appear in employment contracts, contracts for the sale of a business, partnership agreements, and small-business buy–sell agreements. In an employment contract, the noncompetition clause might be the only part of the contract that the parties put in writing.

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Part Three Contracts

Enforceability of Noncompetition Clauses Although noncompetition clauses restrict competition and thereby affect the public policy favoring free competition, courts enforce them if they meet the following three criteria: 1. Clause must serve a legitimate business purpose. This means that the person protected by the clause must have some justifiable interest—such as an interest in protecting goodwill or trade secrets—that is to be protected by the noncompetition clause. It also means that the clause must be ancillary to, or part of, an otherwise valid contract. For example, a noncompetition clause that is one term of an existing employment contract would be ancillary to that contract. By contrast, a promise not to compete would not be enforced if the employee made the promise after he had already resigned his job because the promise not to compete was not ancillary to any existing contract. 2. The restriction on competition must be reasonable in time, geographic area, and scope. Another way of stating this is that the restrictions must not be any greater than necessary to protect a legitimate interest. It would be unreasonable for an employer or buyer of a business to restrain the other party from engaging in some activity that is not a competing activity or from doing business in a territory in which the employer or buyer does not do business because this would not threaten his legitimate interests. 3. The noncompetition clause should not impose an undue hardship. A court will not enforce a noncompetition clause if its restraints are unduly burdensome either on the public or on the party whose ability to compete would be restrained. In one case, for example, the court refused to enforce a noncompetition clause against a gastroenterologist because of evidence that the restriction would have imposed a hardship on patients and other physicians requiring his services.3 Noncompetition clauses in employment contracts that have the practical effect of preventing the restrained person from earning a livelihood are unlikely to be enforced as well. This is discussed further in the next section. Noncompetition Clauses in Employment Contracts  In employment contracts, noncompetition clauses are one form of agreement that places restrictions on an employee’s conduct after the employment is over. Other restrictions on employees’ postemployment conduct can include confidentiality or nondisclosure agreements, which constrain

Iredell Digestive Disease Clinic, P.A. v. Petrozza, 373 S.E.2d 449 (N.C. Ct. App. 1988). 3

the employee from divulging or using certain information gained during his employment, and nonsolicitation agreements, which forbid an employee from soliciting the employer’s employees, clients, or customers. In many cases, employees sign all these forms of postemployment restrictions. In others, the postemployment restriction may reflect just one or two of these forms of restraints. Restrictions on competition work a greater hardship on an employee than on a person who has sold a business. For this reason, courts tend to judge noncompetition clauses contained in employment contracts by a stricter standard than they judge similar clauses contained in contracts for the sale of a business. In some states, statutes limit or even prohibit noncompetition clauses in employment contracts. In others, there is a trend toward refusing enforcement of these clauses in employment contracts unless the employer can bring forth very good evidence that he has a protectible interest that compels enforcement of the clause. The employer can do this by showing that he has entrusted the employee with trade secrets or confidential information, or that his goodwill with “near-permanent” customers is threatened. In the absence of this kind of proof, a court might conclude that the employer is just trying to avoid competition with a more efficient competitor and refuse enforcement because there is no legitimate business interest that requires protection. Furthermore, many courts refuse to enforce noncompetition clauses if they restrict employees from engaging in a “common calling.” A common calling is an occupation that does not require extensive or highly sophisticated training but instead involves relatively simple, repetitive tasks. Under this common calling restriction, various courts have refused to enforce noncompetition clauses against salespersons, a barber, and an auto trim repairperson. In the following Clark’s case, the court determines whether to enjoin employees from violating their noncompete agreement. The Effect of Overly Broad Noncompetition Clauses  The courts of different states treat unreasonably broad noncompetition clauses in different ways. Some courts will strike the entire restriction if they find it to be unreasonable and will refuse to grant the buyer or employer any protection. Others will refuse to enforce the restraint as written, but will adjust the clause and impose such restraints as would be reasonable. In case of breach of an enforceable noncompetition clause, the person benefited by the clause may seek damages or an injunction (a court order preventing the promisor from violating the covenant).



Chapter Fifteen Illegality

15-7

Clark’s Sales and Service, Inc. v. Smith   4 N.E.3d 772 (Ind. Ct. App. 2014) Smith worked for HH Gregg Appliances and Electronics (“Gregg”) for four years prior to commencing employment with Clark’s in 1998. While working for Gregg, Smith became familiar with and sold high-end appliances. Clark’s, a family-owned business since it was founded in 1913, is involved in builder-distributor appliance sales and service in Indiana and concentrates its efforts in high-end appliance sales. Clark’s generated approximately $750,000 in sales in 1986, when Bob Clark purchased the business from his parents, and he grew the business to a peak of $28 million in sales during the first decade of the 2000s. Clark’s seeks to hire sales consultants with prior appliance experience but does not consider its business to be similar to that of Sears, Lowe’s, or Gregg, which do business in a traditional retail setting offering low-end, mid-range, and high-end appliances. Smith acquired knowledge, skill, and information in connection with his employment as an appliance sales representative with Clark’s. In 2004, one of Clark’s high-level managers left to join Gregg in a position that Clark’s viewed to be a competitive role. As a result, in September 2004, Clark’s asked Smith and other employees to sign a written employment agreement, which contained both a nondisclosure clause and a restrictive covenant. The restrictive covenant provides in relevant part as follows: During the term of Employee’s employment and this Agreement and for a period of two (2) years following the termination of Employee’s employment, Employee agrees not to, directly or indirectly, for any other individual, partnership, firm, corporation, company or other entity, engage in the following prohibited activities: (C) Solicit or provide, or offer to solicit or provide, services competitive to those offered by Employer, or to any business or customer of Employer during the term of Employee’s employment within the 12-month period preceding the termination [of] Employee’s employment or about whom Employee obtained Confidential Information; (D) Work in a competitive capacity for HH Gregg’s in Indianapolis, Indiana, within the State of Indiana, or in any state or municipal corporation, city [,] town, village, township, county or other governmental association in which HH Gregg’s does business, or for an individual partnership, firm, corporation, company or other entity providing services similar to those offered by Employer or within any county in Indiana in which Employer provided services or has at least one customer or client, the State of Indiana, or within a 50 mile radius of Employee’s principal office with Employer. (E) Otherwise attempt to interfere with Employer’s business. Smith signed the employment agreement. Smith was made an assistant store manager in 2009 at Clark’s Castleton showroom. After approximately 14 years working for Clark’s, Smith tendered his resignation on April 13, 2012. Prior to tendering his resignation, Smith e-mailed copies of Clark’s 2010 and 2011 monthly and quarterly sales bonus reports for all of Clark’s sales personnel to his personal e-mail account from his company e-mail address, even though he was not authorized to do so. The reports contained information about all of the sales made by each of Clark’s salespeople and included customer and builder contact information, the price of the materials sold, Clark’s costs on those items, and Clark’s profit margin on each sale. Smith provided this information to his attorney, but to no third parties. On April 18, 2012, Smith accepted an offer of employment with Ferguson. Ferguson was also in the business of high-end appliance sales and service, although it was principally engaged in the plumbing and lighting business. Smith currently works for Ferguson at its builder and designer showroom in Carmel as an appliance manager. The showroom is within a 50-mile radius of Smith’s former principal office with Clark’s. Smith’s employment does not involve direct sales but does include training sales employees; coordinating with vendors; and assisting with service, installation, and delivery. Smith’s position is salaried, and he is compensated for the overall growth of the department. Clark Cutshaw, Ferguson’s sales manager for the Indianapolis area, testified that the information contained in Clark’s sales reports is of no value to Ferguson because Ferguson’s corporate office dictates cost and pricing. He further testified that Smith had no direct selling responsibilities. Hoover, Ferguson’s general manager for the central Indiana area and Cutshaw’s boss, testified that appliances constituted only 1 percent of Ferguson’s sales to customers and that he was trying to increase those sales. Smith was expected to convince builders, remodelers, and kitchen designers who had not previously done so to purchase appliances from Ferguson. On June 1, 2012, Clark’s filed an amended verified complaint for preliminary and permanent injunctive relief and compensatory damages against Smith and Ferguson based upon Smith’s alleged violation of the nondisclosure provision and the restrictive covenant in the employment agreement. The trial court’s denial of the preliminary injunction regarding the restrictive covenant was based on its conclusion that the provision was not supported by adequate consideration. Clark’s appeals the trial court’s denial of its motion for preliminary injunction. We review the trial court’s denial of a request for a preliminary injunction for an abuse of discretion. [Citation omitted.]

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Part Three Contracts

Crone, Judge Enforceability of the Restrictive Covenant The parties raise several issues that bear on Clark’s first hurdle to obtain a preliminary injunction, the reasonable likelihood of Clark’s success at trial. The dispositive issues are: (1) whether the restrictive covenant protects a legitimate interest; and (2) whether the restrictive covenant is reasonable in scope as to the time, activity, and geographic area restricted. “Covenants not to compete are contractual provisions which might be described as step-children of the law.” [Citation omitted.] Our supreme court has long held that noncompetition covenants in employment contracts are disfavored in the law, and we will construe these covenants strictly against the employer and will not enforce an unreasonable restriction. [Citation omitted.] Indeed, “[p]ostemployment restraints are scrutinized with particular care because they are often the product of unequal bargaining power and because the employee is likely to give scant attention to the hardship he may later suffer through loss of his livelihood.” Restatement (Second) of Contracts, § 188 cmt. G (1981). In order for a noncompetition agreement to be enforceable it must be reasonable, and such reasonableness is a question of law. [Citation omitted.] In arguing the reasonableness of a noncompetition agreement, the employer must first show that it has a legitimate interest to be protected by the agreement. Second, the employer bears the burden to show that the agreement is reasonable in scope as to the time, activities, and geographic area restricted. Section 1—Legitimate Interest As to the first factor of reasonableness, in order “[t]o demonstrate a legitimate protectable interest, ‘an employer must show some reason why it would be unfair to allow the employee to compete with the former employer.’” [Citation omitted.] Indeed, “the employee should only be enjoined if he has gained some advantage at the employer’s expense which would not be available to the general public.” [Citation omitted.] Our courts have held that “the advantageous familiarity and personal contact which employees derive from dealing with an employer’s customers are elements of an employer’s ‘good will’ and are a protectible interest which may justify a restraint. . . .” [Citation omitted.] “Goodwill includes secret or confidential information such as the names and addresses of customers and the advantage acquired through representative contact.” [Citation omitted.] In addition, “in industries where personal contact between the employee and the customer is especially important due to the similarity in product offered by the competitors, the advantage acquired through the employee’s representative contact with the customer is part of the employer’s good will, regardless of whether the employee has access to confidential information.” [Citation omitted.] Regarding this factor, the evidence supports the trial court’s finding that Clark’s established that, during Smith’s

fourteen-year employment with Clark’s, Smith had the advantage of having been part of Clark’s efforts to build goodwill with its business accounts and referral network of home builders, remodelers, and kitchen designers, and that such advantage is not available to a person in the general public. We agree with Clark’s and the trial court that such goodwill is a legitimate protectable interest. Section 2—Reasonableness of Restrictions Next, Clark’s has the burden to establish that the restrictive covenant is reasonable in scope as to the time, activities, and geographic area restricted. The parties agree that the two-year time restriction in the covenant is reasonable and valid. The parties disagree, however, as to the reasonableness of the noncompetition covenant as to scope of activities and geographic area restricted. We find the covenant unreasonable as to both. Section 2.1—Scope of Activities Paragraph 7(C) of the restrictive covenant prohibits Smith from providing “services competitive to those offered by [Clark’s], or those provided by [Smith] on behalf of [Clark’s]” to anyone who was a customer of Clark’s during the term of Smith’s employment. This Court has held that although present customers are a protectable interest of an employer, a contract prohibiting contact with any past or prospective customers, no matter how much time has elapsed since their patronage ceased, was vague and too broad. Seach [v. Richards, Dieterle & Co.], 439 N.E.2d [208,] at 214[(Ind. Ct. App. 1982)]. We agree with the trial court’s conclusion that Clark’s attempt to protect a customer base spanning the entire term of Smith’s employment is overly broad and unreasonable. For example, although Smith was an inside appliance salesman for Clark’s, he would be prohibited from performing maintenance, repair, delivery, ordering, or pricing services, to name just a few, to anyone who was a customer of Clark’s during his fourteen-year employment, because those services are competitive to services offered by Clark’s. Presumably, assuming arguendo that Clark’s sold snacks or beverages within its showroom, Smith would be prohibited from selling snacks or beverages for a new employer because that would be a service competitive to a service offered by Clark’s. A covenant that restricts the employee from competing with portions of the business with which he was never associated is invalid. As noted by the trial court, whether a geographic scope is reasonable depends on the interest of the employer that the restriction serves. See [Cent. Indiana Podiatry, P.C. v.] Krueger, 882 N.E.2d [723,] at 730 [(Ind. 2008)]. The trial court found that “[a]s one of the largest ‘high end’ appliance stores in the area, with over $1 million in sales each month, it is reasonable for individuals in the community to travel up to 50 miles to visit Clark’s.”



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Appellant’s App. at 15. While we agree with the implication of the trial court’s finding that a fifty-mile geographic restriction would have been reasonable due to Clark’s prominence in the high-end appliance business, as written, the fifty-mile radius is in addition to, and not a limitation of, the much more expansive geographic restriction of this provision, which includes any state in which Gregg does business, the entirety of Indiana and any county in which Clark’s has at least one customer. It is unquestionable that the expansive geographic scope referenced in paragraph 7(D) is unreasonable as written. Even assuming that the restrictive covenant is overly broad and unreasonable as written, Clark’s urges this Court to do what the trial court determined it could not: make the covenant reasonable and enforceable by applying Indiana’s “blue pencil” doctrine. “When reviewing covenants not to compete, Indiana courts have historically enforced reasonable restrictions, but struck unreasonable restrictions, granted they are divisible.” [Citation omitted.] This principle is known as the blue pencil doctrine. If a court finds that portions of a noncompetition agreement are unreasonable, it may not create a reasonable restriction under the guise of interpretation, since this would subject the parties to an agreement that they have not made. [Citation omitted.] But, if the noncompetition agreement is divisible into parts, and some parts are reasonable while others are unreasonable, a court may enforce the reasonable portions only. When blue-penciling, a court must not add terms that were not originally part of the agreement but may only strike unreasonable restraints or offensive clauses to give effect to the parties’ intentions. [Citation omitted.] Clark’s proposes blue pencil modification for paragraph 7(C). The restriction provided by paragraph 7(C) is written as an indiscrete whole. There is no clear separation of terms or clauses that were or could be intended to be excised from the whole without changing the entire meaning and import of the passage. Paragraph 7(C) is indivisible and unreasonable as a whole, and the blue pencil doctrine is inapplicable. Moreover, even were we to blue-pencil paragraph 7(C) as proposed by Clark’s, such modification does nothing to remedy the overbreadth of the scope of activities prohibited. Smith would still be prohibited from providing “services competitive to those offered by [Clark’s]” irrespective of what services Smith actually provided to Clark’s during the term of his employment.

Clark’s also suggests the following blue pencil modification for paragraph 7(D):

Exculpatory Clauses

one of the parties from tort liability. Exculpatory clauses are suspect on public policy grounds for two reasons. First, courts are concerned that a party who can contract away his liability for negligence will not have the incentive to use care to avoid hurting others. Second, courts are concerned that an agreement that accords one party such a powerful advantage might have been the result of the abuse of superior bargaining

LO15-4

Analyze whether a given exculpatory clause is likely to be enforceable.

An exculpatory clause (often called a “release” or “liability waiver”) is a provision in a contract that purports to relieve

Work in a competitive capacity for HH Gregg’s in Indianapolis, Indiana, within the State of Indiana, or in an state or municipal corporation, city town, village, township, county or other governmental association in which HH Gregg’s does business, or for an individual, partnership, firm, corporation, company, or other entity providing services similar or competitive to those offered by Employer to the residential or commercial builder and remodeling business sectors during the term of Employee’s employment with Employer, including but not limited to providing those services performed by Employee while employed by or working for Employer, within Marion County, Indiana, any county contiguous to Marion County, Indiana (including ­Hamilton County, Hancock County, Shelby County, Johnson County, Morgan County, Hendricks County, and Boone County), any county in Indiana in which Employer provided services or has at least one customer or client, the State of Indiana, or within a 50 mile radius of Employee’s principal office with Employer. As we concluded with the proposed modification for the preceding paragraph, this blue-penciling, which merely removes the reference to Gregg, also fails to adequately address the grossly overbroad restrictions. The mere removal of the reference to Gregg does not cure the remaining expansive geographic restriction of the covenant. In sum, the restrictions contained in paragraphs 7(C) and (D) are not clearly separated into divisible parts. Clark’s proposed redactions do not adequately solve the overbreadth of the restrictions, and we would be required to do additional redaction and engage in substantial interpretation to render the restrictions reasonable. This is not the purpose of the blue pencil doctrine as we see it. We remind Clark’s that “Indiana law strongly discourages employers’ attempts to draft unreasonably broad and oppressive covenants.” [Citation omitted.] The overly broad and unenforceable covenant that Clark’s did draft is not clearly separated into divisible parts or severable in terms such that we can mechanically strike unreasonable restrictions and enforce reasonable ones. The trial court’s denial of Clark’s motion for preliminary injunction is affirmed.

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power rather than truly voluntary choice. Although exculpatory agreements are often said to be “disfavored” in the law, courts do not want to prevent parties who are dealing on a fair and voluntary basis from determining how the risks of their transaction shall be borne if their agreement does not threaten public health or safety. Courts enforce exculpatory clauses in some cases and refuse to enforce them in others, depending on the circumstances of the case, the identity and relationship of the parties, and the language of the agreement. A few ground rules can be stated. First, an exculpatory clause cannot protect a party from liability for any wrongdoing greater than negligence. One that purports to relieve a person from liability for fraud or some other willful tort will be considered to be against public policy. In some states, in fact, exculpatory clauses have been invalidated on this ground because of broad language stating that one of the parties was relieved of “all liability.” Second, exculpatory clauses will not be effective to exclude tort liability on the part of a party who owes a duty to the public (such as an airline) because this would present an obvious threat to the public health and safety. A third possible limitation on the enforceability of exculpatory clauses arises from the increasing array of statutes and common law rules that impose certain obligations on one party to a contract for the benefit of the other party to the contract. Workers’ compensation statutes and laws requiring landlords to maintain leased property in a habitable condition are examples of such laws. Sometimes the person on whom such an obligation is placed will attempt

to escape it by inserting an exculpatory or waiver provision in a contract. Such clauses are often—though not always— found to be against public policy because, if enforced, they would frustrate the very purpose of imposing the duty in question. For example, an employee’s agreement to relieve her employer from workers’ compensation liability is likely to be held illegal as a violation of public policy. Even if a clause is not against public policy on any of the above three grounds, a court may still refuse to enforce it if a court finds that the clause was unconscionable, a contract of adhesion, or some other product of abuse of superior bargaining power. (Unconscionability and contracts of adhesion are discussed later in this chapter.) This determination depends on all of the facts of the case. Facts that tend to show that the exculpatory clause was not the product of knowing consent increase the likelihood that the clause will not be enforced. A clause that is written in clear language and conspicuous print is more likely to be enforced than one written in “legalese” and presented in fine print. Facts that tend to show that the exculpatory clause was the product of voluntary consent increase the likelihood of enforcement of the clause. For example, a clause contained in a contract for a frivolous or unnecessary activity is more likely to be enforced than is an exculpatory clause contained in a contract for a necessary activity such as medical care. In the following Walters case, the court is asked to decide the effectiveness of an exculpatory clause used in the context of a fitness center. 

Walters v. YMCA   437 N.J. Super. 111 (App. Div. 2014) Plaintiff James F. Walters badly injured his knee when he slipped on steps leading to the YMCA indoor pool in Newark, New Jersey. Mr. Walters was not engaged in any physical exercise when he slipped and fell on the steps. A photograph produced at trial revealed that all of the stair treads incorporated slip-resistant rubber, except for the bottom stair where the rubber had been removed due to wear.  At the time the accident occurred, Mr. Walters had been a member of this YMCA for more than three years. The continuous health membership agreement he signed contained the following exculpatory provision, using all capital letters: I AGREE THAT THE YMCA WILL NOT BE RESPONSIBLE FOR ANY PERSONAL INJURIES OR LOSSES SUSTAINED BY ME WHILE ON ANY YMCA PREMISES OR AS A RESULT OF YMCA SPONSORED ACTIVITIES. I FURTHER AGREE TO INDEMNIFY AND SAVE HARMLESS THE YMCA FROM ANY CLAIMS OR DEMANDS ARISING OUT OF ANY SUCH INJURIES OR LOSSES. Defendant YMCA argued that the “hold harmless” provision in the membership agreement that was voluntarily signed by Plaintiff Walters is a reasonable condition imposed on anyone engaging in sports and related physical activities. Furthermore, the YMCA argued that Mr. Walters’s accident and resulting injuries were entirely foreseeable consequences given the nature of the activities and facilities offered, including the swimming pool. The trial court, relying on New Jersey Supreme Court precedent in Stelluti v. Casapenn Enters., agreed with Defendant YMCA and granted the motion for summary judgment based on the membership agreement’s exculpatory clause. Although the Plaintiff was not engaged in any physical exercise when he slipped and fell on the



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steps that led to the indoor pool, the trial judge found the pool area was “just another type of equipment that is being offered by the health club.” Now on appeal, Plaintiff Walters argues that the trial court erred in construing the exculpatory clause as a bar to his cause of action because his accident was caused by a negligently maintained stair tread. Additionally, the plaintiff argues that the basis of his cause of action is predicated on the ordinary common law duty of care owed by all business operators to its invitees, and thus it is completely unrelated to the inherent risky nature of the activities offered by health clubs.  Fuentes, Judge . . . We disagree with the motion judge and reverse. A close reading of [New Jersey Supreme Court] Justice LaVecchia’s analysis in Stelluti [v. Casapenn Enters., 203 N.J. 286 (2010),] reveals that the Court’s holding was grounded on the recognition that health clubs, like defendant YMCA, are engaged in a business that offers its members the use of physical fitness equipment and a place to engage in strenuous physical activities that involve an inherent risk of injury. The Court upheld the defendant’s limited exculpatory clause in Stelluti because the injury sustained [when handlebars of a stationary bike dislodged, causing plaintiff to fall off the bike] was foreseeable as an inherent aspect of the nature of the [inherently risky physical activity] of health clubs. As Justice LaVecchia clearly explained on behalf of a majority of the Court: In sum, the standard we apply here places in fair and proper balance the respective public-policy interests in permitting parties to freely contract in this context (i.e., private fitness center memberships) and requires private gyms and fitness centers to adhere to a standard of conduct in respect of their businesses. Specifically, we hold such business owners to a standard of care congruent with the nature of their business, which is to make available the specialized equipment and facility to their invitees who are there to exercise, train, and to push their physical limits. That is, we impose a duty not to engage in reckless or gross negligence. We glean such prohibition as a fair sharing of risk in this setting, which is also consistent with the analogous assumption-of-risk approach used by the Legislature to allocate risks in other recreational settings with limited retained-liability imposed on operators. [Citation omitted.] Indeed, the legal question presented by this case, whether a fitness center or health club can insulate itself through an exculpatory clause from the ordinary common law duty of care owed by all businesses to its invitees, was specifically not addressed or decided by the Court in Stelluti. We again quote directly Justice LaVecchia’s emphatic, cautionary language addressing this issue: In the instant matter . . . we feel no obligation to reach and discuss the validity of other aspects of the agreement not squarely presented by the facts of Stelluti’s case. Thus, we need not address the validity of the agreement’s disclaimer of liability for injuries that occur on the club’s sidewalks or parking lot that are common to any commercial enterprise that has business invitees. With respect to its agreement and

its limitation of liability to the persons who use its facility and exercise equipment for the unique purpose of the business, we hold that it is not contrary to the public interest, or to a legal duty owed, to enforce [the defendant]’s agreement limiting its liability for injuries sustained as a matter of negligence that results from a patron’s voluntary use of equipment and participation in instructed activity. As a result, we find the exculpatory agreement between [the defendant] and Stelluti enforceable as to the injury Stelluti sustained when riding the spin bike. [Citation omitted.]  . . . The plaintiff in Stelluti was injured when the handlebars of her stationary bike dislodged and caused her to fall during a spinning class at a private fitness center. [Citation omitted.] The inherently risky nature of this type of physical activity was the key consideration the Court found to justify enforcing the exculpatory clause at issue. [Citation omitted.]  Here, Mr. Walters’s accident and resulting injuries occurred when he slipped on a step and fell, as he walked to defendant YMCA’s indoor pool. Plaintiff Walters did not injure himself while swimming in the pool or using any physical fitness equipment. The type of accident involved here could have occurred in any business setting. The inherently risky nature of defendant’s activities as a physical fitness club was immaterial to this accident. Stated in the vernacular of the personal injury bar, this is a “garden variety slip and fall case.” Under these circumstances, plaintiff Walters argues here, as he did at the trial level, that defendant YMCA should be held liable to compensate him for his injuries pursuant to the common law duty all business owners owe to their invitees. Our colleague Judge Sabatino aptly described that duty of care in the Appellate Division’s decision in Stelluti v. Casapenn Enters.: In general, “[b]usiness owners owe to invitees a duty of reasonable or due care to provide a safe environment for doing that which is in the scope of the invitation. [Citation omitted.] This duty of care flows from the notion that “business owners ‘are in the best position to control the risk of harm.’ ” [Citations omitted.] We are thus compelled to address and answer the question the [New Jersey] Supreme Court intentionally left unanswered in Stelluti, to wit: whether an exculpatory clause that insulates a physical fitness club, like defendant YMCA, from liability “for any personal injuries or losses sustained by [a member] while on any [of the club’s] premises” is enforceable when the accident

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and resulting injuries sustained by the member/invitee was not caused by or related to an inherently risky physical fitness activity. In answering this question, we will apply the same standards the Supreme Court applied in Stelluti. An exculpatory agreement “is enforceable only if: (1) it does not adversely affect the public interest; (2) the exculpated party is not under a legal duty to perform; (3) it does not involve a public utility or common carrier; or (4) the contract does not grow out of unequal bargaining power or is otherwise unconscionable.” [Citations omitted.]  . . . We will examine the provisions of this exculpatory clause in defendant’s agreement giving due deference to the freedom to contract and to the right of competent adults to bind themselves as they see fit. [Citations omitted.] However, we are mindful that exculpatory agreements “have historically been disfavored in law and thus have been subjected to close judicial scrutiny.” [Citations omitted.] Any ambiguities in language about the scope of an exculpatory agreement’s coverage, or doubts about its enforceability, should be resolved in favor of holding a tortfeasor accountable. “The law does not favor exculpatory agreements because they encourage a lack of care.” [Citations omitted.] Judge Sabatino noted in the Appellate Division version of Stelluti that an exculpatory clause construed “to its outermost limits of protection  . . . [would preclude] literally any and all claims or causes of action[.] [Such a prospect] threatens an adverse impact upon the public interest. As we have already noted, business establishments in New Jersey have well-established duties of care to patrons that come upon their premises. An unbounded waiver of liability unjustifiably eviscerates those protections for business invitees.” [Citations omitted.] Given the expansive scope of the exculpatory clause here, we hold that if applied literally, it would eviscerate the common law duty of care owed by defendant to its invitees, regardless of the nature of the business activity involved. Such a prospect would be inimical to the public interest because it would transfer the redress of civil wrongs from the responsible tortfeasor to either

the innocent injured party or to society at large, in the form of taxpayer-supported institutions. . . . The “Waiver and Release Form” in Stelluti included a relatively lengthy narrative explanation of the inherent risk of being seriously injured while engaging in strenuous physical exercise. Here, the exculpatory clause, although far more brief in language, is considerably more legally expansive in the scope of activity defendant YMCA sought to insulate from civil liability. By signing the membership agreement, plaintiff Walters purportedly agreed to hold defendant YMCA harmless “for any personal injuries or losses sustained by me while on any YMCA premises or as a result of a YMCA sponsored activities [sic].” The key word here is the disjunction “or,” which expands the scope of the exculpatory clause to include injuries resulting “while on the premises” or as a result of participating in defendant’s “sponsored activities.” We reasonably assume the agreement, especially the exculpatory clause, signed by plaintiff Walters is a contract of adhesion. . . . As the Court did in Stelluti, we recognize that “[w]hen a party enters into a signed, written contract, that party is presumed to understand and assent to its terms, unless fraudulent conduct is suspected.” [Citations omitted.] However, all contracts are subject to judicial scrutiny to determine their enforceability. Here, defendant YMCA seeks to shield itself from all civil liability, based on a one-sided contractual arrangement that offers no countervailing or redeeming societal value. Such a contract must be declared unenforceable as against public policy. Finally, defendant YMCA also argues that swimming in the pool is a “sponsored activity,” and therefore an accident resulting from slipping on the steps leading into the pool is also covered under the “activities” part of the clause. Such an interpretation ignores the cause of this accident. Plaintiff Walters was not injured using the pool. Thus, based on the record before us, we conclude the language in defendant’s exculpatory clause is void and unenforceable as against public policy for the reasons expressed here. . . .

Family Relationships and Public Policy 

It used to be widely held that contracts between unmarried cohabitants were against public policy because they were based on an immoral relationship. As unmarried cohabitation has become more widespread, however, the law concerning the enforceability of agreements between unmarried couples has changed. For example, in the 1976 case of Marvin v. Marvin, the California Supreme Court held that an agreement between an unmarried couple to pool income and share property could be enforceable.4

In view of the central position of the family as a valued social institution, it is not surprising that an agreement that unreasonably tends to interfere with family relationships will be considered illegal. Examples of this type of contract include agreements whereby one of the parties agrees to divorce a spouse or agrees not to marry. In recent years, courts have been presented with an increasing number of agreements between unmarried cohabitants that purport to agree upon the manner in which the parties’ property will be shared or divided upon separation.

Reversed and remanded.

134 Cal. Rptr. 815 (1976).

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Today, most courts hold that agreements between unmarried couples are not against public policy unless they are explicitly based on illegal sexual relations as the consideration for the contract or unless one or more of the parties is married to someone else.

Unfairness in Agreements: Contracts of Adhesion and Unconscionable Contracts LO15-5

Explain the concept of unconscionability and identify the circumstances that make a contract unconscionable.

Under classical contract law, courts were reluctant to inquire into the fairness of an agreement. Because the prevailing social attitudes and economic philosophy strongly favored freedom of contract, American courts took the position that so long as there had been no fraud, duress, misrepresentation, mistake, or undue influence in the bargaining process, unfairness in an agreement entered into by competent adults did not render it unenforceable. As the changing nature of our society produced many contract situations in which the bargaining positions of the parties were grossly unequal, the classical contract assumption that each party was capable of protecting himself was no longer persuasive. The increasing use of standardized contracts (preprinted contracts) enabled parties with superior bargaining power and business sophistication to virtually dictate contract terms to weaker and less sophisticated parties. Legislatures responded to this problem by enacting a variety of statutory measures to protect individuals against the abuse of superior bargaining power in specific situations. Examples of such legislation include minimum wage laws and rent control ordinances. Courts became more sensitive to the fact that superior bargaining power often led to contracts of adhesion (contracts in which a stronger party is able to determine the terms of a contract, leaving the weaker party no practical choice but to “adhere” to the terms). Some courts responded by borrowing a doctrine that had been developed and used for a long time in courts of equity,5 the doctrine of unconscionability. Under this doctrine, courts would refuse to grant the equitable remedy of specific performance for breach of a contract if they found the contract to be oppressively unfair. Courts today can use the concepts of unconscionability or adhesion to Chapter 1 discusses courts of equity.

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analyze contracts that are alleged to be so unfair that they should not be enforced.

Unconscionability One of the most far-reaching

efforts to correct abuses of superior bargaining power was the enactment of section 2-302 of the Uniform Commercial Code, which gives courts the power to refuse to enforce all or part of a contract for the sale of goods or to modify such a contract if it is found to be unconscionable. By virtue of its inclusion in Article 2 of the Uniform Commercial Code, the prohibition against unconscionable terms applies to every contract for the sale of goods. The concept of unconscionability is not confined to contracts for the sale of goods, however. Section 208 of the Restatement (Second) of Contracts, which closely resembles the unconscionability section of the UCC, provides that courts may decline to enforce unconscionable terms or contracts. The prohibition of unconscionability has been adopted as part of the public policy of many states by courts in cases that did not involve the sale of goods, such as banking transactions and contracts for the sale or rental of real estate. It is therefore fair to state that the concept of unconscionability has become part of the general body of contract law. Consequences of Unconscionability The UCC and the Restatement (Second) sections on unconscionability give courts the power to manipulate a contract containing an unconscionable provision so as to reach a just result. If a court finds that a contract or a term in a contract is unconscionable, it can do one of three things: It can refuse to enforce the entire agreement, it can refuse to enforce the unconscionable provision but enforce the rest of the contract, or it can “limit the application of the unconscionable clause so as to avoid any unconscionable result.” This last alternative has been taken by courts to mean that they can make adjustments in the terms of the contract. Meaning of Unconscionability Neither the UCC nor the Restatement (Second) of Contracts attempts to define the term unconscionability. Though the concept is impossible to define with precision, unconscionability is generally taken to mean the absence of meaningful choice together with terms unreasonably advantageous to one of the parties. The facts of each individual case are crucial to determining whether a contract term is unconscionable. Courts will scrutinize the process by which the contract was reached to see if the agreement was reached by fair methods and whether it can fairly be said to be the product of knowing and voluntary consent.

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Procedural Unconscionability Courts and writers often

refer to unfairness in the bargaining process as procedural unconscionability. Some facts that may point to procedural unconscionability include the use of fine print or inconspicuously placed terms; complex, legalistic language; and high-pressure sales tactics. One of the most significant facts pointing to procedural unconscionability is the lack of voluntariness as shown by a marked imbalance in the parties’ bargaining positions, particularly where the weaker party is unable to negotiate more favorable terms because of economic need, lack of time, or market factors. In fact, in most contracts that have been found to be unconscionable, there has been a serious inequality of bargaining power between the parties. It is important to note, however, that the mere existence of unequal bargaining power does not make a contract unconscionable. If it did, every consumer’s contract with the telephone company or the electric company would be unenforceable. Rather, in an unconscionable contract, the party with the stronger bargaining power exploits that power by driving a bargain containing a term or terms that are so unfair that they “shock the conscience of the court.” Substantive Unconscionability In addition to looking at

facts that might indicate procedural unconscionability, courts will scrutinize the contract terms themselves to determine whether they are oppressive, unreasonably

one-sided, or unjustifiably harsh. This aspect of unconscionability is often referred to as substantive unconscionability. Examples include situations in which a party to the contract bears a disproportionate amount of the risk or other negative aspects of the transaction and situations in which a party is deprived of a remedy for the other party’s breach. In some cases, unconscionability has been found in situations in which the contract provides for a price that is greatly in excess of the usual market price. There is no mechanical test for determining whether a clause is unconscionable. Generally, in cases in which courts have found a contract term to be unconscionable, there are elements of both procedural and substantive unconscionability. Though courts have broad discretion to determine what contracts will be deemed to be unconscionable, it must be remembered that the doctrine of unconscionability is designed to prevent oppression and unfair surprise—not to relieve people of the effects of bad bargains. The cases concerning unconscionability are quite diverse. Some courts have found unconscionability in contracts involving grossly unfair sales prices. Although the doctrine of unconscionability has been raised primarily by victimized consumers, there have been cases in which businesspeople in an inherently weak bargaining position have been successful in asserting unconscionability. You will see an example of the unconscionability analysis in the following Singh case.

Singh v. Uber Technologies Inc.   235 F. Supp. 3d 656 (D.N.J. 2017) Uber is a technology company that serves as a conduit between riders looking for transportation and drivers seeking riders. Uber provides this technology through its smartphone application that allows riders and drivers to connect based on their geographic location. Raiser LLC is a wholly owned subsidiary of Uber and operates as a technology service provider. Plaintiff Jaswinder Singh, an Uber driver, registered with the Uber App in order to use its “uberX” platform, which provided him with the option to accept ride requests from prospective passengers and transport them for a fare. In doing so, Plaintiff was required to electronically accept the applicable Raiser Software License and Online Services Agreement (“Raiser Agreement”) dated June 21, 2014. When Plaintiff logged on to the Uber App with his unique user name and password, he was given the opportunity to review the Raiser Agreement by clicking a hyperlink to the Raiser Agreement within the Uber App. To advance past the screen with the hyperlink and actively use the Uber App, Plaintiff had to confirm that he had first reviewed and accepted the Raiser Agreement by clicking “YES, I AGREE.” After clicking “YES, I AGREE,” he was prompted to confirm that he reviewed and accepted the Raiser Agreement for a second time.  Plaintiff was permitted to spend as much time as he found necessary in reviewing the Raiser Agreement on his smartphone or other electronic devices before accepting it. In fact, Plaintiff accepted the Raiser Agreement approximately three months after it was made available for his review. After Plaintiff confirmed his acceptance for a second time through the Uber App, the Raiser Agreement was uploaded to Plaintiff’s “driver portal,” where he could access the Agreement at his own leisure, either online or by printing out a hard copy. The first page of the Raiser Agreement contains a paragraph, written in large bold and capital text, indicating that a voluntary arbitration agreement (“Arbitration Provision”) is contained therein and that Plaintiff should review the Raiser Agreement with an attorney before agreeing to its terms and conditions:



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IMPORTANT: PLEASE NOTE THAT TO USE THE UBER SERVICES, YOU MUST AGREE TO THE TERMS AND CONDITIONS SET FORTH BELOW. PLEASE REVIEW THE ARBITRATION PROVISION SET FORTH BELOW CAREFULLY, AS IT WILL REQUIRE YOU TO RESOLVE DISPUTES WITH THE COMPANY ON AN INDIVIDUAL BASIS THROUGH FINAL AND BINDING ARBITRATION UNLESS YOU CHOOSE TO OPT OUT OF THE ARBITRATION PROVISION. BY VIRTUE OF YOUR ELECTRONIC EXECUTION OF THIS AGREEMENT, YOU WILL BE ACKNOWLEDGING THAT YOU HAVE READ AND UNDERSTOOD ALL OF THE TERMS OF THIS AGREEMENT (INCLUDING THE ARBITRATION PROVISION) AND HAVE TAKEN TIME TO CONSIDER THE CONSEQUENCES OF THIS IMPORTANT BUSINESS DECISION. IF YOU DO NOT WISH TO BE SUBJECT TO ARBITRATION, YOU MAY OPT OUT OF THE ARBITRATION PROVISION BY FOLLOWING THE INSTRUCTIONS PROVIDED IN THE ARBITRATION PROVISION BELOW. A similar paragraph, also written in large bold and capital text, appears within the text of the arbitration provision itself, stating: WHETHER TO AGREE TO ARBITRATION IS AN IMPORTANT BUSINESS DECISION. IT IS YOUR DECISION TO MAKE, AND YOU SHOULD NOT RELY SOLELY UPON THE INFORMATION PROVIDED IN THIS AGREEMENT AS IT IS NOT INTENDED TO CONTAIN A COMPLETE EXPLANATION OF THE CONSEQUENCES OF ARBITRATION. YOU SHOULD TAKE REASONABLE STEPS TO CONDUCT FURTHER RESEARCH AND TO CONSULT WITH OTHERS—INCLUDING BUT NOT LIMITED TO AN ATTORNEY—REGARDING THE CONSEQUENCES OF YOUR DECISION, JUST AS YOU WOULD WHEN MAKING ANY OTHER IMPORTANT BUSINESS DECISION OR LIFE DECISION. The Arbitration Provision requires transportation drivers—if they do not opt out—to individually arbitrate all disputes arising out of, or relating to, the Raiser Agreement, or their relationship with Uber, including disputes alleging breach of contract, wages and hours, and compensation claims. The Arbitration Provision, in pertinent part, reads as follows: IMPORTANT: This Arbitration Provision will require you to resolve any claim that you may have against the Company or Uber on an individual basis pursuant to the terms of the Raiser Agreement unless you choose to opt out of the Arbitration Provision. This provision will preclude you from bringing any class, collective, or representative action against Uber.  It further provides: Except as it otherwise provides, this Arbitration Provision is intended to apply to the resolution of disputes that otherwise would be resolved in a court of law or before a forum other than arbitration. This Arbitration Provision requires all such disputes to be resolved only by an arbitrator through final and binding arbitration on an individual basis only and not by way of court or jury trial, or by way of class, collective, or representative action. Notably, after Plaintiff confirmed that he had reviewed and accepted the Raiser Agreement, along with the Arbitration Provision, Plaintiff was provided with an additional 30 days to optout of the Arbitration Provision: Your Right to Opt Out of Arbitration. Arbitration is not a mandatory condition of your contractual relationship with Uber. If you do not want to be subject to this Arbitration Provision, you may opt out of this Arbitration by notifying Uber in writing of your desire to opt out of this Arbitration Provision, either by (1) sending, within 30 days of the date this Raiser Agreement is executed by you, electronic mail to [email protected], stating your name and intent to opt out of the Arbitration Provision or (2) by sending a letter by U.S. Mail, or by any nationally recognized delivery service (e.g., UPS, Federal Express, etc.), or by hand delivery to [Raiser’s legal department]. Despite these terms of his contract with Uber, Singh filed his Complaint in federal court, alleging that Uber (1) misclassified him and other Uber drivers as independent contractors, as opposed to employees; (2) failed to pay overtime compensation; and (3) required the drivers to pay for significant business expenses that were incurred for the benefit of Uber. Defendant Uber moved to dismiss the Complaint and compel arbitration, arguing that Plaintiff is bound by the Arbitration Provision in the Raiser Agreement. Plaintiff Singh, attempting to keep his lawsuit in federal court, argued that the Arbitration Provision is unenforceable for multiple reasons, including his claim that it is unconscionable. Only the portion of the court’s analysis addressing the unconscionability claim is included below.

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Part Three Contracts

Wolfson, District Judge . . . Lastly, Plaintiff contends that the Arbitration Provision is unconscionable and cannot be enforced. In support of this contention, Plaintiff primarily attacks the Arbitration Provision on two separate grounds. First, Plaintiff takes issue with the parties’ purported grossly unequal bargaining power. Plaintiff maintains that Uber capitalized on this imbalance by providing him with “a standardized mass contract,” without the opportunity to bargain for, or negotiate any of its terms, thereby making it a contract of adhesion, despite its opt-out provision. Second, Plaintiff points to the language of the Arbitration Provision’s cost-sharing provision, which “requires [Plaintiff] to pay for half the costs of arbitration,” and posits that this cost-sharing provision renders the Arbitration Provision unconscionable because it prevents him from vindicating his statutory rights. However, the Court finds both of these arguments meritless. A contract in New Jersey will be enforceable unless there are indicia of both procedural and substantive unconscionability. “Procedural unconscionability pertains to the process by which an agreement is reached and the form of an agreement, including the use therein of fine print and convoluted or unclear language.” [Citation omitted.] This element of the unconscionability analysis may be satisfied if the agreement constitutes a contract of adhesion. Such agreements are typically prepared by a party with excessive bargaining power, and signed by a weaker party on a “take-it-or-leave-it” basis. However, a disparity in bargaining power alone will not render an agreement unconscionable. The party challenging the agreement must also establish that it is substantively unconscionable. “This element refers to the terms that unreasonably favor one party to which the disfavored party does not truly assent.” [Citation omitted.] Indeed “gross inequality of bargaining power, together with terms unreasonably favorable to the stronger party . . . may show that the weaker party had no meaningful choice, no real alternative, or did not in fact assent or appear to assent to the unfair terms.” [Citation omitted.] Thus, unconscionability “requires a two-fold determination: that the contractual terms are unreasonably favorable to the drafter and that there

Contracts of Adhesion A contract of adhesion is a contract, usually on a standardized form, offered by a party who is in a superior bargaining position on a “take-it-or-leave-it” basis. The person presented with such a contract has no opportunity to negotiate the terms of the contract; they are imposed on him if he wants to receive the goods or services offered by the stronger party. In addition to not having a “say” about the terms of the contract, the person who signs a standardized

is no meaningful choice on the part of the other party regarding acceptance of the provisions.” [Citation omitted.] Here, the agreement between the parties was not a contract of adhesion. Plaintiff contends that “[t]here was and is absolutely no ability for [Uber drivers] to bargain or negotiate the terms [of the Raiser Agreement] with Defendant.” However, this assertion is baseless, as Plaintiff was presented with the choice of either arbitrating or litigating his disputes against Uber. Indeed, arbitration between the parties is not required; Plaintiff was afforded a 30-day period to opt-out. Nor was Plaintiff coerced or pressured into accepting arbitration as a means of resolving his claims with Uber. Accordingly, Plaintiff was free to decline the Raiser Agreement’s Arbitration Provision—without any consequences. Therefore, the contract between the parties cannot be construed as a contract of adhesion. [Citations omitted.] Furthermore, the Arbitration Provision’s cost-sharing provision is not substantively unconscionable. “[W]here, as here, a party seeks to invalidate an arbitration agreement on the ground that arbitration would be prohibitively expensive, that party bears the burden of showing the likelihood of incurring such costs.” [Citation omitted.] The Raiser Agreement’s Arbitration Provision contains a cost-sharing provision: In all cases where required by law, [Uber] will pay the Arbitrator’s and arbitration fees. If under applicable law [Uber] is not required to pay all of the Arbitrator’s and/or arbitration fees, such fee(s) will be apportioned equally between the Parties or as otherwise required by applicable law. Significantly, Plaintiff does not adequately allege any facts indicating that the arbitration fees would be prohibitively expensive. Rather, Plaintiff merely summarizes the terms of the cost-sharing provision and then asserts, in a conclusory fashion, that “the costsharing language precludes [Plaintiff] from vindicating his statutory rights.” Therefore, Plaintiff does not establish a likelihood of incurring prohibitively expensive costs, and there can be no finding of substantive unconscionability based on this reason. The Court dismisses the case in favor of arbitration.

contract of adhesion may not even know or understand the terms of the contract that he is signing. When these factors are present, the objective theory of contracts and the normal duty to read contracts before signing them may be modified. These factors may be viewed as a form of procedural unconscionability. A court may use the word adhesion to describe procedural unconscionability. All of us have probably entered contracts of adhesion at one time or another. The mere fact that a contract is a contract of adhesion does not, in and of itself, mean that the



Chapter Fifteen Illegality

contract is unenforceable. Courts will not refuse enforcement to such a contract unless the term complained of either is substantively unconscionable or is a term that the adhering party could not reasonably expect to be included in the form that he was signing. Unenforceable contracts of adhesion can take different forms. The first is seen when the contract of adhesion contains a term that is harsh or oppressive. In this kind of case, the party offering the contract of adhesion has used his superior bargaining power to dictate unfair terms. In the second situation in which contracts of adhesion are refused, enforcement occurs when a contract of adhesion contains a term that, while it may not be harsh or oppressive, is a term that the adhering party could not be expected to have been aware that he was agreeing to. This type of case relates to the fundamental concept of agreement in an era in which lengthy, complex, standardized contracts are common. If a consumer presented with a contract of adhesion has no opportunity to negotiate terms and signs the contract without knowing or fully understanding what he is signing, is it fair to conclude that he has consented to the terms? It is reasonable to conclude that he has consented at least to the terms that he could have expected to be in the contract, but not to any terms that he could not have expected to be contained in the contract.

Effect of Illegality LO15-6 Determine the effect of illegality in a given scenario.

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General Rule: No Remedy for Breach of Illegal Agreements As a general rule, courts

will refuse to give any remedy for the breach of an illegal agreement. A court will refuse to enforce an illegal agreement and will also refuse to permit a party who has fully or partially performed her part of the agreement to recover what she has parted with. The reason for this rule is to serve the public interest, not to punish the parties. In some cases, the public interest is best served by allowing some recovery to one or both of the parties. Such cases constitute exceptions to the “hands-off” rule. The following discussion concerns the most common situations in which courts will grant some remedy even though they find the agreement to be illegal.

Exceptions Excusable Ignorance of Facts or Legislation Though it is often said that ignorance of the law is no excuse, courts will, under certain circumstances, permit a party to an illegal agreement who was excusably ignorant of facts or legislation that rendered the agreement illegal to recover damages for breach of the agreement. This exception is used where only one of the parties acted in ignorance of the illegality of the agreement and the other party was aware that the agreement was illegal. For this exception to apply, the facts or legislation of which the person claiming damages was ignorant must be of a relatively minor character—that is, it must not involve an immoral act or a serious threat to the public welfare. Finally, the person who is claiming damages cannot recover damages

Ethics and Compliance in Action Murphy, a welfare recipient with four minor children, saw an advertisement in the local newspaper that had been placed by McNamara, a television and stereo dealer. It stated: Why buy when you can rent? Color TV and stereos. Rent to own! Use our Rent-to-own plan and let TV Rentals deliver either of these models to your home. We feature—Never a repair bill—No deposit—No credit needed—No long term obligation—Weekly or monthly rates available—Order by phone—Call today—Watch color TV tonight. As a result of the advertisement, Murphy leased a 25-inch Philco color console TV set from McNamara under the “Rent to Own” plan. The lease agreement provided that Murphy would pay a $20 delivery charge and 78 weekly payments of $16. At the end of the period, Murphy would own the set. The agreement also

provided that the customer could return the set at any time and terminate the lease as long as all rental payments had been made up to the return date. Murphy entered the lease because she believed that she could acquire ownership of a TV set without first establishing credit as was stressed in McNamara’s ads. At no time did McNamara inform Murphy that the terms of the lease required her to pay a total of $1,268 for the TV. The retail sales price for the same TV was $499. After making $436 in payments over a period of about six months, Murphy read a newspaper article criticizing the lease plan and realized the amount that the agreement required her to pay. She stopped making payments and McNamara sought to repossess the TV. Murphy argued that the agreement was unconscionable. Was it ethical to market the Rent to Own plan? Was McNamara ethically required to inform Murphy that the total price of the TV would be $1,268 under the Rent to Own plan?

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Part Three Contracts

for anything that he does after learning of the illegality. For example, Warren enters a contract to perform in a play at Craig’s theater. Warren does not know that Craig does not have the license to operate a theater as required by statute. Warren can recover the wages agreed on in the parties’ contract for work that he performed before learning of the illegality. When both of the parties are ignorant of facts or legislation of a relatively minor character, courts will not permit them to enforce the agreement and receive what they had bargained for, but they will permit the parties to recover what they have parted with. Rights of Parties Not Equally in the Wrong The courts will often permit a party who is not equally in the wrong (in technical legal terms, not in pari delicto) to recover what she has parted with under an illegal agreement. One of the

most common situations in which this exception is used involves the rights of “protected parties”—people who were intended to be protected by a regulatory statute—who contract with parties who are not properly licensed under that statute. Most regulatory statutes are intended to protect the public. As a general rule, if a person guilty of violating a regulatory statute enters into an agreement with another person for whose protection the statute was adopted, the agreement will be enforceable by the party whom the legislature intended to protect. Another common situation in which courts will grant a remedy to a party who is not equally in the wrong is one in which the less guilty party has been induced to enter the agreement by misrepresentation, fraud, duress, or undue influence. The following Gamboa  case illustrates how courts analyze the doctrine of in pari delicto to protect victims of fraud in an otherwise criminal contract.

Gamboa v. Alvarado   941 N.E.2d 1012 (Ill. Ct. App. 2011) On December 7, 2009, plaintiffs (individually referred to as Gamboa, Nava, and Lopez) filed a five-count complaint against defendants alleging (count I) violations of the Consumer Fraud Act, (count II) common law fraud, (count III) unjust enrichment, (count IV) civil conspiracy, and (count V) intentional infliction of emotional distress. In early 2006, Alvarado told plaintiffs he could obtain “authentic citizenship documents” for plaintiffs through a contact at the U.S. Consulate office in Ciudad Juarez, Mexico, and plaintiffs would be able to use the documents to obtain Social Security numbers. He stated his contact could influence both American and Mexican immigration officials to expedite the application process but would need to pay employees in the different departments to obtain the necessary releases. The cost for adjustments to legal permanent residency status would be $12,000 per person and to obtain U.S. citizenship would add an additional $3,000 per person. Alvarado stated he and his brother were obtaining their citizenship documents through the contact and invited plaintiffs to join their group. He explained that once the contact obtained the necessary documents, the group would travel across the Mexican border and pick up the documents at the consulate office after having photos and fingerprints taken and a short interview. If plaintiffs could get their money to him by the end of June 2006, they could have their documents by October. Otherwise, there would be a six-month delay. Plaintiffs each made payments totaling $15,000 to Alvarado over a period of months and received receipts from Marco’s Digital Photography in return for their payments. Alvarado explained he was providing receipts from his business to assure plaintiffs that the process was legitimate. Gamboa made some of his payments at Alvarado’s home and at Marco’s Digital Photography. Nava and Lopez alleged Alvarado used “high-pressure tactics” to get the payments by the June deadline, calling them weekly until they had paid in full. Nava did not make his final payment until October 2006. Alvarado informed plaintiffs that, because the deadline had not been met, there would be a delay and plaintiffs would not receive their documents until December 2006. In February 2007, Alvarado told Gamboa that Gamboa’s documents were ready and Gamboa needed to make plane reservations to fly to El Paso in order to cross the border and get the documents. Gamboa went to Marco’s Digital Photography where Alvarado “purchased” the reservations for $500 plus a $25 credit card fee. Shortly before Gamboa was to leave, Alvarado told him his Mexican contact would not be able to get the documents and the trip was canceled. Alvarado refunded Gamboa’s $500 but not the $25 fee. Plaintiffs regularly called Alvarado inquiring about the status of their documents. Alvarado avoided plaintiffs. After repeated calls from plaintiffs, he told them that his contact had suffered a heart attack, which would delay obtaining the documents. He gave Lopez his contact’s phone number in Mexico. Lopez spoke to the contact, “Jose de Jesus Castellanos,” who confirmed Alvarado’s version of heart attack–induced delay. At some later point, Alvarado stated the delays were due to problems in Phoenix and El Paso, which “Castellanos” confirmed when Gamboa called him.



Chapter Fifteen Illegality

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In March 2009, Alvarado met with plaintiffs and told them that there was nothing he could do for them. He stated they had all been swindled by Castellanos and it was necessary to bring legal action in Mexico. He requested plaintiffs each pay him $200 to hire a Mexican lawyer and sign a power of attorney. Lopez and Nava paid and signed the power of attorney. Gamboa refused and demanded his money back. Alvarado subsequently called Nava and Lopez, asking if they knew what Gamboa was planning and threatened them that if Alvarado “fell, they would all fall.” Plaintiffs pressed Alvarado to return their money. In September 2009, Alvarado told Nava and Lopez the lawsuit was no longer a viable option and explained his new plan was to hire thugs in Mexico to kidnap Castellanos and get the money back from Castellanos in return for Castellanos’s release. If Castellanos did not return the money, Alvarado implied the kidnappers would kill Castellanos. Nava and Lopez told Alvarado they were opposed to the violence and did not want to be part of the kidnapping scheme. On October 29, 2009, Alvarado told Nava and Lopez the kidnapping was on hold. Plaintiffs’ complaint alleged defendants engaged in numerous instances of unfair and deceptive practices in the conduct of trade or commerce in violation of section 2AA of the Consumer Fraud Act (815 Ill. Comp. Stat. 505/2AA (West 2008)), which governs private providers of immigration assistance services. Plaintiffs also alleged defendants committed common law fraud by inducing plaintiffs to rely on their misrepresentations; defendants were unjustly enriched by the monies plaintiffs paid them; defendants engaged in a civil conspiracy to defraud plaintiffs; and defendants intended to inflict emotional distress on plaintiffs by making the malicious statements that if Alvarado fell, they would all fall. Plaintiffs requested the court enjoin defendants from engaging in conduct relating to the provision of immigration services or in any of the deceptive practices charged and payment of assorted damages, including $45,000 to each plaintiff as the civil penalty provided for by section 2AA(m) (815 Ill. Comp. Stat. 505/2AA(m) (West 2008)). Defendants filed a motion to dismiss pursuant to section 2-619 of the Illinois Code of Civil Procedure (735 Ill. Comp. Stat. 5/2-619 et seq. (West 2008)). They asserted the entire complaint should be dismissed pursuant to section 2-619(a)(9) because the agreement between the parties was an illegal contract that violated the law and public policy and courts refuse to enforce a contract when the purpose of the contract violates the law. The court granted defendants’ motion to dismiss on all counts, ruling that the plaintiffs and defendants entered into a contract that violated the law and public policy. It declared the order final and appealable. The plaintiffs appealed to Illinois Court of Appeals. Karnezis, Judge Taking the well-pleaded facts in plaintiffs’ complaint as true, there is no question that the verbal contract between defendants and plaintiffs was illegal. Indeed, defendants admit that the parties entered into a contract that violates Illinois and Federal law and public policy. They correctly describe the parties’ agreement as a “scheme” wherein the five members of the group agreed to obtain their residency or citizenship documents “by circumventing the normal, legal process that the public follows in obtaining such documents” such as by paying bribes and paying off government officials in violation of assorted criminal codes. Courts will not enforce an illegal contract, a contract that expressly contravenes either Illinois or Federal law and thus violates public policy. Kim v. Citigroup, Inc., 368 Ill. App. 3d 298, 307, 856 N.E.2d 639, 305 Ill. Dec. 834 (2006). Illegality of contract is, therefore, a defense to actions seeking enforcement of a contract. Kim, 368 Ill. App. 3d at 307. Arguably, therefore, the illegality of the contract between plaintiffs and defendants would be a defense to plaintiffs’ enforcement of the contract. But plaintiffs are not seeking to enforce the contract. Rather, they are seeking to be reimbursed for the monies they paid defendants on the basis of the apparently fraudulent contract, costs they incurred as a result of the contract and assorted punitive damages including those provided for by section 2AA of the Consumer Fraud Act. As the basis for plaintiffs’ claimed relief,

they are asserting (1) violations of section 2AA of the Consumer Fraud Act; (2) common law fraud; (3) unjust enrichment; (4) civil conspiracy; and (5) intentional infliction of emotional distress. They do not, in any of these counts, seek enforcement of the agreement they had with defendants or assert a breach of contract claim. Illegality of contract, therefore, would not be a valid defense to plaintiffs’ claims. We do not find, notwithstanding defendants’ argument to the contrary, that allowing plaintiffs to proceed with their claims would be tantamount to allowing them to enforce an illegal contact. On the contrary, allowing plaintiffs’ claims to proceed will send a message to those unscrupulous individuals who mislead and prey on others by promising them immigration services they cannot deliver that there are ramifications for this antisocial behavior. These individuals cannot be allowed to use the very illegality of their agreement as a way to avoid the consequences of their actions. Granted, generally, “parties to a void contract will be left where they have placed themselves with no recovery of the money paid for illegal services.” Ransburg v. Haase, 224 Ill. App. 3d 681, 686, 586 N.E.2d 1295, 167 Ill. Dec. 23 (1992). However, exceptions to this rule have been recognized where (1) the person who paid for the services was not in pari delicto (“in equal fault” with the offender) and (2) the law in question was passed for the protection of the person who paid for the services

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and the purpose of the law would be better served by granting relief than by denying it. Ransburg, 224 Ill. App. 3d at 686. On the facts as they stand now, it appears plaintiffs were not in pari delicto with defendants: plaintiffs spoke little English, did not know defendants were lying/unable to deliver on their promises and would not necessarily know the agreement was illegal or that, as will be described below, they had recourse under section 2AA. Further, section 2AA was clearly passed for the protection of persons such as plaintiffs and would be best served if plaintiffs are allowed to proceed with their claims. Section 2AA was created to deter the abuses allegedly committed by defendants here. In section 2AA, the General Assembly, given the substantial effect on the public interest of private individuals providing or offering to provide immigration assistance services, established rules of practice and conduct for such individuals in order to promote honesty and fair dealing with Illinois residents and preserve public confidence. 815 ILCS 505/2AA(a1), (a-5) (West 2008). Any person performing any of the authorized services must register with the Illinois Attorney General and submit verification of malpractice insurance or a surety bond (815 ILCS 505/2AA(c) (West 2008)); provide the customer with a written contract explaining the services and costs in English and in the customer’s native language before performing any services (815 ILCS 505/2AA(d), (f) (West 2008)); and post a sign, a separate sign for each language in which he offers immigration assistance services at his place of business stating he is not an attorney licensed to practice law and disclosing his fee schedule and assorted other information. 815 ILCS 505/2AA(e) (West 2008). Persons violating section 2AA shall be guilty of a Class A misdemeanor for a first offense and Class 3 felony for second

or subsequent offenses. 815 ILCS 505/2AA(m) (West 2008). If the Attorney General or State’s Attorney fails to file an action under this section, any person may file a civil action to enforce the provisions of the section and maintain an action for injunctive relief, compensatory damages to recover prohibited fees. 815 ILCS 505/2AA(m) (West 2008). A prevailing plaintiff may be awarded three times the prohibited fees. 815 ILCS 505/2AA(m) (West 2008). Plaintiffs filed such a civil action here, seeking triple the amount they paid defendants pursuant to section 2AA(m). Again taking the well-pleaded facts in plaintiffs’ complaint as true, there is no question that defendants were providers of immigration assistance services. There is also no question that they, as plaintiffs asserted in their complaint, violated section 2AA when they (1) failed to provide plaintiffs with a written contract explaining services to be performed and compensation to be charged in violation of section 2AA(d); (2) failed to provide plaintiffs with a written contract in English and Spanish, the language spoken by plaintiffs, in violation of section 2AA(f); (3) failed to post signs with the mandated disclosures at Marco’s Digital Photography in violation of section 2AA(e); (4) retained plaintiffs’ money after failing to obtain the promised documents, misrepresented to plaintiffs they could assist them in obtaining immigration documents and misrepresented that Castellanos was employed by the United States Consulate in Juarez, Mexico, in violation of section 2AA(j); and (5) failed to file the required registration statement or verification of malpractice statement or surety bond in violation of section 2AA(c).

Rescission before Performance of Illegal Act Obviously, public policy is best served by any rule that encourages people not to commit illegal acts. People who have fully or partially performed their part of an illegal contract have little incentive to raise the question of illegality if they know that they will be unable to recover what they have given because of the courts’ hands-off approach to illegal agreements. To encourage people to cancel illegal contracts, courts will allow a person who rescinds such a contract before any illegal act has been performed to recover any consideration that he has given. For example, Dixon, the owner of a restaurant, pays O’Leary, an employee of a competitor’s restaurant, $1,000 to obtain some of the competitor’s recipes. If Dixon has second thoughts and tells O’Leary the deal is off before receiving any recipes, he can recover the $1,000 he paid O’Leary.

Divisible Contracts If part of an agreement is legal and part is illegal, the courts will enforce the legal part so long as it is possible to separate the two parts. A contract is said to be divisible—that is, the legal part can be separated from the illegal part—if the contract consists of several promises or acts by one party, each of which corresponds with an act or a promise by the other party. In other words, there must be a separate consideration for each promise or act for a contract to be considered divisible. Where no separate consideration is exchanged for the legal and illegal parts of an agreement, the agreement is said to be indivisible. As a general rule, an indivisible contract that contains an illegal part will be entirely unenforceable unless it comes within one of the exceptions discussed above. However, if the major portion of a contract is legal but the contract contains an illegal provision

Trial court’s order of dismissal reversed, and case remanded for further proceedings.



Chapter Fifteen Illegality

that does not affect the primary, legal portion, courts will often enforce the legal part of the agreement and simply decline to enforce the illegal part. For example, suppose Alberts sells his barbershop to Bates. The contract of sale provides that Alberts will not engage in barbering anywhere in the world for the rest of his life. The major

portion of the contract—the sale of the business—is perfectly legal. A provision of the contract—the ancillary covenant not to compete—is overly restrictive, and thus illegal. A court would enforce the sale of the business but modify or refuse to enforce the restraint provision. See Figure 15.1.

Figure 15.1 Effect of Illegality Illegal contract

Was one party excusably ignorant of the illegality?

Yes

Person who was ignorant may be able to recover damages.

Yes

Both can recover what they parted with.

Yes

Innocent party can recover what he parted with.

Yes

Rescinding party can recover what he parted with.

No

Were both parties excusably ignorant of illegality? No Was one of the parties less guilty of wrongdoing than the other? (Parties not equally in the wrong.) No Did one of the parties rescind the contract before the performance of the illegal act? No

Is the contract divisible?

No

“Hands off” (no remedy will be given).

Yes

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Enforce the legal part.

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Part Three Contracts

Problems and Problem Cases 1. Defendants who are citizens of the United Kingdom and have played, taught, coached, and worked in the soccer industry most of their lives were hired by plaintiffs to provide soccer camp services to roughly 185 soccer clubs in the past year, accounting for approximately $1.5 million in annual revenue. Each of the defendants entered into an employment contract that included clauses of noncompete, not to solicit, and not to disclose. After several months, defendants all wished to distance themselves from Russell, MLS Camps’s owner, because of alleged mistreatment, deception, bullying, and abuse. Defendants attained new employment.   Plaintiffs alleged that, since defendants left their employment with plaintiffs, plaintiffs experienced an immediate drop in customers in the New York–New Jersey area. They sought injunctive relief to bar defendants from working. After balancing the equities in public interest of noncompetition clauses as well as the basic need for employment, who will prevail? 2. Broemmer, age 21, was unmarried and 16 or 17 weeks pregnant. She was a high school graduate earning less than $100 a week and had no medical benefits. Broemmer was in considerable turmoil and confusion. The father-to-be insisted that she have an abortion, but her parents advised against it. Broemmer went to Abortion Services with her mother and was escorted into an adjoining room and asked to complete three forms: a consent to treatment form, a questionnaire asking for a detailed medical history, and an agreement to arbitrate. The agreement to arbitrate stated that “any dispute arising between the Parties as a result of the fees and/or services would be settled by binding arbitration” and that “any arbitrators appointed by the AAA [American Arbitration Association] shall be licensed medical doctors who specialize in obstetrics/ gynecology.” No one made any effort to explain this to Broemmer, and she was not provided with a copy of the agreement. She completed all three forms in less than five minutes. After Broemmer returned the forms to the front desk, she was taken into an examination room where preoperation procedures were performed. She was then instructed to return at 7:00 A.M. the next day. She returned the following day and a physician performed the abortion. As a result of this procedure, Broemmer suffered a punctured uterus, which required medical treatment. Broemmer later filed a malpractice lawsuit against Abortion Services. Abortion

Services moved to dismiss the suit on the ground that arbitration was required under the agreement. Should the arbitration clause be enforced in this situation? 3. Piatek had served a 10-year term in San Quentin State Prison for assault with a deadly weapon with great bodily injury. His criminal background prevented him from acquiring the license to sell insurance that was required by state law. Nevertheless, he sold insurance for American Income Life Insurance Company under several false names. He then sued American Income Life Insurance to recover commissions on the sales that he had made. Will he be successful? 4. Strickland attempted to bribe Judge Sylvania Woods to show leniency toward one of Strickland’s friends who had a case pending before the judge. Judge Woods immediately reported this to the state’s attorney and was asked to play along with Strickland until the actual payment of money occurred. Strickland gave $2,500 to the judge, who promptly turned it over to the state’s attorney’s office. Strickland was indicted for bribery, pled guilty, and was sentenced to a four-year prison term. Three months after the criminal trial, Strickland filed a motion for the return of his $2,500. Will the court order the return of his money? 5. Steamatic of Kansas City Inc. specialized in cleaning and restoring property damaged by fire, smoke, water, or other elements. It employed Rhea as a marketing representative. His duties included soliciting customers, preparing cost estimates, supervising restoration work, and conducting seminars. At the time of his employment, Rhea signed a noncompetition agreement prohibiting him from entering into a business in competition with Steamatic within six counties of the Kansas City area for a period of two years after the termination of his employment with Steamatic. Late in 1987, Rhea decided to leave Steamatic. In contemplation of the move, he secretly extracted the agreement restricting his postemployment activity from the company’s files and destroyed it. Steamatic learned of this and discharged Rhea. Steamatic filed suit against Rhea to enforce the noncompetition agreement when it learned that he was entering a competing business. Will the noncompetition agreement be enforced? 6. Plaintiff filed a lawsuit after discovering that defendant allegedly had engaged in a fraudulent accounting scheme designed to reduce plaintiff’s compensation by expensing monies, which defendant received from Centegra Health Systems, directly to her. Plaintiff also learned that defendant was not a licensed professional corporation, even though she had given plaintiff prior



Chapter Fifteen Illegality

assurances that she was properly registered. According to plaintiff, to induce her to join its medical practice, defendant expressly represented in writing that the “Corporation [was] registered to practice medicine in the State of Illinois.”    Can the defendant’s failure to comply with the act’s certificate of registration requirement render the employment agreement void? 7. Pinnacle Market Development constructed and sold condominiums in downtown San Diego known as the Pinnacle Museum Tower Project. In connection with this project, Pinnacle recorded a declaration of covenants, conditions, and restrictions (CC&R) forming the Pinnacle Museum Tower Association (“Association”) to manage and govern the project’s common areas. Each condo buyer became a part-owner of the Association. The CC&R stated a mandatory arbitration procedure for resolution of construction disputes. When condo buyers signed the paperwork to purchase their units, they were presented with a document that waived their right to trial by jury and stated that they were bound by the terms of the CC&R, which would be recorded in the official records of San Diego County. Is the jury waiver provision unconscionable? 8. Marcinczyk, a security officer at University of Medicine and Dentistry of New Jersey (UMDNJ), received a promotion to the position of police officer conditioned upon his attendance at a police academy for training. In order to attend the Academy, all other recruits were required to execute an exculpatory agreement accepting possible risk of physical or psychological harm.   In training, Marcinczyk was designated as one of two “lunch recruits. . . .” He slipped on “some kind of substance” on the steps and fell, suffering severe and disabling back injuries. Can Marcinczyk argue that the exculpatory agreement violated public policy? 9. Mantor began working for Circuit City in August 1992. When Circuit City hired Mantor, it had no arbitration program. In 1995, Circuit City instituted an arbitration program called the “Associate Issue Resolution Program” (AIRP). Circuit City emphasized to managers the importance of full participation in the AIRP, claiming that the company had been losing money because of lawsuits filed by employees. Circuit City management stressed that employees had little choice in this matter. They suggested that employees should sign the agreement or prepare to be terminated. Although Circuit City circulated the forms regarding the AIRP in 1995, Mantor was able to avoid either signing up or openly refused to

15-23

participate in the AIRP for three years. In 1998, two Circuit City managers arranged a meeting with Mantor to discuss his participation in the AIRP. During this meeting, Mantor asked the two Circuit City managers what would happen should he decline to participate in the arbitration program. They responded to the effect that he would have no future with Circuit City. In February 1998, Mantor agreed to participate in the AIRP, acknowledging in writing his receipt of (1) an “Associate Issue Resolution Handbook,” (2) the “Circuit City Dispute Resolution Rules and Procedures,” and (3) a “Circuit City Arbitration OptOut Form.” Under its arbitration program, Circuit City requires an employee to pay a $75 filing fee to initiate an arbitration proceeding. There is a provision for waiving this fee at Circuit City’s discretion. In October 2000, Circuit City terminated Mantor’s employment. A year later, Mantor brought a civil action in state court, alleging 12 causes of action. Circuit City petitioned the district court to compel arbitration, and the district court granted Circuit City’s motion to compel arbitration. Mantor appealed, arguing that the arbitration agreement was unenforceable because it was unconscionable. Was it unconscionable? 10. Gianni Sport was a New York manufacturer and distributor of women’s clothing. Gantos was a clothing retailer headquartered in Grand Rapids, Michigan. In 1980, Gantos’s sales total was 20 times greater than Gianni Sport’s, and in this industry, buyers were “in the driver’s seat.” In June 1980, Gantos submitted to Gianni Sport a purchase order for women’s holiday clothing to be delivered on October 10, 1980. The purchase order contained the following clause: Buyer reserves the right to terminate by notice to Seller all or any part of this Purchase Order with respect to Goods that have not actually been shipped by Seller or as to Goods which are not timely delivered for any reason whatsoever.

    Gianni Sport made the goods in question especially for Gantos. This holiday order comprised 20 to 22 percent of Gianni Sport’s business. In late September 1980, before the goods were shipped, Gantos canceled the order. Was the cancellation clause unconscionable? 11. During a prenatal appointment for her high-risk pregnancy, Monica Moore was told to complete a series of forms related to medical treatment, privacy rights, and payment of services. Neither the office receptionist who gave her the forms nor her OBGYN specialist physician (to whom she had been referred) brought her attention to the fact that among the

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Part Three Contracts

forms she was signing was also included a four-pagelong arbitration agreement. The title of the top page, however, was in boldface type and capitalized letters: “ARBITRATION AGREEMENT FOR CLAIMS ­ARISING OUT OF OR RELATED TO MEDICAL CARE AND TREATMENT.”  The arbitration agreement purported to be binding on Monica, her husband, and their unborn child; required that all future claims against any medical provider in the practice would be arbitrated (if the medical provider elected to be involved in arbitration); stated that Monica’s, her husband’s, and her unborn child’s constitutional rights

to jury trial or trial by judge were being waived; noted that the patient acknowledged her right to consult with an attorney prior to signing the contract; and provided Monica with 15 days in which to rescind the agreement after she signed it, although she was not provided with a copy of the arbitration agreement. Monica later filed a medical malpractice action in state court, and the trial judge granted the defendant medical provider’s motion to compel arbitration. Monica appealed on the grounds that the arbitration agreement is a contract of adhesion with both procedural and substantive unconscionability. Is this arbitration agreement enforceable?

CHAPTER 16

Writing

M

oore went to First National Bank and requested that the president of the bank allow his adult sons, Rocky and Mike, to open an account in the name of Texas Continental Express Inc. Moore promised to bring his own business to the bank and orally agreed to make good any losses that the bank might incur from receiving dishonored checks from Texas Continental. The bank then furnished a regular checking account and bank draft services to Texas Continental. Several years later, Texas Continental wrote checks that were returned for insufficient funds. The amounts of those checks totaled $448,942.05. Texas Continental did not cover the checks, and the bank turned to Moore for payment. • Was Moore’s oral promise to pay Texas Continental’s dishonored checks enforceable? • If not, what would have been required in the nature of a writing to make the promise enforceable? • Suppose there had been a written agreement between Moore and the bank. Would the bank have been able to enforce an oral promise made by Moore that was not stated in the written contract? • Would it be ethical of Moore not to pay the bank?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 16-1 List the contracts that must be evidenced by a writing under the statute of frauds. 16-2 Explain the exceptions to the statute of  frauds.

YOUR STUDY OF CONTRACT law so far has focused on the requirements for the formation of a valid contract. You should be aware, however, that even when all the elements of a valid contract exist, the enforceability of the contract and the nature of the parties’ obligations can be greatly affected by the form in which the contract is set out and by the language that is used to express the agreement. This chapter discusses such issues.

The Significance of Writing in Contract Law Purposes of Writing Despite what many people

believe, there is no general requirement that contracts be in writing. In most situations, oral contracts are legally

16-3 Explain how to satisfy the statute of frauds under both the common law and UCC. 16-4 Explain the parol evidence rule and the exceptions to the rule. enforceable, assuming that they can be proven. Still, oral contracts are less desirable than written contracts in many ways. They are more easily misunderstood or forgotten than written contracts tend to be. They are also more subject to the danger that a person might fabricate terms or fraudulently claim to have made an oral contract when none exists. Writing is important in contract law and practice for a number of reasons. When people memorialize their contracts in a writing, they are enhancing their chances of proving that an obligation was undertaken and making it harder for the other party to deny making the promise. A person’s signature on a written contract provides a basis for the contract to be authenticated, or proved to be genuinely the contract of the signer. In addition, signing a writing

16-2

Part Three Contracts

also communicates the seriousness of the occasion to the signer. Occasionally there are problems with proving the genuineness of the writing, and often there are disagreements about the interpretation of language in a contract, but the written form is still very useful in increasing the chances that you will be able to depend on the enforcement of your contracts.

Writing and Contract Enforcement In

contract law, there are certain situations in which a promise that is not in writing can be denied enforcement. In such situations, an otherwise valid contract can become unenforceable if it does not comply with the formalities required by state law. These situations are controlled by a type of statute called the statute of frauds.

Overview of the Statute of Frauds History and Purposes In 17th-century England,

the dangers inherent in oral contracts were exacerbated by a legal rule that prohibited parties to a lawsuit from testifying in their own cases. Because the parties to an oral contract could not give testimony, the only way they could prove the existence of the contract was through the testimony of third parties. As you might expect, third parties were sometimes persuaded to offer false testimony about the existence of contracts. In an attempt to stop the widespread fraud and perjury that resulted, Parliament enacted the Statute of Frauds in 1677. It required written evidence before certain classes of contracts would be enforced. Although the possibility of fraud exists in every contract, the statute focused on contracts in which the potential for fraud was great or the consequences of fraud were thought to be especially serious. The legislatures of American states adopted very similar statutes, also known as statutes of frauds. These statutes, which require certain kinds of contracts to be evidenced by a signed writing, are exceptions to the previously noted general rule that oral contracts are enforceable. Statutes of frauds have produced a great deal of litigation, due in part to the public’s ignorance of their provisions. It is difficult to imagine an aspect of contract law that is more practical for businesspeople to know about than the circumstances under which an oral contract will not suffice.

What happens if an executory contract is within the statute of frauds but has not been evidenced by the type of writing required by the statute? It is not treated as an illegal contract because the statute of frauds is more of a formal rule than a rule of substantive law. Rather, the contract that fails to comply with the statute of frauds is unenforceable. Although the contract will not be enforced, a person who has conferred some benefit on the other party pursuant to the contract may be able to recover the reasonable value of his performance in an action based on quasi-contract.

Contracts Covered by the Statute of Frauds LO16-1

List the contracts that must be evidenced by a writing under the statute of frauds.

A contract is said to be “within” (covered by) the statute of frauds if the statute requires that sort of contract to be evidenced by a writing. In almost all states, the following types of contracts are within the statute of frauds: 1. Collateral contracts in which a person promises to perform the obligation of another person. 2. Contracts for the sale of an interest in real estate. 3. Bilateral contracts that cannot be performed within a year from the date of their formation. 4. Contracts for the sale of goods for a price of $500 or more. 5. Contracts in which an executor or administrator promises to be personally liable for the debt of an estate. 6. Contracts in which marriage is the consideration.

Of this list, the first four sorts of contracts have the most significance today, and our discussion will focus primarily on them. The statutes of frauds of the various states are not uniform. Some states require written evidence of other contracts in addition to those listed above. For example, a number of states require written evidence of contracts to pay a commission for the sale of real estate. Others require written evidence of ratifications of infants’ promises or Effect of Violating the Statute of Frauds  promises to pay debts that have been barred by the statute The statute of frauds applies only to executory contracts. of limitations or discharged by bankruptcy. If an oral contract has been completely performed by both The following discussion examines in greater detail the parties, the fact that it did not comply with the statute of sorts of contracts that are within most states’ statute of frauds would not be a ground for rescission of the contract. frauds.



Chapter Sixteen Writing

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The Global Business Environment Under the CISG (United Nations Convention on Contracts for the International Sale of Goods), there is no requirement that a contract be evidenced by a writing. A contract need not take any particular

Collateral Contracts A collateral contract is one

in which one person (the guarantor) agrees to pay the debt or obligation that a second person (the principal debtor) owes to a third person (the obligee) if the principal debtor fails to perform. For example, Cohn, who wants to help Davis establish a business, promises First Bank that he will repay the loan that First Bank makes to Davis if Davis fails to pay it. Here, Cohn is the guarantor, Davis is the principal debtor, and First Bank is the obligee. Cohn’s promise to First Bank must be in writing to be enforceable. Figure 16.1 shows that a collateral contract involves at least three parties and at least two promises to perform (a promise by the principal debtor to pay the obligee and a promise by the guarantor to pay the obligee). In a collateral contract, the guarantor promises to pay only if the principal debtor fails to do so. The essence of the collateral contract is that the debt or obligation is owed primarily by the principal debtor and the guarantor’s debt is secondary. Thus, not all three-party transactions are collateral contracts. The Dynegy case, which follows shortly, focuses on whether an obligation was primary or collateral and, therefore, on whether the oral contract at issue was subject to the statute of frauds. When a person undertakes an obligation that is not conditioned on the default of another person, and the debt is his own rather than that of another person, his obligation is

Figure 16.1 Collateral Contract Obligee Primary contract

Principal debtor

Collateral contract

Guarantor Guarantor's promise must be evidenced by a writing.

form, and can be proven by any means. The CISG does permit parties to a written contract to require that any modifications of the contract be in writing, however.

said to be original, not collateral. For example, when Timmons calls Johnson Florist Company and says, “Send flowers to Elrod,” Timmons is undertaking an obligation to pay her own—not someone else’s—debt. When a contract is determined to be collateral, however, it will be unenforceable unless it is evidenced by a writing. Exception: Main Purpose or Leading Object Rule LO16-2 Explain the exceptions to the statute of frauds.

There are some situations in which a contract that is technically collateral is treated as if it were an original contract. Under the main purpose or leading object rule, no writing is required where the guarantor makes a collateral promise for the main purpose of obtaining some personal economic advantage. When the consideration given in exchange for the collateral promise is something the guarantor seeks primarily for his own benefit rather than for the benefit of the primary debtor, the contract is outside the statute of frauds. Suppose, for example, that Penn is a major creditor of Widgetmart, a retailer. To help keep Widgetmart afloat and increase the chances that Widgetmart will repay the debt it owes him, Penn orally promises Rex Industries, one of Widgetmart’s suppliers, that he will guarantee Widgetmart’s payment for goods that Rex sells to Widgetmart. In this situation, Penn’s oral agreement could be enforced under the main purpose rule if the court finds that Penn was acting for his own personal financial benefit. In the Dynegy case, which follows, the court not only explores the primary-versus-collateral distinction but also considers whether the main purpose exception applies and renders an oral contract of a collateral nature enforceable.

Interest in Land Any contract that creates or trans-

fers an interest in land is within the statute of frauds. The inclusion of real estate contracts in the statute of frauds reflects the values of an earlier, agrarian society in which land was the primary basis of wealth. Our legal system historically has treated land as being more important than

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Part Three Contracts

other forms of property. Courts have interpreted the land provision of the statute of frauds broadly to require written evidence of any transaction that will affect the ownership of an interest in land. Thus, a contract to sell or mortgage real estate must be evidenced by a writing, as must an option to purchase real estate or a contract to grant an easement or permit the mining and removal of minerals on land. A lease is also a transfer of an interest in land, but most states’ statutes of frauds do not require leases

to be in writing unless they are long-term leases, usually those for one year or more. On the other hand, a contract to construct or insure a building would not be within the real estate provision of the statute of frauds because such contracts do not involve the transfer of interests in land.1

Note, however, that a writing might be required under state insurance statutes. 1

Dynegy, Inc. v. Yates   422 S.W.3d 638 (Tex. 2013) A grand jury indicted James Olis, a former officer of Dynegy, Inc., on multiple counts of securities fraud, mail and wire fraud, and conspiracy arising out of work he performed while at Dynegy. Dynegy’s board of directors passed a resolution authorizing the advancement of attorney fees for Olis’s defense, provided that Olis acted in good faith, in Dynegy’s best interests, and in compliance with applicable law. Olis hired attorney Terry Yates to defend him in the criminal investigation and an ongoing civil investigation conducted by the Securities and Exchange Commission. Olis told Yates and Mark Clark, Yates’s associate, that Dynegy would be paying his legal fees. Clark telephoned Cristin Cracraft, an attorney in Dynegy’s legal department, who confirmed during the conversation that Dynegy would pay Olis’s legal fees. Clark testified in the litigation referred to below that Cracraft stated, “The Board has passed a resolution, so, yes, we are paying Jamie Olis’s fees,” and instructed Clark that the bills should be submitted to her. Cracraft’s later testimony was similar to Clark’s version of the conversation. In Olis’s written fee agreement with Yates, Olis acknowledged that he was responsible for payment of his legal fees. The contract stated that “all fees are due when billed unless other specific arrangements have been made.” Yates later testified that despite the written fee agreement, he and Olis had a separate agreement under which Yates would not look to Olis for payment of fees, but instead would look to Dynegy for payment. Yates also testified that he spoke to Cracraft after faxing his fee agreement and hourly rate to Dynegy and that Cracraft told him Dynegy would pay Olis’s legal fees through his criminal trial. Cracraft’s testimony contradicted Yates’s testimony about the phone call, however. Cracraft testified that she spoke only to Clark and never to Yates as of the date of the trial. After the communications noted above, Dynegy hand-delivered a letter notifying Yates that it would pay him directly for Olis’s legal fees through August 17, 2003, but that the remaining fees incurred were to be paid into escrow pursuant to a board resolution. Dynegy paid Yates’s initial invoice for $15,000. Yates submitted a further bill for $105,176 in August, but Dynegy did not pay it until after Olis’s trial in November. Olis was ultimately convicted of securities fraud, mail and wire fraud, and conspiracy. Yates submitted a third and final invoice for $448,556, representing all work performed from August 2003 through April 2004, including the November 2003 trial. Dynegy initially escrowed that amount pursuant to the board resolution, but later refused to release the escrowed funds after concluding that Olis did not meet the “good faith” standard for indemnification set forth in the board’s resolution. Alleging that Dynegy orally promised that it would pay Yates’s fees through Olis’s trial, Yates sued Dynegy for breach of contract. A Texas jury returned a verdict in favor of Yates. Dynegy moved for judgment notwithstanding the verdict on the theory that the statute of frauds should have been held to bar Yates’s claim, but the trial court denied the motion. Dynegy appealed to the Texas Court of Civil Appeals. In affirming the lower court’s judgment in favor of Yates, the appellate court concluded that the statute of frauds did not apply because Dynegy’s promise amounted to a primary obligation rather than a promise to pay the debt of another. Dynegy appealed to the Supreme Court of Texas. Green, Justice The statute of frauds’ suretyship provision provides that an oral promise “by one person to answer for the debt, default, or miscarriage of another person” is generally unenforceable. Tex. Bus. &

Com. Code § 26.01(a), (b)(2). Dynegy contends that this provision bars the current suit [because the] breach of contract claim against it is based on an oral promise to pay the attorney’s fees incurred by one of Dynegy’s former officers.



Chapter Sixteen Writing

The statute of frauds generally renders a contract that falls within its purview unenforceable. The party pleading the statute of frauds bears the initial burden of establishing its applicability. Once that party meets its initial burden, the burden shifts to the opposing party to establish an exception that would take the verbal contract out of the statute of frauds. One recognized exception to the statute of frauds’ suretyship provision is the main purpose doctrine [(described below)]. Here, Dynegy pleaded the statute of frauds as an affirmative defense and thus had the initial burden to establish that the alleged promise fell within the statute of frauds. Yates argues that the suretyship provision does not apply to the oral agreement in this case because there is not a preexisting debt. On the contrary, the suretyship provision applies regardless of “whether [the debt was] already incurred or to be incurred in the future.” Restatement (Second) of Contracts § 112 cmt. b (1981). The record indicates that Olis hired Yates to represent him in the criminal proceedings. Olis signed a fee agreement with Yates, in which Dynegy was not mentioned. Yates agreed to defend Olis, and Olis agreed in exchange that fees were due when billed unless other arrangements were made. Both Clark and Yates testified that Cracraft orally promised that Dynegy would be paying Olis’s fees through trial, and it is undisputed that this agreement was never reduced to writing. These facts establish one conclusion: Dynegy orally promised to pay attorney’s fees associated with Olis’s defense that, under the fee agreement, were Olis’s obligation (i.e., Olis’s debt). We hold that Dynegy established as a matter of law that the statute of frauds’ suretyship provision initially applied to bar the claims against it. The court of appeals erred when it held otherwise. At this point, the burden shifted to Yates to establish an exception that would take the verbal contract out of the statute of frauds—namely, the main purpose doctrine. The main purpose doctrine required Yates to prove: (1) Dynegy intended to create primary responsibility in itself to pay the debt; (2) there was consideration for the promise; and (3) the consideration given for the promise was primarily for Dynegy’s own use and benefit—that is, the benefit it received was Dynegy’s main purpose for making the promise. We have noted that the question of intent to be primarily responsible for the debt is a question for the finder of fact, taking into account all the facts and circumstances of the case. Thus, the burden was on Yates to secure favorable findings [from the trial court] on the main purpose doctrine. [Yates did not do so, however.] Yates failed to plead and prove the [intent and] consideration elements of the main purpose exception. [In its written objection to the jury instructions approved by the trial judge.] Dynegy even

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pointed out to the trial court and Yates the omission of any jury questions related to an exception to the statute of frauds. [Because Yates did not carry his burden to prove the elements of the main purpose doctrine, the trial court and the court of appeals erred in holding that the statute of frauds did not apply.] Based on the preceding analysis, we hold that the statute of frauds renders the oral agreement between Dynegy and Yates unenforceable. Court of Appeals decision reversed in favor of Dynegy; Yates’s case dismissed. Devine, Justice, dissenting The statute of frauds “is a two-edged sword. It . . . may be used to perpetrate frauds as well as to prevent them. Under it a person may obtain an oral promise to pay the debt of a third person and then resist payment on the ground that this promise is oral and therefore unenforceable under the statute of frauds. Because of this and other dangers, the courts of England and this country have sought to keep the statute within its intended purpose.” [Citation omitted.] The dispute in this case is not about whether Dynegy agreed to pay Yates; it clearly did. The dispute instead is about the extent of Dynegy’s promise. Dynegy contends that its promise to Yates was conditioned by the [good faith provision in] the board resolution. Yates contends that Dynegy’s promise to pay for Olis’ defense through trial was unconditional and, as to Yates, primarily the company’s responsibility. The dispute was submitted to a jury, which was asked to determine the extent of Dynegy’s agreement with Yates. The charge instructed the jury that an essential term of the asserted agreement was whether Dynegy agreed to pay Yates for his legal services to Olis through trial. In closing argument, Dynegy argued that the jury should not find it in breach of the agreement unless it believed Dynegy made an uncon- ditional promise to pay Yates through trial. The jury found Dynegy in breach of its agreement to pay Yates and awarded damages. The court concludes, however, that the written fee agreement between Yates and Olis conclusively establishes Olis as the primary obligor, making Dynegy merely the surety of that obligation. Because Dynegy never intended to act as a guarantor of Olis’ debt, however, the statute of frauds’ suretyship provision should not apply as a matter of law. I therefore disagree with the court’s conclusion, but even if I agreed with it, I would nevertheless hold that the main purpose exception takes Dynegy’s promise to Yates out of the statute.

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Part Three Contracts

Exception: Full Performance by the Vendor LO16-2 Explain the exceptions to the statute of frauds.

An oral contract for the sale of land that has been completely performed by the vendor (seller) is “taken out of the statute of frauds”—that is, is enforceable without a writing. For example, Peterson and Lincoln enter into an oral contract for the sale of Peterson’s farm at an agreed-on price and Peterson, the vendor, delivers a deed to the farm to Lincoln. In this situation, the vendor has completely performed, making the contract enforceable despite its oral nature. Exception: Part Performance (Action in Reliance) by the Vendee LO16-2 Explain the exceptions to the statute of frauds.

When the vendee (purchaser of land) acts in clear reliance on an oral contract for the sale of land, an equitable doctrine commonly known as the “part performance doctrine” permits the vendee to enforce the contract notwithstanding the fact that it was oral. The doctrine recognizes that a person’s conduct can “speak louder than words” and can indicate the existence of a contract almost as well as a writing can. The part performance doctrine is also based on the desire to avoid the injustice that would otherwise result if the contract were repudiated after the vendee’s reliance. Under § 129 of the Restatement (Second) of Contracts, a contract for the transfer of an interest in land can be enforced even without a writing if the person seeking enforcement: 1. Has reasonably relied on the contract and on the other party’s assent. 2. Has changed his position to such an extent that enforcement of the contract is the only way to prevent injustice. In other words, the vendee must have acted in reliance on the contract and the nature of the action must be such that restitution (returning his money) would not be an adequate remedy. The part performance doctrine will not permit the vendee to collect damages for breach of contract, but it will permit him to obtain the equitable remedy of specific performance, a remedy whereby the court orders the breaching party to perform his contract.2 Specific performance is discussed in more detail in Chapter 18.

2

A vendee’s reliance on an oral contract could be shown in many ways. Traditionally, many states have required that the vendee pay part or all of the purchase price and either make substantial improvements on the property or take possession of it. For example, Contreras and Miller orally enter into a contract for the sale of Contreras’s land. If Miller pays Contreras a substantial part of the purchase price and either takes possession of the land or begins to make improvements on it, the contract would be enforceable without a writing under the part performance doctrine. These are not the only sorts of acts in reliance that would make an oral contract enforceable, however. Under the Restatement (Second) approach, if the promise to transfer land is clearly proven or is admitted by the breaching party, it is not necessary that the act of reliance include making payment, taking possession, or making improvements.3 It still is necessary, however, that the reliance be such that restitution would not be an adequate remedy. For this reason, a vendee’s payment of the purchase price, standing alone, is usually not sufficient for the part performance doctrine.

Contracts That Cannot Be Performed within One Year A bilateral, executory contract that,

according to its terms, cannot be performed within one year from the day on which it comes into existence is within the statute of frauds and must be evidenced by a writing. The apparent purpose of this provision is to guard against the risk of faulty or willfully inaccurate recollection of long-term contracts. Courts have tended to construe it very narrowly. One aspect of this narrow construction is that most states hold that a contract that has been fully performed by one of the parties is “taken out of the statute of frauds” and is enforceable without a writing. For example, Nash enters into an oral contract to perform services for Thomas for 13 months. If Nash has already fully performed his part of the contract, Thomas will be required to pay him the contract price. In addition, this provision of the statute has been held to apply only when the terms of the contract make it impossible for the contract to be completed within one year. If the contract is for an indefinite period of time, it is not within the statute of frauds. This is true even if, in retrospect, the contract was not completed within a year. Thus, Weinberg’s agreement to work for Wolf for an indefinite period of time would not have to be evidenced by a writing, even if Weinberg eventually works for Wolf for many years. The mere fact that performance is unlikely to be completed in one year does not bring the contract within the statute of frauds. Browning v. Poirier, which follows shortly, provides an illustration of the principles noted above. Restatement (Second) of Contracts § 129, comment d.

3



Chapter Sixteen Writing

In most states, a contract “for life” is not within the statute of frauds because it is possible—because death is an uncertain event—for the contract to be performed within a year. In a few states, contracts for life are within the statute of frauds. Computing Time In determining whether a contract is within the one-year provision, courts begin counting time on the day when the contract comes into existence. If, under the terms of the contract, it is possible to perform it within one year from this date, the contract does not fall within the statute of frauds and does not have to be in writing. If, however, the terms of the contract make it impossible to

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complete performance of the contract (without breaching it) within one year from the date on which the contract came into existence, the contract falls within the statute and must meet its writing requirement to be enforceable. Thus, if Hammer Co. and McCrea orally agree on August 1, 2020, that McCrea will work for Hammer Co. for one year, beginning October 1, 2020, the terms of the contract dictate that it is not possible to complete performance until October 1, 2021. Because that date is more than one year from the date on which the contract came into existence, the contract falls within the statute of frauds and must be evidenced by a writing to be enforceable.

Browning v. Poirier   113 So. 3d 976 (Fla. Dist. Ct. App. 2013) Beginning in 1991, Howard Browning and Lynn Anne Poirier lived together in a romantic relationship. In approximately 1993, the parties entered into an oral agreement in which they agreed to purchase lottery tickets on a regular basis and to share equally in the proceeds of any winning tickets. While the two were still co-habitating, Poirier purchased a winning lottery ticket on June 2, 2007, and won $1,000,000, minus deductions for taxes. Poirier refused to share.  When Browning requested half of the proceeds and Poirier refused, he sued her for breach of contract. Browning alleged their agreement was to apply whether the tickets were purchased “together, separately, in different locations, or at different times. . . .” Browning’s breach of contract claim further alleged that “[t]his agreement was capable of being performed within one (1) year” and that the agreement had been “reaffirmed and/or ratified several times orally and by the parties’ conduct since 1993.” At trial, Browning testified that he and Poirier would go in and buy lottery tickets together, play together, and that if either were to win, “we would split the money.” He claimed that Poirier had purchased the $1 million winning ticket when they had stopped at the convenience store together to buy more tickets for the upcoming lottery drawing on July 4, 2007. He claimed to have given Poirier $20 with which to purchase the ticket and that they had both purchased tickets that night. Browning conceded that their agreement was to be effective only as long as they were in a romantic relationship, and he had friendships with other women. At the close of Browning’s case, prior to any findings by the trier of fact, the trial court granted a directed verdict for Poirier, holding that the breach of oral contract action was barred as a matter of law by the statute of frauds because it was not in writing as required for a contract “not to be performed within the space of 1 year from the making thereof . . .” (citing Fla. Stat. section 725.01). Browning appealed the directed verdict.

Jacobus, Judge

No action shall be brought . . . upon any agreement that is not to be performed within the space of 1 year from the making thereof . . . unless the agreement or promise upon which such action shall be brought, or some note or memorandum thereof, shall be in writing and signed by the party to be charged therewith or by some other person by her or him thereunto lawfully authorized.

The fact that a contract may not be performed within a year does not bring it within the statute. “In other words, to make a parol contract void, it must be apparent that it was the understanding of the parties that it was not to be performed within a year from the time it was made.” Id. Contracts for an indefinite period generally do not fall within the statute of frauds. Id.; Restatement (Second) of Contracts  § 130 cmt. (a) (1981) (“Contracts of uncertain duration are simply excluded; the provision covers only those contracts whose performance cannot possibly be completed within a year.”). As the court explained in Yates:

The general rule is that the statute of frauds bars enforcement of oral contracts which by their terms are not to be performed within a year. Yates v. Ball, 132 Fla. 132, 181 So. 341, 344 (1937).

When, as in this case, no definite time was fixed by the parties for the performance of their agreement, and there is nothing in its terms to show that it could not be performed within a year

The threshold issue presented by this case is whether Browning’s action [for breach of contract] is barred by the statute of frauds. We hold that it is not. The statute provides in relevant part that:

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Part Three Contracts

according to its intent and the understanding of the parties, it should not be construed as being within the statute of frauds. Id. . . . In arguing that enforcement of the contract was barred by statute, Poirier . . . contends that the parties did not intend for the agreement to be fully performed within one year as it was a “perpetual” agreement with no termination date. The flaw in her argument is the assumption that the agreement was intended to be “perpetual.” It was simply an agreement for an indefinite term which, according to Browning’s testimony, was to continue as long as the parties were involved in a romantic relationship. Although the parties contemplated that the relationship would last more than one year, there was nothing in the agreement, which was terminable at will, to show that it could not be performed within one year, or which required performance for a period of time exceeding one year. Hence, Browning’s suit for breach of contract is not barred by the statute (citations omitted). . . . Reversed and remanded. Sawaya, Judge, concurring in part, dissenting in part This case involves two romantically involved individuals who allegedly agreed to split the proceeds of any lottery tickets they purchased, only to have the eventual winning ticket split their romance. The purchaser of the winning ticket is Lynn Anne Poirier, the Appellee. The claimant of half of the proceeds is Howard Browning, the Appellant. Browning testified at trial that he and Poirier became romantically involved in 1991 and started living together that year. He further testified that in 1993, they entered into an oral agreement to split the proceeds of any lottery tickets they may purchase and that this agreement was to last as long as they remained romantically involved. Some fourteen years after the alleged agreement was made and while the parties were still romantically involved and living together, Poirier purchased the winning ticket, collected one million dollars, and refused Browning’s request for half of the proceeds. The displeased and disgruntled Browning then filed the underlying suit for breach of contract and unjust enrichment seeking half of the proceeds. Poirier denied the existence of any oral agreement to split future lottery proceeds and interposed the defense of the statute of frauds. The trial court directed a verdict in favor of Poirier concluding that if there was an oral agreement, Browning’s claim is barred because the parties intended it to last for far longer than one year. Browning appeals, arguing that factual issues remain that should be resolved by a jury and asks us to reverse the judgment in favor of Poirier and remand this case for a new trial. The majority holds that the alleged oral contract to share lottery winnings is not barred by the statute of frauds and remands for a new trial only on the issue of whether the oral agreement was entered into by the parties. That holding is based on reasoning that it was possible that the alleged oral contract could have

been performed within the statutory one-year performance period and, therefore, the statute does not apply to bar the claim for breach of the agreement. I believe the key factor to determine the applicability of the statute to this alleged oral contract which, as the majority concedes, is for an indefinite period of time, is whether the parties intended that the contract extend beyond the one-year statutory period. What the parties intended is a question that should be left to the jury to resolve.  . . . The courts have consistently applied the rule that when an alleged oral contract is for an indefinite period of time, the determining factor is whether the parties intended the contract to extend beyond the one year statutory period (citations omitted). The courts have construed the statutory language found in section 725.01 “not to be performed within the space of one year” to refer to the express intent of the parties at the time they make the oral contract (citations omitted).  Therefore, when an oral contract is for an indefinite period, the court must determine whether it was the intent of the parties that the contract be fully performed within one year. The district courts have consistently followed this rule (citations omitted). The intent of the parties is a fact question that should be resolved by the finder of fact (citations omitted). The object to be accomplished was to win the lottery. The circumstances surrounding the alleged oral agreement was that it would last for as long as the parties remained romantically involved. The record reveals that the romantic relationship lasted many years after the date the agreement was allegedly made and that is a factor that can be considered in determining what the parties intended at the time the agreement was made (citations omitted). The majority applies the “possible” principle reasoning that it was possible that one of the parties would win the lottery and they would end their relationship within the year performance period. Appellant goes so far as to argue that it was possible that the agreement “could have been completed within 1 year based on the fact that either party could have died during the year. . . .” In Hesston Corp. v. Roche, 599 So. 2d 148, 153 (Fla. 5th DCA 1992), this court explained that even if it is possible to perform an alleged oral contract within one year, it must be shown that the parties intended and expected performance within the year. . . .  Hence, if it was possible to perform the alleged oral agreement in one year, there is no evidence that the parties intended or expected that. To the contrary, it does not take an advanced degree in statistics or mathematics to know that the odds of winning the lottery are very slim and the odds of winning it within a year period are even slimmer. I think it stretches the “possible” principle too far to suggest that two people would enter into an agreement to split lottery winnings intending that they would both win and end their relationship either voluntarily or by death within the year period. At least death is an eventual certainty and



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the only question is when it will happen. I believe that applying the “possible” principle to this case offends the admonition enunciated in Yates and many other cases that “[t]he statute should be strictly construed to prevent the fraud it was designed to correct, and so long as it can be made to effectuate this purpose, courts should be reluctant to take cases from its protection.” Yates, 181 So. 2d at 344. The majority remands this case for trial so the jury can decide whether the parties entered into the alleged oral agreement. I think that in order to determine whether the alleged oral agreement was made, the jury will have to determine the terms and conditions of the alleged agreement, including what the parties intended the duration of the agreement to be. Unlike the majority, I believe those findings should determine whether the statute of frauds applies in the instant case. Finally, I would note that even Appellant requests remand for trial so the jury can decide whether the agreement was entered into and whether the parties intended it to extend beyond the year period. I, therefore, concur in the decision to reverse the judgment in favor of Poirier and to remand this case for a new trial. Regarding the part of the majority opinion that declares the statute of

frauds inapplicable, I respectfully dissent because I believe that is an issue for the trier of fact to decide. This case ultimately came before the Florida Supreme Court to resolve the question of whether a terminable-at-will agreement to pool lottery winnings is unenforceable in the absence of an express agreement to continue the agreement for a period of time exceeding one year, when full performance of the agreement is possible within one year from the inception of the agreement. The Court answered this question in the negative, upholding the majority opinion authored by Judge Jacobus and reiterating that because the oral agreement between Browning and Poirier was of indefinite duration and could have possibly been performed within one year, it falls outside the statute of frauds. Relying on its interpretation of Yates, the Court explained that if Browning or Poirier had purchased a winning lottery ticket and split the proceedings before the expiration of one year, the agreement would have been fully performed before the expiration of one year. Alternatively, either Browning or Poirier could have ended the agreement at any time. Thus, judging from the time the oral contract was made, nothing in the terms of their contract demonstrated that it could not be performed within one year.

The original English Statute of Frauds required a writing for contracts for the sale of goods for a price of 10 pounds sterling or more. In the United States today, the writing requirement for the sale of goods is governed by § 2-201 of the Uniform Commercial Code. This section provides that contracts for the sale of goods for the price of $500 or more are not enforceable without a writing or other specified evidence that a contract was made. There are a number of alternative ways of satisfying the requirements of § 2-201. These will be explained later in this chapter.

they later modify the contract by increasing the contract price to $510, the modification falls within the statute of frauds and must meet its requirements to be enforceable.

Modifications of Existing Sales Contracts Just as some contracts to extend the time for performance fall within the one-year provision of the statute of frauds, agreements to modify existing sales contracts can fall within the statute of frauds if the contract as modified is for a price of $500 or more.4 UCC § 2-209(3) provides that the requirements of the statute of frauds must be satisfied if the contract as modified is within its provisions. For example, if Carroll and Kestler enter into a contract for the sale of goods at a price of $490, the original contract does not fall within the statute of frauds. However, if See UCC §2-209(3). Modifications of sales contracts are discussed in greater detail in Chapter 12. 4

Promise of Executor or Administrator to Pay a Decedent’s Debt Personally When

a person dies, a personal representative is appointed to administer his estate. One of the important tasks of this personal representative, called an executor if the person dies leaving a will or an administrator if the person dies without a will, is to pay the debts owed by the decedent. No writing is required when an executor or administrator— acting in her representative capacity—promises to pay the decedent’s debts from the funds of the decedent’s estate. The statute of frauds requires a writing, however, if the executor, acting in her capacity as a private individual rather than in her representative capacity, promises to pay one of the decedent’s debts out of her own (the executor’s) funds. For example, Anne, who has been appointed executor of her Uncle Max’s estate, is presented with a bill for $10,500 for medical services rendered to Uncle Max during his last illness by the family physician, Dr. Friend. Feeling bad that there are not adequate funds in the estate to compensate Dr. Friend for his services, Anne

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CONCEPT REVIEW Contracts within the Statute of Frauds Exceptions (Situations in Which Contract Does Not Require a Writing)

Provision

Description

Marriage

Contracts, other than mutual promises to marry, where marriage is the consideration

—

Year

Bilateral contracts that, by their terms, cannot be performed within one year from the date on which the contract was formed

Full (complete) performance by one of the parties

Land

Contracts that create or transfer an ownership interest in real property

1. Full performance by vendor (vendor deeds property to vendees) or 2. “Part performance” doctrine: Vendee relies on oral contract—for example, by: a. Paying substantial part of purchase  price and b. Taking possession or making improvements

Executor’s promise

Executor promises to pay estate’s debt out of his own funds

—

Sale of goods at price  Contracts for the sale of goods for a contract of $500 or more (UCC  price of $500 or more; also applies to modifi§ 2-201) cations of contracts for goods where price as modified is $500 or more

See alternative ways of satisfying statute of frauds under UCC

Collateral contracts guaranty

“Main purpose” or “leading object” exception: Guarantor makes promise primarily for her own economic benefit

Contracts where promisor promises to pay the debt of another if the primary debtor fails to pay

promises to pay Dr. Friend from her own funds. Anne’s promise would have to be evidenced by a writing to be enforceable.

Contract in Which Marriage Is the Consideration The statute of frauds also requires a writing when marriage is the consideration to support a contract. The marriage provision has been interpreted to be inapplicable to agreements that involve only mutual promises to marry. It can apply to any other contract in which one party’s promise is given in exchange for marriage or the promise to marry on the part of the other party. This is true whether the promisor is one of the parties to the marriage or a third party. For example, if Hank promises to deed his ranch to Edna in exchange for Edna’s agreement to marry Hank’s son, Edna could not enforce Hank’s promise without written evidence of the promise.

Prenuptial (or antenuptial) agreements present a common contemporary application of the marriage provision of the statute of frauds. These are agreements between couples who contemplate marriage. They usually involve such matters as transfers of property, division of property upon divorce or death, and various lifestyle issues. Assuming that marriage or the promise to marry is the consideration supporting these agreements, they are within the statute of frauds and must be evidenced by a writing.5 Note, however, that “nonmarital” agreements between unmarried cohabitants who do not plan marriage are not within the marriage provision of the statute of frauds, even though the agreement may pertain to the same sorts of matters that are typically covered in a prenuptial agreement. 5



Chapter Sixteen Writing

Meeting the Requirements of the Statute of Frauds LO16-3

Explain how to satisfy the statute of frauds under both the common law and UCC.

Nature of the Writing Required The statutes

of frauds of the various states are not uniform in their formal requirements. However, most states require only a memorandum of the parties’ agreement; they do not require that the entire contract be in writing. Essential terms of the contract must be stated in the writing. The memorandum must provide written evidence that a contract was made, but it need not have been created with the intent that the memorandum itself would be binding. In fact, in some cases, written offers that were accepted orally have been held sufficient to satisfy the writing requirement. Typical examples include letters, e-mails, telegrams, receipts, or any other writing indicating that the parties had a contract. The memorandum need not be made at the same time the contract comes into being; in fact, the memorandum may be made at any time before suit is filed. If a memorandum of the parties’ agreement is lost, its loss and its contents may be proven by oral testimony. Contents of the Memorandum Although there is a general trend away from requiring complete writings to satisfy the statute of frauds, an adequate memorandum must still contain several things. The essential terms of the contract generally must be indicated in the memorandum. States differ in their requirements concerning how specifically the terms must be stated, however. The identity of the parties must be indicated in some way, and the subject matter of the contract must be identified with reasonable certainty. This last requirement causes particular problems in contracts for the sale of land because many statutes require a detailed description of the property to be sold. Contents of Memorandum under the UCC The standard for determining the sufficiency of the contents of a memorandum is more flexible in cases concerning contracts for the sale of goods. This looser standard is created by UCC § 2-201, which states that the writing must be sufficient to indicate that a contract for sale has been made between the parties, but that a writing can be sufficient even if it omits or incorrectly states a term agreed on. However, the memorandum is not enforceable for more than the quantity of goods stated in the memorandum. Thus, a writing that does not indicate the quantity of goods to be sold would not satisfy the Code’s writing requirement.

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Signature Requirement The memorandum must be signed by the party to be charged or his authorized agent. (The party to be charged is the person using the statute of frauds as a defense—generally the defendant unless the statute of frauds is asserted as a defense to a counterclaim.) This means that it is not necessary for purposes of meeting the statute of frauds for both parties’ signatures to appear on the document. It is, however, in the best interests of both parties for both signatures to appear on the writing; otherwise, the contract evidenced by the writing is enforceable only against the signing party. Unless the statute expressly provides that the memorandum or contract must be signed at the end, the signature may appear anywhere on the memorandum. Any writing, mark, initials, stamp, engraving, electronic signature, or other symbol placed or printed on a memorandum will suffice as a signature, as long as the party to be charged intended it to authenticate (indicate the genuineness of) the writing. Memorandum Consisting of Several Writings In many situations, the elements required for a memorandum are divided among several documents. For example, Wayman and Allen enter into a contract for the sale of real estate, intending to memorialize their agreement in a formal written document later. While final drafts of a written contract are being prepared, Wayman repudiates the contract. Allen has a copy of an unsigned preliminary draft of the contract that identifies the parties and contains all of the material terms of the parties’ agreement, an unsigned note written by Wayman that contains the legal description of the property, and a letter signed by Wayman that refers to the contract and to the other two documents. None of these documents, standing alone, would be sufficient to satisfy the statute of frauds. However, Allen can combine them to meet the requirements of the statute, provided that they all relate to the same agreement. This can be shown by physical attachment, as where the documents are stapled or bound together, or by references in the documents indicating that they all apply to the same transaction. In some cases, it has also been shown by the fact that the various documents were executed at the same time. LO16-3

Explain how to satisfy the statute of frauds under both the common law and UCC.

LOG ON You can learn more about e-signatures in this article: Ennis & Green, Electronic Signatures: Not So Fast, www.americanbar.org/groups/litigation/ committees/commercial-business/practice/2019/ electronic-signatures-contracts-agreements/

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UCC: Alternative Means of Satisfying the Statute of Frauds in Sale of Goods Contracts As you have learned, the basic requirement

of the UCC statute of frauds [2-201] is that a contract for the sale of goods for the purchase price of $500 or more must be evidenced by a written memorandum that indicates the existence of the contract, states the quantity of goods to be sold, and is signed by the party to be charged. Recognizing that the underlying purpose of the statute of frauds is to provide more evidence of the existence of a contract than the mere oral testimony of one of the parties, however, the Code also permits the statute of frauds to be satisfied by any of four other types of evidence. These different methods of satisfying the UCC statute of frauds are depicted in Figure 6.2. Under the UCC, then, a contract for the sale of goods for a purchase price of $500 or more is enforceable even in the absence of a suitable written memorandum, if the evidence makes applicable any of the following alternative ways of satisfying the statute of frauds: 1. Confirmatory memorandum between merchants. Suppose Gardner and Roth enter into a contract over the telephone for the sale of goods at a price of $5,000. Gardner then sends a memorandum to Roth confirming the deal they made orally. If Roth receives the memo and does not object to it, it would be fair to say that the parties’ conduct provides some evidence that a contract exists. Under some circumstances, the UCC permits such confirmatory memoranda to satisfy the statute of frauds even though the writing is signed by the party who is seeking to enforce the contract rather than the party against whom enforcement is sought [2-201(2)]. This exception applies only when both of the parties to a contract are merchants. Furthermore, the memo must be sent within a reasonable time after the contract is made and must be sufficient to bind the person who sent it if enforcement were sought against him (that is, it must indicate that a contract was made, state a quantity, and be signed by the sender). If the party against whom enforcement is sought receives the memo, has reason to know its contents, and yet fails to give written notice of objection to the contents of the memo within 10 days after receiving it, the memo can be introduced to meet the requirements of the statute of frauds. 2. Part payment or part delivery. Suppose Rice and Cooper enter into a contract for the sale of 1,000 units of goods at $1 each. After Rice has paid $600, Cooper refuses to deliver the goods and asserts the statute of frauds as a defense to enforcement of the contract. The Code permits part payment or part delivery to satisfy the statute of frauds, but only for the quantity of goods that have

been delivered or paid for [2-201(3)(c)]. Thus, Cooper would be required to deliver only 600 units rather than the 1,000 units Rice alleges that he agreed to sell. 3. Admission in pleadings or court. Another situation in which the UCC statute of frauds can be satisfied without a writing occurs when the party being sued admits the existence of the oral contract in his trial testimony or in any document that he files with the court. For example, Nelson refuses to perform an oral contract he made with Smith for the sale of $2,000 worth of goods, and Smith sues him. If Nelson admits the existence of the oral contract in pleadings or in court proceedings, his admission is sufficient to meet the statute of frauds. This exception is justified by the strong evidence that such an admission provides. After all, what better evidence of a contract can there be than is provided when the party being sued admits under penalty of perjury that a contract exists? When such an admission is made, the statute of frauds is satisfied as to the quantity of goods admitted [2-201(3)(b)]. For example, if Nelson admits contracting only for $1,000 worth of goods, the contract is enforceable only to that extent. 4. Specially manufactured goods. Finally, an oral contract within the UCC statute of frauds can be enforced without a writing in some situations involving the sale of specially manufactured goods. This exception to the writing requirement will apply only if the nature of the specially manufactured goods is such that they are not suitable for sale in the ordinary course of the seller’s business. Completely executory oral contracts are not enforceable under this exception. The seller must have made a substantial beginning in manufacturing the goods for the buyer, or must have made commitments for their procurement, before receiving notice that the buyer was repudiating the sale [2-201(3)(a)]. For example, Bennett Co. has an oral contract with Stevenson for the sale of $2,500 worth of calendars imprinted with Bennett Co.’s name and address. If Bennett Co. repudiates the contract before Stevenson has made a substantial beginning in manufacturing the calendars, the contract will be unenforceable under the statute of frauds. If, however, Bennett Co. repudiated the contract after Stevenson had made a substantial beginning, the oral contract would be enforceable. The specially manufactured goods provision is based both on the evidentiary value of the seller’s conduct and on the need to avoid the injustice that would otherwise result from the seller’s reliance. The Green Garden case, which follows shortly, deals with whether the statute of frauds has been satisfied in regard to an oral contract for the sale of goods for at least $500.



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Figure 16.2 Satisfying the Statute of Frauds through a Contract for the Sale of Goods with a Price of $500 or More

Is the contract evidenced by a sufficient Written Memorandum signed by the party to be charged?

Yes

Contract satisfies the statute of frauds.

Yes

Contract satisfies the statute of frauds.

Yes

Contract is enforceable up to quantity of goods paid for or delivered.

Yes

Contract satisfies the statute of frauds.

Yes

Contract is enforceable up to the quantity of goods admitted.

No If both parties are Merchants, has there been a sufficient Confirmatory Memorandum, to which the party to be charged has not objected within 10 days? No

Has either party made Part Payment or Part Delivery that has been accepted by the other party?

No Are the goods contracted for Specially Manufactured Goods that the seller has already substantially begun producing or procuring and that he cannot resell in the ordinary course of his business? No

Has the party to be charged Admitted the Contract under oath?

No

Contract is unenforceable because it violates the statute of frauds.

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Part Three Contracts

CYBERLAW IN ACTION E-Signatures and the Statute of Frauds The necessity of being able to prove the existence of a contract is as great online as it is in offline transactions. When we communicate or transact business online, we cannot depend on the traditional means of authenticating a contract—reading a person’s distinctive signature, seeing the face, or hearing the voice of the other party, for example. Practical questions flow from this state of affairs, such as how can we be sure that a transmission arrives in the same condition as it left the sender and that it has not been altered or forged? Technologies to increase security online have been developed and new ones are emerging all the time. One method of increasing security in electronic transmissions is the use of digital signatures. A digital signature is an electronic identifier that tells a person receiving the document whether it is genuinely from the sender and whether it has been altered in any way. It is important to note that a digital signature is not an electronic image of a person’s signature or a person’s name typed out. Rather, digital signatures employ encryption technology to create a unique identifier for a sender that can be verified by the receiver. The absence of traditional authentication methods raises legal questions as well, such as whether a contract formed electronically, through e-mail or on an e-tailer’s website, satisfies the statute of frauds. Few courts have dealt with this issue. However, the vast majority of states have enacted some form of legislation to accommodate formal legal requirements to the realities of e-commerce. The trouble is that this legislation has not been uniform. Some states’ legislation has been tied to a particular technology, such as recognizing only digital signatures as satisfying legal requirements. The Uniform Electronic Transactions Act (UETA) takes a different approach. It is a proposed uniform state law that was designed

to “remove barriers to electronic commerce by validating and effectuating electronic records and signatures.”6 It is not tied to any particular technology. The UETA states that an “electronic signature” (defined as an “electronic sound, symbol, or process attached to or logically associated with an electronic record and executed or adopted by a person with the intent to sign the electronic record”) satisfies any law requiring a signature. Thus, digital signatures, which are one form of electronic signature, would satisfy the UETA, but so would a more commonplace symbol or event such as a typewritten name at the end of an e-mail or a click of a mouse. The UETA has been enacted in nearly all states and the District of Columbia. Against the background of lack of uniformity in state law, the federal government enacted the Electronic Signatures in Global and National Commerce Act (E-Sign) in 2000. E-Sign provides that in transactions that are in or affecting interstate commerce, “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,” nor can “a contract relating to such a transaction be denied legal effect, validity, or enforceability solely because an electronic signature or electronic record was used in its formation.” As does the UETA, E-Sign broadly interprets the concept of electronic signature—using, in fact, the same statutory definition of electronic signature as that which is used in the UETA. E-Sign overrides any state law that is inconsistent with the UETA, thus helping to harmonize U.S. law about the interaction of formal requirements such as the statute of frauds and electronic contracts. The most recent legal development in this area occurred in December 2018 at the federal level with passage of the 21st Century Integrated Digital Experience Act (IDEA), which required the head of each executive federal agency to accelerate use of electronic signatures under E-Sign. Uniform Electronic Transactions Act, Prefatory Note (1999).

6

Green Garden Packaging Co. v. Schoenmann Produce Co.    2010 Tex. App. LEXIS 8887 (Tex. Ct. App. Nov. 4, 2010)

Green Garden Packaging Co. is a wholesale producer of fresh-cut vegetables, fruits, and ready-made products, including salad kits. It develops and owns equipment, recipes, and manufacturing processes for use in producing these items. Schoenmann Produce Co. distributes fresh and packaged food items and produce to various clients, including the Houston Independent School District (HISD). In order to fulfill a produce contract it had with HISD, Schoenmann began purchasing food items from Green Garden in 2005. In the spring of 2007, HISD was compiling competitive bids on the produce contract. According to Green Garden, Schoenmann asked Green Garden to provide its items “exclusively” to Schoenmann in exchange for Schoenmann’s agreement to use Green Garden as the supplier of these items if HISD accepted Schoenmann’s bid. Based upon this agreement, Green Garden provided Schoenmann detailed written information on its products for use in preparing a bid to HISD. Green Garden prepared a confidentiality notice, which provided that Green Garden’s information and product specifications were “confidential” and “proprietary,” and then gave samples of its products to Schoenmann. Schoenmann submitted the confidentiality notice and the samples to HISD. Schoenmann was the only distributor to submit a compliant bid, and Schoenmann won the HISD contract for a one-year term beginning in August 2007. However, Schoenmann



Chapter Sixteen Writing

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did not purchase food items from Green Garden to fulfill the HISD contract, and it shared Green Garden’s specifications and confidential information with other suppliers. Green Garden sued Schoenmann, claiming that Schoenmann had breached its contract to purchase Green Garden products after using its trade secrets, samples, and other information in submitting the bid to HISD. Schoenmann filed a motion for partial summary judgment on Green Garden’s breach of contract claim, arguing that it was barred as a matter of law by the statute of frauds. The trial court granted Schoenmann’s summary judgment motion and Green Garden appealed. Jennings, Justice Schoenmann sought summary judgment under the statute of frauds for a contract for the sale of goods for the price of $500 or more. Section 2-201, which applies to a sale of goods, provides, (a) Except as otherwise provided in this section a contract for the sale of goods for the price of $500 or more is not enforceable by way of action or defense unless there is some writing sufficient to indicate that a contract for sale has been made between the parties and signed by the party against whom enforcement is sought or by his authorized agent or broker. . . . Here, it is undisputed that there is no writing evidencing the alleged agreement between Green Garden and Schoenmann. Moreover, the summary judgment evidence conclusively establishes that the alleged agreement that Green Garden seeks to enforce against Schoenmann was for a sale of goods that exceeded $500. Thus, § 2-201 applies to bar Green Garden’s breach of contract claim, unless an exception applies. Section 2-201 provides several statutory exceptions to the application of the statute of frauds. A contract for a sale of goods of $500 or more that does not satisfy the requirements of subsection (a) of section 2-201 but is valid in other respects is enforceable, (1) if the goods are to be specially manufactured for the buyer and are not suitable for sale to others in the ordinary course of the seller’s business and the seller, before notice of repudiation is received and under circumstances which reasonably indicate that the goods are for the buyer, has made either a substantial beginning of their manufacture or commitments for their procurement; or (2) if the party against whom enforcement is sought admits in his pleading, testimony or otherwise in court that a contract

Promissory Estoppel and the Statute of Frauds The statute of frauds, which was created to pre-

vent fraud and perjury, has often been criticized because it can create unjust results. While the statute exists to defeat

for sale was made, but the contract is not enforceable under this provision beyond the quantity of goods admitted; or (3) with respect to goods for which payment has been made and accepted or which have been received and accepted. However, none of these exceptions apply in this case. Green Garden did not specially manufacture any food items, Schoenmann has not admitted that a contract for sale of these food items was ever made, and there is no evidence that any payments were made or accepted or that any food items were received or accepted by Schoenmann. Green Garden asserts that it partially performed the contract; that “the essence of the agreement” was “the proprietary information, forms, and samples” it provided to Schoenmann during the bidding process; and that in its attempt to recover the lost profits from the produce contract, the “valuable consideration” it provided “could not possibly be separated apart from the goods that were then to be supplied if the HISD contract was obtained.” However, the agreement on which Green Garden seeks recovery is, at its core, an agreement that would have required Schoenmann to purchase food items, valued well in excess of $500, from Green Garden for a minimum of a one-year term. Although Green Garden has presented evidence that it exclusively provided Schoenmann with information and samples of its products in the course of the bidding process, and although Green Garden asserts that it did this pursuant to an agreement with Schoenmann, the only consideration Green Garden sought under its alleged agreement was Schoenmann’s purchase of goods from Green Garden. Such a contract plainly falls within § 2-201(a), and, without a writing to evidence the agreement, it is unenforceable under the statute of frauds. Accordingly, we hold that the trial court did not err in granting summary judgment on Green Garden’s breach of contract claim. Affirmed in favor of Schoenmann.

fictitious agreements, its harsh requirements present the possibility that it can be used to defeat a contract that was actually made. As you have seen, courts and legislatures have created several exceptions to the statute of frauds that

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Part Three Contracts

reduce the statute’s potential for creating unfair results. In recent years, courts in some states have allowed the use of the doctrine of promissory estoppel7 to enable some parties to recover under oral contracts that the statute of frauds would ordinarily render unenforceable. Courts in these states hold that, when one of the parties would suffer serious losses because of her reliance on an oral contract, the other party is estopped from raising the statute of frauds as a defense. This position has been approved in the Restatement (Second) of Contracts. According to § 139 of the Restatement (Second), a promise that induces action or forbearance can be enforceable notwithstanding the statute of frauds if the reliance was foreseeable to the person making the promise and if injustice can be avoided only by enforcing the promise. The idea behind this section and the cases employing promissory estoppel is that the statute of frauds, which is designed to prevent injustice, should not be allowed to work an injustice. Section 139 and these cases also impliedly recognize the fact that the reliance required by promissory estoppel to some extent provides evidence of the existence of a contract between the parties because it is unlikely that a person would materially rely on a nonexistent promise. The use of promissory estoppel as a means of circumventing the statute of frauds is still controversial, however. Many courts fear that enforcing oral contracts on the basis of a party’s reliance will essentially negate the statute. In cases involving the UCC statute of frauds, an additional source of concern involves the interpretation of § 2-201. Some courts have construed the provisions listing specific alternative methods of satisfying § 2-201’s formal requirements to be exclusive, precluding the creation of any further exceptions by courts.

The Parol Evidence Rule LO16-4

Explain the parol evidence rule and the exceptions to the rule.

Explanation of the Rule In

many situations, contracting parties prefer to express their agreements in writing even when they are not required to do so by the statute of frauds. Written contracts rarely come into being without some prior discussions or negotiations between the parties, however. Various promises, proposals, or representations are often made by one or both of the parties The doctrine of promissory estoppel is discussed in Chapters 9 and 12.

7

before the execution of a written contract. What happens when one of those prior promises, proposals, or representations is not included in the terms of the written contract? For example, suppose that Jackson wants to buy Stone’s house. During the course of negotiations, Stone states that he will pay for any major repairs that the house needs for the first year that Jackson owns it. The written contract that the parties ultimately sign, however, does not say anything about Stone paying for repairs, and, in fact, states that Jackson will take the house “as is.” The furnace breaks down three months after the sale, and Stone refuses to pay for its repair. What is the status of Stone’s promise to pay for repairs? The basic problem is one of defining the boundaries of the parties’ agreement. Are all the promises made in the process of negotiation part of the contract, or do the terms of the written document that the parties signed supersede any preliminary agreements? The parol evidence rule provides the answer to this question. The term parol evidence means written or spoken statements that are not contained in the written contract. The parol evidence rule provides that, when parties enter into a written contract that they intend as a complete integration (a complete and final statement of their agreement), a court will not permit the use of evidence of prior or contemporaneous statements to add to, alter, or contradict the terms of the written contract. This rule is based on the presumption that when people enter into a written contract, the best evidence of their agreement is the written contract itself. It also reflects the idea that later expressions of intent are presumed to prevail over earlier expressions of intent. In the hypothetical case involving Stone and Jackson, assuming that they intended the written contract to be the final integration of their agreement, Jackson would not be able to introduce evidence of Stone’s promise to pay for repairs. The effect of excluding preliminary promises or statements from consideration is, of course, to confine the parties’ contract to the terms of the written agreement. The lesson to be learned from this example is that people who put their agreements in writing should make sure that all the terms of their agreement are included in the writing. The Yung-Kai Lu case, which follows shortly, illustrates the application of the parol evidence rule.

Scope of the Parol Evidence Rule The

parol evidence rule is relevant only in cases in which the parties have expressed their agreement in a written contract. Thus, it would not apply to a case involving an oral contract or to a case in which writings existed that were not intended to embody the final statement of



Chapter Sixteen Writing

at least part of the parties’ contract. The parol evidence rule has been made a part of the law of sales in the Uniform Commercial Code [2-202], so it is applicable to contracts for the sale of goods as well as to contracts governed by the common law of contracts. Furthermore, the rule excludes only evidence of statements made prior to or during the signing of the written contract. It does not apply to statements made after the signing of the contract. Thus, evidence of subsequent statements is freely admissible. LO16-4

Explain the parol evidence rule and the exceptions to the rule.

Admissible Parol Evidence In

some situations, evidence of statements made outside the written contract is admissible notwithstanding the parol evidence rule. Parol evidence is permitted in the situations discussed below either because the writing is not the best evidence of the contract or because the evidence is offered, not to contradict the terms of the writing, but to explain the writing or to challenge the underlying contractual obligation that the writing represents. 1. Additional terms in partially integrated contracts. In many instances, parties will desire to introduce evidence of statements or agreements that would supplement rather than contradict the written contract. Whether they can do this depends on whether the written contract is characterized as completely integrated or partially integrated. A completely integrated contract is one that the parties intend as a complete and exclusive statement of their entire agreement. A partially integrated contract is one that expresses the parties’ final agreement as to some but not all of the terms of their contract. When a contract is only partially integrated, the parties are permitted to use parol evidence to prove the additional terms of their agreement. Such evidence cannot, however, be used to contradict the written terms of the contract. To determine whether a contract is completely or partially integrated, a court must determine the parties’ intent. A court judges intent by looking at the language of the contract, the apparent completeness of the writing, and all the surrounding circumstances. It will also consider whether the contract contains a merger clause (also known as an integration clause). These clauses, which are very common in form contracts and commercial contracts, provide that the written contract is the complete integration of the parties’ agreement. They are designed to prevent a party from giving testimony about prior statements or agreements and are generally effective

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in indicating that the writing was a complete integration. However, even if a contract contains a merger clause, parol evidence could be admissible when one of the following exceptions applies. 2. Explaining ambiguities. Parol evidence can be offered to explain an ambiguity in the written contract. Suppose a written contract between Lowen and Matthews provides that Lowen will buy “Matthews’s truck,” but Matthews has two trucks. The parties could offer evidence of negotiations, statements, and other circumstances preceding the creation of the written contract to identify the truck to which the writing refers. Used in this way, parol evidence helps the court interpret the contract. It does not contradict the written contract. 3. Circumstances invalidating contract. Any circumstances that would be relevant to show that a contract is not valid can be proven by parol evidence. For example, evidence that Holden pointed a gun at Dickson and said, “Sign this contract, or I’ll kill you,” would be admissible to show that the contract was voidable because of duress. Likewise, parol evidence would be admissible to show that a contract was illegal or was induced by fraud, misrepresentation, undue influence, or mistake. 4. Existence of condition. It is also permissible to use parol evidence to show that a writing was executed with the understanding that it was not to take effect until the occurrence of a condition (a future, uncertain event that creates a duty to perform). Suppose Farnsworth signs a contract to purchase a car with the agreement that the contract is not to be effective unless and until Farnsworth gets a new job. If the written contract is silent about any conditions that must occur before it becomes effective, Farnsworth could introduce parol evidence to prove the existence of the condition. Such proof merely elaborates on, but does not contradict, the terms of the writing. 5. Subsequent agreements. As you read earlier, the parol evidence rule does not forbid parties to introduce proof of subsequent agreements. This is true even if the terms of the later agreement cancel, subtract from, or add to the obligations stated in the written contract. The idea here is that when a writing is followed by a later statement or agreement, the writing is no longer the best evidence of the agreement. You should be aware, however, that subsequent modifications of contracts may sometimes be unenforceable because of lack of consideration or failure to comply with the statute of frauds. In addition, contracts sometimes expressly provide that modifications must be written. In this situation, an oral modification would be unenforceable.

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Part Three Contracts

CONCEPT REVIEW Parol Evidence Rule Parol Evidence Rule

Applies when:

Provides that:

Parties create a writing intended as a final and complete integration of  at least part of the parties’ contract.

Evidence of statements of promises made before  or during the creation of the writing cannot be  used to supplement, change, or contradict the  terms of the written contract.

But parol evidence can be 1. Prove consistent, additional terms when the contract is partially integrated. used to 2. Explain an ambiguity in the written contract. 3. Prove that the contract is void, voidable, or unenforceable. 4. Prove that the contract was subject to a condition. 5. Prove that the parties subsequently modified the contract or made a new agreement.

Yung-Kai Lu v. University of Utah   660 Fed. App’x. 573 (10th Cir. 2016) The University of Utah entered into a written agreement with Yung-Kai Lu, a citizen of Taiwan, in May 2010, agreeing to give him a doctoral-studies scholarship in return for Lu’s agreement to be a teaching assistant (the “contract”). The contract specified that scholarships and teaching assistant appointments are limited to “one academic year at a time” and that Lu’s appointment was “a nine-month appointment beginning August 16, 2010, and ending May 15, 2011.” Despite this limitation, Lu alleged that University Assistant Music Director Donn Schaefer verbally promised him that as long as he maintained a 3.00 GPA, the assistantship and scholarship would be renewed for the full three years Lu planned to study for his doctorate. In April 2011, Schaefer told Lu the contract wouldn’t be renewed because the university lacked sufficient funding. According to Lu, however, he was told the contract wouldn’t be renewed because of a report to university officials that he had been rude. Lu didn’t re-enroll for the next academic term, and his failure to enroll was reported to immigration officials. As a result, Lu’s visa wasn’t extended and he was deported to Taiwan.  Lu’s complaint against the university and university officials in their official capacities alleged they breached the contract and verbal promises, in addition to tort claims for slander, false statements, providing inaccurate information to immigration officials, and violations of the Taiwan Relations Act and International Covenant on Economic, Social and Cultural Rights. The defendants moved to dismiss the suit on the basis that Lu’s complaint failed to state any plausible claim as a matter of law. The trial court granted defendants’ motion, finding Lu lacked any plausible claim under international treaties and his tort claims were barred under the Eleventh Amendment and the Utah Governmental Immunity Act. Further, the court concluded that Lu failed to allege any plausible breach of contract claims given the contract’s unambiguous language as to the term of the contract. Additionally, the court reasoned that Utah’s parol evidence rule and statute of frauds barred any verbal promise to extend Lu’s appointment for three years. Lu made his appeal to the 10th Circuit Court of Appeals pro se. Moritz, Judge To survive a motion to dismiss, a complaint must contain sufficient factual matter, accepted as true, “to state a claim to relief that is plausible on its face” (citations omitted). . . . Because Lu proceeds pro se, we construe his complaint liberally, but pro se parties are “not relieved of the burden of alleging sufficient facts on which a recognized legal claim could be based” (citations omitted).

[The court dispensed with all ancillary legal allegations and then considered Lu’s contract-based claims.] Lu challenges the dismissal of his breach of contract claims. He argues Utah’s parol evidence rule doesn’t apply because the contract was an incomplete integrated contract. Contrary to Lu’s suggestion, the contract contained a complete, final expression as to the length of Lu’s scholarship and teaching assistant appointment. See Tangren Family Tr. v. Tangren, 182 P.3d 326, 330 (Utah 2008)



Chapter Sixteen Writing

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(defining an integrated agreement as “a writing . . . constituting a final expression of one or more terms of an agreement” and holding that an agreement reduced to writing is “conclusively presumed” to contain “the whole of the agreement between the parties”). Thus, the district court correctly ruled Utah’s parol evidence rule would bar admission of any pre-contract verbal agreement to extend the appointment past May 15, 2011. Citing language in the contract limiting doctoral students to three-year teaching assistant appointments, Lu argues the district court erred in applying the statute of frauds to bar his breach of contract claim. But the language Lu relies on does

not bind the parties to renewing the appointment for three years; instead, it simply states the outside limit on such reappointments. Thus, the district court correctly ruled that evidence of a verbal agreement to renew his appointment for two years after the May 2011 termination date would be barred by Utah’s statute of frauds. . . . Having found no error in the district court’s dismissal of Lu’s complaint, we affirm the dismissal for substantially the reasons stated by the district court in its order dated October 7, 2015.

Interpretation of Contracts

Sometimes, there is internal conflict in the terms of an agreement and courts must determine which term should prevail. When the parties use a form contract or some other type of contract that is partially printed and partially handwritten, the handwritten provisions will prevail. If the contract was drafted by one of the parties, any ambiguities will be resolved against the party who drafted the contract. If both parties to the contract are members of a trade, profession, or community in which certain words are commonly given a particular meaning (this is called a usage), the courts will presume that the parties intended the meaning that the usage gives to the terms they use. For example, if the word dozen in the bakery business means 13 rather than 12, a contract between two bakers for the purchase of 10 dozen loaves of bread will be presumed to mean 130 loaves of bread rather than 120. Usages can also add provisions to the parties’ agreement. If the court finds that a certain practice is a matter of common usage in the parties’ trade, it will assume that the parties intended to include that practice in their agreement. If contracting parties are members of the same trade, business, or community but do not intend to be bound by usage, they should specifically say so in their agreement.

Once a court has decided what promises are included in a contract, it is faced with interpreting the contract to determine the meaning and legal effect of the terms used by the parties. Courts have adopted broad, basic standards of interpretation that guide them in the interpretation process. The court will first attempt to determine the parties’ principal objective. Every clause will then be determined in the light of this principal objective. Ordinary words will be given their usual meaning and technical words (such as those that have a special meaning in the parties’ trade or business) will be given their technical meaning, unless a different meaning was clearly intended. Guidelines grounded in common sense are also used to determine the relationship of the various terms of the contract. Specific terms that follow general terms are presumed to qualify those general terms. Suppose that a provision that states that the subject of the contract is “guaranteed for one year” is followed by a provision describing the “one-year guarantee against defects in workmanship.” Here, it is fair to conclude that the more specific term qualifies the more general term and that the guarantee described in the contract is a guarantee of workmanship only, and not of parts and materials.

Judgment affirmed.

Ethics and Compliance in Action For those who draft and present standardized form contracts to the other contracting party, the parol evidence rule can be a powerful ally because it has the effect of limiting the scope of an integrated, written contract to the terms of the writing. Although statements and promises made to a person before she signs a contract might be highly influential in persuading her to enter the contract, the

parol evidence rule effectively prevents these precontract communications from being legally enforceable. Consider also that standardized form contracts are usually drafted by, and for the benefit of, the more sophisticated and powerful party in a contract (e.g., the landlord rather than the tenant, the bank rather than the customer). Considering all of this, do you believe that the parol evidence rule promotes ethical behavior?

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Part Three Contracts

Problems and Problem Cases 1. In August 2003, R.F. Cunningham & Co., a farm products dealer, and Driscoll, a farmer in Cayuga County, entered into an oral contract for the sale of 4,000 bushels of soybeans at a price of $5.50 per bushel, to be picked up after harvest time. Immediately afterward, Cunningham sent to Driscoll a “purchase confirmation,” and Driscoll did not object to its contents. In October 2003, with his attorney asserting that he had no legal obligation to perform, Driscoll refused to sell his soybeans to Cunningham. As a result, Cunningham was forced to purchase replacement soybeans at the then-prevailing market price of $7.74 per bushel. Cunningham suffered a financial loss of $8,960.00, which was the difference between the contract price and Cunningham’s costs to obtain the replacement soybeans. Cunningham sued Driscoll for breach of contract. Driscoll moved for summary judgment on the ground that the contract did not satisfy the statute of frauds. Did he win?

condition.” Regarding his retirement plans, Hodge later testified, “I really questioned whether I was going to go much beyond 65.” Hodge later accepted Evans’s offer of employment as vice president and general counsel. He moved from Pittsburgh to Washington, D.C., in ­September 1980 and worked for Evans from that time until he was fired by Tilley on May 7, 1981. Hodge brought a breach of contract lawsuit against Evans. Evans argued that the oral contract was unenforceable because of the statute of frauds. Was Evans correct?

2. In July 2008, the Fuglebergs agreed to purchase from Triangle Ag 352.5 tons of urea fertilizer at a cost of $660 per ton and 135 tons of MES-15 fertilizer at a cost of $1,100 per ton. No terms of the contract were put in writing. The Fuglebergs prepaid the $381,150 purchase amount. The Fuglebergs later contended that Triangle’s agents told them at the time they agreed to the purchase that they could rescind the contract at any time by remitting $50 for each ton of undelivered fertilizer plus payment of accrued interest. In ­November 2008, the Fuglebergs attempted to rescind the contract with Triangle, but Triangle refused to cancel the contract, stating that it had already ordered the fertilizer. The Fuglebergs filed suit against Triangle for rescission and other claims. Both parties admitted the existence of the contract in court. One of Triangle’s defenses was that the statute of frauds barred the Fuglebergs’ contract claims. Did it?

4. Wintersport Ltd. contacted Millionaire.com Inc. to offer advertising, production, and printing ser­vices for Millionaire.com’s magazine, Opulence. Wintersport and Millionaire.com entered into a $170,000 contract for the printing of one monthly issue in October 2000. They performed that contract and launched negotiations to print the next month’s issue. Strong, senior vice president of Millionaire.com, and Leiter, president of Wintersport, handled most of the negotiations and communications. Due to financial difficulties, Millionaire.com reduced the size of its order for the second issue and requested payment terms on the reduced price of $80,000. Concerned about Millionaire.com’s creditworthiness, Leiter told Strong that Wintersport would extend credit to Millionaire.com only if Millionaire.com paid a $10,000 down payment and Millionaire.com’s CEO (White) personally guaranteed the balance due. During a phone call between their respective offices in Washington and South Carolina, Leiter requested and received White’s oral agreement to the personal guaranty. Leiter then sent a confirming fax to White’s office, and White express mailed to Wintersport a $10,000 check drawn on Millionaire.com’s account. When Millionaire.com failed to pay the amount due on the contract, Wintersport filed suit against White and others. White argued that the action should have been dismissed because the statute of frauds prevented the enforcement of his oral guaranty. Was he correct?

3. On two occasions in 1980, Hodge met with Tilley, president and chief operating officer of Evans Financial Corporation, to discuss Hodge’s possible employment by Evans. Hodge was 54 years old at that time and was assistant counsel and assistant secretary of Mellon National Corporation and Mellon Bank of Pittsburgh. During these discussions, Tilley asked Hodge what his conditions were for accepting employment with Evans, and Hodge replied, “Number 1, the job must be permanent. Because of my age, I have a great fear about going back into the marketplace again. I want to be here until I retire.” Tilley allegedly responded, “I accept that

5. Carrow owned a farm and Arnold and Mitchell, who were partners in a real estate partnership, were interested in buying it. In mid-April 2003, they met with Carrow at his farm. At this meeting, Carrow expressed reservations about selling the farm. Arnold offered Carrow $1.2 million for the farm, but Carrow declined. During their discussions, Arnold told Carrow that if he sold Arnold the farm, he could continue to live on the farm and till the land as long as Arnold owned it. Approximately a week later, Arnold and Mitchell returned to the farm and negotiated with Carrow over the terms and conditions of a sale. During these negotiations,



Chapter Sixteen Writing

Carrow again expressed reservations about selling the farm because he did not want to leave it. Carrow testified that Arnold assured him that “Nothing would ever change for you, nothing. . . .” and that Carrow could “go right on farming this farm the rest of your life. . . .” Carrow claimed that Arnold assured him that he wanted to buy the land to use strictly as a hunting farm. He understood this to mean that Arnold did not intend to develop the property or to transfer it any time in the near future. Carrow later testified that he would not have sold the farm without these representations. Arnold admitted that during various stages of the negotiations he assured Carrow that Carrow could continue to live on and farm the land and that he would never develop it. He also agreed that he told Carrow that he wanted the land for hunting purposes. According to Arnold, however, in making this and other assurances to Carrow, he always included the qualifier “as long as I own it.”    After some bargaining, Carrow agreed to sell the farm to Arnold for $1.4 million, not including the farm equipment. Arnold returned to the farm and left a draft of a written contract with Carrow. Carrow put the contract on a shelf and did not discuss it with anyone for approximately one week. Although he saw provisions in the draft agreement that he did not like, he did not pay too much attention to it and did not “look at [the agreement] like I should have.” Carrow did not seek the advice of an attorney or tell his adult children that he was selling the farm. He instead sought the assistance of his accountant. In late April, Carrow and Arnold met in the accountant’s office to discuss the proposed contract. Carrow expressed reservations about certain provisions in the contract, and the parties changed those provisions in response to Carrow’s concerns. At the conclusion of the meeting, the parties signed the Agreement and Arnold gave Carrow a $200,000 deposit. Within days of executing the Agreement, Arnold and Mitchell began to have the land surveyed for subdivision. Mitchell submitted plans to county officials to have the land approved for residential development. Arnold and Mitchell testified that they never had any intention to develop the land, but submitted the plans to the county because the land would be more valuable if approved for residential development. By early May, Carrow was having reservations about selling his farm, so he called Arnold and told him that he wanted to return the deposit. Arnold replied that Carrow could not back out of the deal. Carrow asserted that he did not know Arnold and Mitchell were professional real estate developers and that he began to reconsider the

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agreement after he saw surveyors on various parts of the property. Carrow sued Arnold and Mitchell based on the representations made to him before the contract was signed. Was he successful? 6. According to the Chavezes, they entered into a May 1998 verbal agreement with Bravo to purchase a home located in Alamo, Texas, for $65,000, payable through a $2,000 down payment and monthly installments of $500. The Chavezes moved into the home and made monthly payments to Bravo from June 1998 until December 2005. They also made a number of repairs. When Bravo died, his widow sold the Alamo home to Cantu. After obtaining ownership of the home, Cantu gave the Chavezes notice to vacate the premises. Cantu and Mrs. Bravo claimed that the monthly payments from the Chavezes were rent and that no contract of sale was ever consummated. The Chavezes filed suit against Mrs. Bravo and Cantu, seeking a determination that they had an enforceable contract with Bravo and were wrongfully evicted. Cantu and Mrs. Bravo asserted that the statute of frauds barred enforcement of any contract. The Chavezes claimed that they provided partial performance, making the oral contract valid. Did the Chavezes win? 7. John Jacobs, the owner of Sataria Distribution and Packaging, met with Mark Hinkel in August 2005 to discuss the possibility that Hinkel might go to work for Sataria instead of continuing to work for the two companies that employed him. Although Jacobs offered Hinkel a job with Sataria, Hinkel had reservations. According to Hinkel, Jacobs told him, “Mark, are you worried that I’ll f*** you? If so, and things don’t work, I’ll pay you one year’s salary and cover your insurance for one year as well. But let me make it clear, should you decide this is not for you, and you terminate your own employment, then the agreement is off.” Jacobs later sent Hinkel the following written job offer:

Dear Mark,

This is written as an offer of employment. The terms are as described below:

1. Annual Compensation: $120,000



2. Work Location: Belmont Facility



3. Initial Position: Supervisor Receiving Team



4. Start Date: 08/19/2005



5. Paid Vacation: To be determined



6. Health Insurance: Coverage begins 09/01/2005 pending proper enrollment submission



Please sign and return.

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Part Three Contracts

   Hinkel signed the offer, returned it to Jacobs, and resigned from his two other jobs. He began working at Sataria in September 2005. Hinkel claimed in the lawsuit referred to later that Jacobs reiterated the abovenoted severance promise in November 2005. Sataria terminated Hinkel’s employment on January 23, 2006. Thereafter, Sataria paid Hinkel six weeks of severance compensation. Hinkel sued Sataria for breach of contract, claiming that Sataria owed him the full severance package that Jacobs promised him in August and again in November. The trial court granted Sataria’s motion for summary judgment. Was the court correct in doing so? 8. In July 2004, the Harrises entered into a contract with the Hallbergs to purchase the Hallbergs’ home in Waccabuc, New York, for the sum of $1.9 million. Later, the Harrises had second thoughts about the purchase. In November 2004, the Harrises and the Hallbergs signed an agreement that provided that, upon the forfeiture of the Harrises’ down payment, “all contractual obligations” that the parties owed each other under the contract of sale would be terminated and each party would “have no further obligation” toward the other. The release was consistent with the terms of the contract of sale, which had specified the Hallbergs’ remedy in the event of a default by the Harrises. Both parties were represented by independent counsel during the transaction. Mr. Harris was a lawyer. Later, the Harrises alleged that prior to signing the release, the parties ente­red into an oral agreement whereby the Hallbergs agreed that if they could sell the property for more than $1.9 million, they would return all or part of the Harrises’ down payment. The Harrises alleged that the Hallbergs sold the property for $2.4 million but had refused to return any part of the down payment. Did the Harrises have the legal right to enforce the alleged oral agreement for the return of the down payment? 9. Roose hired the law firm of Gallagher, Langlas, and Gallagher P.C. to represent her in her divorce. Langlas, an attorney in the firm, signed an attorney fee contract and gave it to Roose to sign and return. He also requested a $2,000 retainer fee. Roose never signed or returned the contract and did not pay the retainer fee in full. The firm represented Roose even though she did not sign the contract or pay the retainer fee in full. In April 1995, the Gallagher attorneys met with Roose and her father, Burco. The attorneys told Burco that the expense of his daughter’s child custody trial would be approximately $1,000 per day. The firm would not guarantee Burco

that the trial would last for only two or three days. The firm later contended that during the meeting, Burco gave the firm a check for $1,000 to pay the outstanding balance on Roose’s account and said he would pay for future services. Before the trial, an attorney with the firm contacted Burco and requested an additional retainer to secure fees to be incurred. Burco told her, “My word as a gentleman should be enough . . . I told Mr. Langlas I would pay and I will pay.” Roose failed to pay her legal fees. In July 1995, the attorneys sent Burco a letter requesting either $5,000 for Roose’s legal fees or the signing of a promissory note. At the end of July 1995, they sent Burco another letter asking him to sign a promissory note for $10,000. Neither Roose nor Burco paid the fees or signed the note. The firm represented Roose in the July 1995 trial. Burco took an active part in the trial by testifying and participating in conferences with counsel during recesses. After trial, Burco returned the second letter and promissory note with a notation stating that he was not responsible for his daughter’s attorney fees. The firm sued Roose and Burco for the unpaid fees. Was Burco legally responsible for the fees? 10. Rosenfeld, an art dealer, claimed that Jean-Michel Basquiat, an acclaimed neoexpressionist artist, had agreed to sell her three paintings titled Separation of the “K,” Atlas, and Untitled Head. She claimed that she went to Basquiat’s apartment on October 25, 1982; that while she was there he agreed to sell her three paintings for $4,000 each; and that she picked out the three works. According to Rosenfeld, Basquiat asked for a cash deposit of 10 percent. She left his loft and later returned with $1,000 in cash, which she paid him. When she asked for a receipt, he insisted on drawing up a “contract,” and got down on the floor and wrote it out in crayon on a large piece of paper, remarking that “some day this contract will be worth money.” She identified a handwritten document listing the three paintings, bearing her signature and that of Basquiat, which stated: “$12,000—$1,000 DEPOSIT—OCT 25 82.” Was this writing sufficient to satisfy the statute of frauds? 11. St. Jude Medical S.C. is a medical device manufacturer. In July 2001, Jennifer Schaadt began working as a product manager in St. Jude’s Cardiac Rhythm Management Division. By all accounts, she performed well. Eventually, however, she became frustrated by what she regarded as sexual harassment and other sex discrimination within her division, so she applied for and obtained a position in St. Jude’s



Chapter Sixteen Writing

U.S. Sales Division (USD). Schaadt began working in USD as a field marketing manager in May 2004. Shortly after she started her new position, upper management in USD asked Schaadt and all other field marketing managers to sign a written contract containing nonsolicitation and confidentiality provisions. In return for agreeing to those provisions, the field marketing managers—who otherwise would have been employees at will—were to be given one-year terms of employment. The contract required St. Jude to employ Schaadt for a minimum of one year and prohibited Schaadt from soliciting St. Jude’s employees for one year after the termination of her employment with St. Jude. USD provided the agreement to Schaadt and asked her to sign it. Schaadt alleged in the litigation referred to below that she signed the agreement, but there was no proof that any representative of St. Jude signed it.  After Schaadt had conflicts with her supervisor in USD, she began looking for another job. Before Schaadt could obtain other employment, however, she was fired. The firing occurred less than one year from the time of the agreement referred to above. Schaadt sued St. Jude for breach of contract. St. Jude moved for summary judgment on the ground that Schaadt’s breach of contract claim was barred by the statute of frauds. How did the court rule? 12. In July 2002, attorneys Linscott, Shasteen, and Brock formed a law firm and two years later drafted a proposed shareholder agreement specifying how attorney fees would be divided if any of the three left the firm. The proposed agreement contemplated that the departing attorney would receive a one-third share of all fees collected from existing in-process, open cases and that the firm would receive two-thirds. The proposed agreement was never executed, and in 2004 Linscott left the firm at the request of Shasteen and Brock, who offered to honor the proposed

16-23

agreement for distribution of fees. From September 17, 2004, through January 10, 2005, Linscott sent 42 fee checks to Shasteen and Brock. Likewise, starting on ­September 20, 2004, and continuing through December 28, 2004, Shasteen and Brock sent 26 fee checks to Linscott. According to Brock, the exchange of fees was done without his knowledge, and when he learned of the arrangement, he ordered it to stop. Shasteen and Brock ceased sending checks on December 28, 2004, and Linscott filed a breach of contract lawsuit. In court, Shasteen and Brock argued that any implied contract was void under the statute of frauds as the time period from the break-up of the firm until the time of trial was over seven years. Based on these facts, was there an implied contract and could it have been performed within one year?   13. HVAC Inc., a contractor that installs and services air handling equipment, was sued by Jacco & Associates for breach of contract after HVAC canceled an order and refused to pay the $23,000 cancelation fee. In court, HVAC argued that certain delivery obligations (not specified in the original contract) had not been met by Jacco, and thus, HVAC had a valid defense for canceling the order and refusing to pay Jacco’s fee. Jacco argued that HVAC’s claims regarding failure to deliver by a certain date constituted parol evidence not permissible in light of the contract’s “Terms and Conditions for Sale” provision, which stated: “The terms and conditions stated herein constitute the full understanding between Jacco & Associates and the buyer, and no terms, conditions, understanding or agreement purporting to modify or vary these terms shall be binding unless hereafter made in writing by Jacco and the buyer.” Furthermore, the contract also included a provision that “Jacco & Associates does not guarantee a particular date of shipment or delivery.” If Jacco is successful in court, what will be the court’s rationale?

C H A P T E R 17

Rights of Third Parties

P

eterson was employed by Post-Network as a newscaster-anchor on station WTOP-TV Channel 9 under a three-year employment contract with two additional one-year terms at the option of Post-Network. During the first year of Peterson’s employment, Post-Network sold its operation license to Evening News in a sale that provided for the assignment of all contracts, including Peterson’s employment contract. Peterson continued working for the station for more than a year after the change of ownership but then found a job at a competing station and resigned. Evening News sued Peterson for breach of the employment contract. • Can a person who was not an original party to a contract sue to enforce it? • Was the assignment of Peterson’s employment contract a valid transfer, or does Peterson have a right not to have his employment transferred to another employer? • Does Peterson have any right to enforce the contract between Post-Network and Evening News? • Would it be ethical for Evening News to prevent Peterson from changing jobs and working for a competing station?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 17-1 Explain the concept of assignment and the consequences of an assignment. 17-2 Explain the concept of delegation and the consequences of a delegation.

IN PRECEDING CHAPTERS, WE have emphasized the way in which an agreement between two or more people creates legal rights and duties on the part of the contracting parties. Because a contract is founded on the consent of the contracting parties, it might seem to follow that they are the only ones who have rights and duties under the contract. Although this is generally true, there are two situations in which people who were not parties to a contract have legally enforceable rights under it: when a contract has been assigned (transferred) to a third party and when a contract is intended to benefit a third person (a third-party beneficiary). This chapter discusses the circumstances in which third parties have rights under a contract.

17-3 Explain the concept of third-party beneficiary and distinguish among the three kinds of thirdparty beneficiaries.

Assignment of Contracts LO17-1

Explain the concept of assignment and the consequences of an assignment.

Contracts give people both rights and duties. If Murphy buys Wagner’s motorcycle and promises to pay him $1,000 for it, Wagner has the right to receive Murphy’s promised performance (the payment of the $1,000), and Murphy has the duty to perform the promise by paying $1,000. In most situations, contract rights can be transferred to a third person and contract duties can be delegated to a third person.

17-2

Part Three Contracts

The transfer of a right under a contract is called an assignment. The appointment of another person to perform a duty under a contract is called a delegation.

Nature of Assignment of Rights A

person who owes a duty to perform under a contract is called an obligor. The person to whom he owes the duty is called the obligee. For example, Samson borrows $500 from Jordan, promising to repay Jordan in six months. Samson, who owes the duty to pay the money, is the obligor, and Jordan, who has the right to receive the money, is the obligee. An assignment occurs when the obligee transfers his right to receive the obligor’s performance to a third person. When there has been an assignment, the person making the assignment—the original obligee—is then called the assignor. The person to whom the right has been transferred is called the assignee. Figure 17.1 summarizes these key terms. Suppose that Jordan, the obligee in the example above, assigns his right to receive Samson’s payment to Kane. Here, Jordan is the assignor and Kane is the assignee. The relationship between the three parties is represented in Figure 17.2. Notice that the assignment is a separate transaction: It occurs after the formation of the original contract. The effect of the assignment is to extinguish the assignor’s right to receive performance and to transfer that right to the assignee. In the above example, Kane now owns the right to collect payment from Samson. If Samson fails to pay, Kane, as an assignee, now has the right to file suit against Samson to collect the debt.

People assign rights for a variety of reasons. A person might assign a right to a third party to satisfy a debt that he owes. For example, Jordan, the assignor in the above example, owes money to Kane, so he assigns to Kane the right to receive the $500 that Samson owes him. A person might also sell or pledge the rights owed to him to obtain financing. In the case of a business, the money owed to the business by customers and clients is called accounts receivable. A business’s accounts receivable are an asset to the business that can be used to raise money in several ways. For example, the business may pledge its accounts receivable as collateral for a loan. Suppose Ace Tree Trimming Co. wants to borrow money from First Bank and gives First Bank a security interest (an interest in the debtor’s property that secures the debtor’s performance of an obligation) in its accounts receivable.1 If Ace defaults in its payments to First Bank, First Bank will acquire Ace’s rights to collect the accounts receivable. A person might also make an assignment of a contract right as a gift. For example, Lansing owes $2,000 to Father. Father assigns the right to receive Lansing’s performance to Son as a graduation gift. Evolution of the Law Regarding Assignments Contract rights have not always been transferable. Early common law refused to permit assignment or delegation because debts were considered to be too personal to transfer. A debtor who failed to pay an honest debt was subject to severe penalties, including imprisonment, because such a failure to pay was viewed as the equivalent of theft.

Figure 17.1 Assignment: Key Terms Obligor

Obligee

Assignment

Assignor

Assignee

Person who owes the duty to perform

Person who has the right to receive obligor’s performance

Transfer of the right to receive obligor’s performance

Obligee who transfers the right to receive obligor’s performance

Person to whom the right to receive obligor’s performance is transferred

Figure 17.2 Assignment Before assignment Owes duty to perform Obligor

Obligee

Assignment Transfers right to receive obligor’s performance Obligee (Assignor)

Assignee

Result of assignment Owes duty to perform Obligor

Assignee

Security interests in accounts and other property are discussed in  Chapter 29. 1



Chapter Seventeen Rights of Third Parties

The identity of the creditor was of great importance to the debtor because one creditor might be more lenient than another. Courts also feared that the assignment of debts would stir up unwanted litigation. In an economy that was primarily land-based, the extension of credit was of relatively small importance. As trade increased and became more complex, however, the practice of extending credit became more common. The needs of an increasingly commercial society demanded that people be able to trade freely in intangible assets such as debts. Consequently, the rules of law regarding the assignment of contracts gradually became more liberal. Today, public policy favors free assignability of contracts. Sources of Assignment Law Today Legal principles regarding assignment are found not only in the common law of contracts but also in Articles 2 and 9 of the Uniform Commercial Code. Section 2-210 of Article 2 contains principles applicable to assignments of rights under a contract for the sale of goods. Article 9 governs security interests in accounts and other contract rights as well as the outright sale of accounts. Article 9’s treatment of assignments will be discussed in more detail in Chapter 29, Security Interests in Personal Property, but some provisions of Article 9 relating to assignments will be discussed in this chapter.

Creating an Assignment An assignment can be

made in any way that is sufficient to show the assignor’s intent to assign. No formal language is required, and a writing is not necessary unless required by a provision of the statute of frauds or some other statute. Many states do have statutes requiring certain types of assignments to be

17-3

evidenced by a writing, however. Additionally, an assignment for the purposes of security must meet Article 9’s formal requirements for security interests.2 It is not necessary that the assignee give any consideration to the assignor in exchange for the assignment. Gratuitous assignments (those for which the assignee gives no value) are generally revocable until such time as the obligor satisfies the obligation, however. They can be revoked by the assignor’s death or incapacity or by notification of revocation given by the assignor to the assignee.

Assignability of Rights Most, but not all, con-

tract rights are assignable. Although the free assignability of contract rights performs a valuable function in our modern credit-based economy, assignment is undesirable if it would adversely affect some important public policy or if it would materially vary the bargained-for expectations of the parties. There are several basic limitations on the assignability of contract rights. First, an assignment will not be effective if it is contrary to public policy. For example, most states have enacted statutes that prohibit or regulate a wage earner’s assignment of future wages. These statutes are designed to protect people against unwisely impoverishing themselves by signing away their future incomes. State law may prohibit assignment of lottery prizes or certain kinds of lawsuits on grounds of public policy. The court in the following Sogeti USA case considers if an assignment of a noncompete agreement to a successor employer violates public policy when the employee never agreed to the assignment. These requirements are discussed in Chapter 29.

2

Sogeti USA LLC v. Scariano   606 F. Supp. 2d 1080 (D. Ariz. 2009) Christian Martinez was originally employed by Software Architects Inc. (SARK), with whom he signed an employment agreement containing a noncompetition provision (restrictive covenant). The provision said nothing about assignability. Sogeti acquired SARK in March 2007. Martinez became Sogeti’s employee at that time. While Sogeti was not a party to the employment agreement between SARK and Martinez, it alleges that SARK’s rights under the restrictive covenant were assigned to Sogeti as part of the acquisition. Martinez resigned his employment with Sogeti in 2008 and went to work for Neudesic LLC a few days afterward. Sogeti sued Martinez and others, alleging that Martinez violated the restrictive covenant by working for Neudesic and recruiting Sogeti’s employees to do the same. The defendants filed a motion to dismiss for failure to state a claim, arguing that Martinez’s express consent was required for a valid assignment of his employment contract. Silver, U.S. District Judge Whether an employee’s express consent is required before an employment contract can be assigned to a successor company employer is a question of first impression in Arizona. Under

Arizona law, contractual rights are generally assignable unless the assignment is precluded by the contract, is forbidden by public policy, or materially alters the duties of the obligor. Moreover, an obligor’s assent is not necessary to make an assignment effective.

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Part Three Contracts

Jurisdictions outside Arizona disagree on whether an employee must consent to the assignment of a restrictive covenant prior to enforcement by a successor company. a. Jurisdictions Requiring Express Consent Some jurisdictions require express consent because a restrictive covenant contained in an employment agreement is “personal” to the employee. The jurisdictions do not explicitly define “personal” as used in this context. However, the term appears to refer to a contract in which the promisor (employee) agrees to limit a right so fundamental to his liberty that the law presumes the ­promisor only agreed to bind himself in that way because the promisor knows and trusts the identity of the promisee (employer). Addressing the issue as a matter of first impression, the Supreme Court of Nevada held a restrictive covenant is “unassignable absent an express clause permitting assignment.” A similar conclusion was reached in Pennsylvania, where the court held that, because restrictive covenants are “personal” to the employee, they are not assignable absent employee consent. b. Jurisdictions Not Requiring Express Consent Other jurisdictions support the enforcement of restrictive covenants in employment contracts by successor companies even when the contract is silent as to assignability. In these jurisdictions, contractual rights are generally assignable, the “personal” nature of an employment contract ends following termination, and restrictive covenants are scrutinized to ensure reasonableness in scope or duration. In an Illinois case, for example, a successor company could enforce restrictive covenants against several employees who left to work for a competitor even though the employment contracts were silent on assignability. The same reasoning was applied in a case involving stylists at a hair salon who challenged the ability of a successor company to enforce restrictive covenants. Analyzing the dispute in a context supportive of the general assignability of contractual rights, the court rejected

Second, an assignment will not be effective if it adversely affects the obligor in some significant way. An assignment is ineffective if it materially changes the obligor’s duty or increases the burden or risk on the obligor. Naturally, any assignment will change an obligor’s duty to some extent. The obligor will have to pay money or deliver goods or render some other performance to one party instead of to another. These changes are not considered to be sufficiently material to render an assignment ineffective. Thus, a right to receive money or goods or land is generally assignable. In addition, covenants not to compete are generally considered to be assignable to buyers of businesses. For example, Jefferson sells RX Drugstore

authority requiring express consent, stating such a position is based on “certain quaint notions of employment contracts” requiring the employee to know “the character and personality of his master” before agreeing to a restrictive covenant. Additional jurisdictions allow a successor company to enforce a restrictive covenant in personal services contracts following a merger or acquisition, because a mere change in the nature of the business is not enough to prevent enforcement of a restrictive covenant by a successor company even when the contract is silent on assignability. Arizona law is most consistent with the jurisdictions that allow successor companies to enforce restrictive covenants, even when the contract is silent regarding assignability and the employee has not consented. Like those jurisdictions, Arizona law favors the enforcement and assignment of contractual rights, does not disfavor restrictive covenants in employment agreements, and allows such restrictive covenants to be assigned. Arizona courts treat restrictive covenants in employment agreements as assignable assets enforceable by successor companies, not as highly personalized arrangements between employee and employer. Arizona law has a distinct focus, less concerned with the personal relationship between employer and employee and more concerned with protecting employees from overreaching or other unconscionable arrangements, scrutinizing restrictive covenants for whether they are “unreasonable . . . demonstrate bad faith, or contravene public policy.” The Court agrees with the holding of the Northern ­District of Illinois which found, in the absence of “precedent holding that restrictive covenants may never be assigned without consent . . . new public policy restrictions on contractual rights” should not be created. As such, absent a contrary ruling by an Arizona court, express consent of an employee is not required before an employer’s contractual rights can be assigned to, and enforced by, a successor company. Defendants’ motion to dismiss denied in favor of Sogeti.

to Waldman, including in the contract of sale a covenant whereby Jefferson promises not to operate a competing drugstore within a 30-mile radius of RX for 10 years after the sale. Waldman later sells RX to Tharp. Here, Tharp could enforce the covenant not to compete against Jefferson. The reason for permitting assignment of covenants not to compete is that the purpose of such covenants is to protect an asset of the business—goodwill—for which the buyer has paid. An assignment could be ineffective because of its variation of the obligor’s duty, however, if the contract right involved a personal relationship or an element of personal skill, judgment, or character. For this reason, contracts



Chapter Seventeen Rights of Third Parties

of employment in which an employee works under the direct and personal supervision of an employer cannot be assigned to a new employer. An employer could assign a contract of employment, however, if the assignee-employer could perform the contract without adversely affecting the interests of the employee, such as would be the case when an employment relationship does not involve personal supervision by an individual employer. A purported assignment is ineffective if it significantly increases the burden of the obligor’s performance. For example, if Walker contracts to sell Dwyer all of its requirements of wheat, a purported assignment of Dwyer’s rights to a corporation that has much greater requirements of wheat would probably be ineffective because it would significantly increase the burden on Walker. Contract Clauses Prohibiting Assignment A contract right may also be nonassignable because the original contract expressly forbids assignment. For example, leases often contain provisions forbidding assignment or requiring the tenant to obtain the landlord’s permission for assignment.3 Antiassignment clauses in contracts are generally enforceable. Because of the strong public policy favoring assignability, however, such clauses are often interpreted The assignment of leases is discussed further in Chapter 25.

3

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narrowly. For example, a court might view an assignment made in violation of an antiassignment clause as a breach of contract for which damages may be recovered but not as an invalidation of the assignment. Another tactic is to interpret a contractual ban on assignment as prohibiting only the delegation of duties. The UCC takes this latter position. Under section 2-210(2), general language prohibiting assignment of “the contract” or “all my rights under the contract” is interpreted as forbidding only the delegation of duties, unless the circumstances indicate to the contrary. Section 2-210 also states that a right to damages for breach of a whole sales contract or a right arising out of the assignor’s performance of his entire obligation may be assigned even if a provision of the original sales contract prohibited assignment. In addition, UCC section 9-318(4) invalidates contract terms that prohibit (or require the debtor’s consent to) an assignment of an account or creation of a security interest in a right to receive money that is now due or that will become due. As the following Filer case illustrates, however, specific enough antiassignment language will bar a purported assignee from exercising rights under a contract.   And much rides on whether a purported assignment of accounts receivable is for a security interest or simply for purposes of collection on the account.

Filer, Inc. v. Staples, Inc.   766 F. Supp. 2d 314 (D. Mass. 2011) In 2006, Staples Inc., the office supplies retailer, entered into two manufacturing and purchase agreements with Hwa Fuh Plastics Co., Ltd. (HFP), whose president held the patent on a particular style of file folders. The agreements set out the terms and conditions for the sale of products and manufacturing services from HFP to Staples. Each agreement included a choice of law clause, providing that Massachusetts law would govern the agreement. The following year, however, the relationship between HFP and Staples deteriorated. Staples alleged that HFP unilaterally demanded an increase in the sales price for the file folders in contravention of the procedures outlined in the agreements and that HFP delayed and withheld shipments of file folders, which disrupted Staples’s supply chain and caused product shortages. As a result, Staples purchased substitute products from an alternative supplier. In November 2009, HFP purportedly assigned its rights under the agreements with Staples to Filer Inc. On June 11, 2010, Filer filed a complaint against Staples for breach of contract in the U.S. District Court for the Central District of California. Staples moved for a transfer of venue to the District of Massachusetts, pursuant to the choice of law clause, which the California court granted. In the Massachusetts court, Staples filed counterclaims against both Filer and HFP and moved for summary judgment of Filer’s breach of contract claim, arguing that Filer had no rights under the contract because the purported assignment of HFPs rights to Filer was prohibited by the agreements’ provisions regarding assignments. Stearns, District Judge The parties do not dispute that the Agreements contain provisions governing assignments. In the first agreement, the assignment clause states: “Staples may assign in whole or in part its rights and obligations hereunder to any other entity. Without

the prior written consent of Staples, Manufacturer [HFP] shall not transfer or assign this Agreement or any rights or obligations thereunder.” Similarly, the assignment clause in the second agreement reads: “Staples may assign in whole or in part its rights and obligations hereunder to any other entity without Company’s

17-6

Part Three Contracts

[HFP’s] consent. Without the prior written consent of Staples, Company [HFP] shall not transfer or assign this Agreement or any rights or obligations thereunder.” It is undisputed that Staples has not consented to the assignment of HFP’s rights or obligations under the Agreements. Staples contends that these clauses governing assignment (or non-assignment, with respect to HFP) are valid and enforceable. . . . Staples argues that because the Agreements bar any assignment from HFP to Filer, Filer holds no legal rights under either of the Agreements and therefore cannot maintain a breach of contract claim. Filer, for its part, argues that the non-assignment clauses are rendered unenforceable by Uniform Commercial Code (U.C.C.) § 9-406(d), which is entitled, “Term restricting assignment generally ineffective.” However, as Staples points out, Article 9 of the U.C.C. applies to secured transactions (obligations the payment of which is guaranteed by the borrower’s pledge of collateral), while HFP’s assignment of rights to Filer involved a transfer of “certain accounts receivable” from HFP to Filer. An assignment of an account exclusively for the purpose of collection is not governed by Article 9 of the U.C.C. See Mass. Gen.

Laws Ann. ch. 106, § 9-109(d) (“This article shall not apply to: . . . an assignment of accounts, chattel paper, payment intangibles, or promissory notes which is for the purpose of collection only.”); see also In re Gull Air, Inc., 90 B.R. 10, 14 n.4 (Bankr. D. Mass. 1988) (“An assignment of an account which is for the purpose of collection only or a transfer of an account to an assignee in whole or partial satisfaction of a pre-existing indebtedness is not subject to Article 9 of the Uniform Commercial Code.”). Because the HFP assignment to Filer is for the purpose of collection, in satisfaction of a pre-existing indebtedness, it is not subject to Article 9 of the U.C.C. Moreover, as the non-assignment clauses in the Agreements are valid and enforceable, Filer holds no legal rights under either of the Agreements and cannot maintain a breach of contract claim.

Nature of Assignee’s Rights When an assign-

obligor who does not have reason to know of the assignment could render performance to the assignor and claim that his obligation had been discharged by performance. An obligor who renders performance to the assignor without notice of the assignment has no further liability under the contract. For example, McKay borrows $500 from Goodheart, promising to repay the debt by June 1. Goodheart assigns the debt to Rogers, but no one informs McKay of the assignment, and McKay pays the $500 to Goodheart, the assignor. In this case, McKay is not liable for any further payment. But if Rogers had immediately notified McKay of the assignment and, after receiving notice, McKay had mistakenly paid the debt to Goodheart, McKay would still have the legal obligation to pay $500 to Rogers. Having been given adequate notice of the assignment, he may remain liable to the assignee even if he later renders performance to the assignor. An assignor who accepts performance from the obligor after the assignment holds any benefits that he receives as a trustee for the assignee. If the assignor fails to pay those benefits to the assignee, however, an obligor who has been notified of the assignment and renders performance to the wrong person may have to pay the same debt twice. An obligor who receives notice of an assignment from the assignee will want to assure himself that the assignment has in fact occurred. He may ask for written evidence of the

ment occurs, the assignee is said to “step into the shoes of his assignor.” This means that the assignee acquires all of the rights that his assignor had under the contract. The assignee has the right to receive the obligor’s performance, and if performance is not forthcoming, the assignee has the right to sue in his own name for breach of the obligation. By the same token, the assignee acquires no greater rights than those possessed by the assignor. Because the assignee has no greater rights than did the assignor, the obligor may assert any defense or claim against the assignee that he could have asserted against the assignor, subject to certain time limitations discussed below. A contract that is void, voidable, or unenforceable as between the original parties does not become enforceable just because it has been assigned to a third party. For example, if Richards induces Dillman’s consent to a contract by duress and subsequently assigns his rights under the contract to Keith, Dillman can assert the doctrine of duress against Keith as a ground for avoiding the contract. Importance of Notifying the Obligor An assignee should promptly notify the obligor of the assignment. Although notification of the obligor is not necessary for the assignment to be valid, such notice is of great practical importance. One reason notice is important is that an

*** ORDER For the foregoing reasons, Staples’s motion for summary judgment . . . is ALLOWED. . . . SO ORDERED.



Chapter Seventeen Rights of Third Parties

assignment or contact the assignee and ask for verification of the assignment. Under UCC section 9-318(3), a notification of assignment is ineffective unless it reasonably identifies the rights assigned. If requested by the account debtor (an obligor who owes money for goods sold or leased or services rendered), the assignee must furnish reasonable proof that the assignment has been made, and, unless he does so, the account debtor may disregard the notice and pay the assignor. Defenses against the Assignee An assignee’s rights in an assignment are subject to the defenses that the obligor could have asserted against the assignor. Keep in mind that the assignee’s rights are limited by the terms of the underlying contract between the assignor and the obligor. When defenses arise from the terms or performance of that contract, they can be asserted against the assignee even if they arise after the obligor receives notice of the assignment. For example, on June 1, Worldwide Widgets assigns to First Bank its rights under a contract with Widgetech, Inc. This contract obligates Worldwide Widgets to deliver a quantity of widgets to Widgetech by September 1, in return for which Widgetech is obligated to pay a stated purchase price. First Bank gives prompt notice of the assignment to Widgetech. Worldwide Widget fails to deliver the widgets and Widgetech refuses to pay. If First Bank brought an action against Widgetech to recover the purchase price of the widgets, Widgetech could assert Worldwide Widget’s breach as a defense, even though the breach occurred after Widgetech received notice of the assignment.4 In determining what other defenses can be asserted against the assignee, the time of notification plays an important role. After notification, as we discussed earlier, payment by the obligor to the assignor will not discharge the obligor.

Subsequent Assignments An

assignee may “reassign” a right to a third party, who would be called a subassignee. The subassignee then acquires the rights held by the prior assignee. He should give the obligor prompt notice of the subsequent assignment because he takes his interest subject to the same principles discussed above

Similarly, if the assignor’s rights were subject to discharge because of other factors such as the nonoccurrence of a condition, impossibility, impracticability, or public policy, this can be asserted as a defense against the assignee even if the event occurs after the obligor receives notice of assignment. See Restatement (Second) of Contracts § 336(3). The doctrines relating to discharge from performance are explained in Chapter 18. 4

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regarding the claims and defenses that can be asserted against him.

Successive Assignments Notice to the obligor

may be important in one other situation. If an assignor assigns the same right to two assignees in succession, both of whom pay for the assignment, a question of priority results. An assignor who assigns the same right to different people will be held liable to the assignee who acquires no rights against the obligor, but which assignee is entitled to the obligor’s performance? Which assignee will have recourse only against the assignor? There are several views on this point. In states that follow the “American rule,” the first assignee has the better right. This view is based on the rule of property law that a person cannot transfer greater rights in property than he owns. In states that follow the “English rule,” however, the assignee who first gives notice of the assignment to the obligor, without knowledge of the other assignee’s claim, has the better right. The Restatement (Second) of Contracts takes a third position. Section 342 of the Restatement (Second) provides that the first assignee has priority unless the subsequent assignee gives value (pays for the assignment) and, without having reason to know of the other assignee’s claim, does one of the following: obtains payment of the obligation, gets a judgment against the obligor, obtains a new contract with the obligor by novation, or possesses a writing of a type customarily accepted as a symbol or evidence of the right assigned (such as a passbook for a savings account).

Assignor’s Warranty Liability to Assignee  Suppose that Ross, a 16-year-old boy, contracts to buy a used car for $2,000 from Donaldson. Ross pays Donaldson $500 as a down payment and agrees to pay the balance in equal monthly installments. Donaldson assigns his right to receive the balance of the purchase price to Beckman, who pays $1,000 in cash for the assignment. When Beckman later attempts to enforce the contract, however, Ross disaffirms the contract on grounds of lack of capacity. Thus, Beckman has paid $1,000 for a worthless claim. Does Beckman have any recourse against Donaldson? When an assignor is paid for making an assignment, the assignor is held to have made certain implied warranties about the claim assigned. The assignor impliedly warrants that the claim assigned is valid. This means that the obligor has capacity to contract, the contract is not illegal, the contract is not voidable for any other reason known to the assignor (such as fraud or duress), and the contract has not been discharged prior to assignment. The assignor also warrants that he has good

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title to the rights assigned and that any written instrument representing the assigned claim is genuine. In addition, the assignor impliedly agrees that he will not do anything to impair the value of the assignment. These guarantees are imposed by law unless the assignment agreement clearly indicates to the contrary. One important aspect of the assigned right that the assignor does not impliedly warrant, however, is that the obligor is solvent.

Delegation of Duties LO17-2

Explain the concept of delegation and the consequences of a delegation.

Nature of Delegation A

delegation of duties occurs when an obligor indicates his intent to appoint another person to perform his duties under a contract. For example, White owns a furniture store. He has numerous existing contracts to deliver furniture to customers, including a contract to deliver a sofa to Coombs. White is the obligor of the duty to deliver the sofa and Coombs is the obligee. White decides to sell his business to Rosen. As a part of the sale of the business, White assigns the rights in the existing contracts to Rosen and delegates to him the performance of those contracts, including the duty to deliver the sofa to Coombs. Here, White is the delegator and Rosen is the delegatee. White

is appointing Rosen to carry out his duties to the obligee, Coombs. Figure 17.3 summarizes the key terms regarding delegation. In contrast to an assignment of a right, which extinguishes the assignor’s right and transfers it to the assignee, the delegation of a duty does not extinguish the duty owed by the delegator. The delegator remains liable to the obligee unless the obligee agrees to substitute the delegatee’s promise for that of the delegator (this is called a novation and will be discussed in greater detail later in this chapter). This makes sense because, if it were possible for a person to escape his duties under a contract by merely delegating them to another, any party to a contract could avoid liability by delegating duties to an insolvent acquaintance. The significance of an effective delegation is that performance by the delegatee will discharge the delegator. In addition, if the duty is a delegable one, the obligee cannot insist on performance by the delegator; he must accept the performance of the delegatee. The relationship between the parties in a delegation is shown in Figure 17.4.

Delegable Duties A duty that can be performed

fully by a number of different persons is delegable. Not all duties are delegable, however. The grounds for finding a duty to be nondelegable resemble closely the grounds for finding a right to be nonassignable. A duty is nondelegable if delegation would violate public policy or if the

Figure 17.3 Delegation: Key Terms Obligor

Obligee

Delegation

Delegator

Delegatee

Person who owes the duty to perform

Person who has the right to receive the obligor’s performance

Appointment of another person to perform the obligor’s duty to the obligee

Obligor who appoints another to perform his duty to the obligee

Person who is appointed to perform the obligor’s duty to the obligee

Figure 17.4 Delegation Before delegation Owes duty to perform Obligor

Obligee

Delegation Appoints delegatee to perform his duty to obligee Delegator* (Obligor)

Delegatee

*Delegator retains duty to obligee until performance is rendered by delegatee.

Result of delegation Performs obligor’s duty Delegatee

Obligee



Chapter Seventeen Rights of Third Parties

original contract between the parties forbids delegation. In addition, both section 2-210(1) of the UCC and section 318(2) of the Restatement (Second) of Contracts take the position that a party to a contract may delegate his duty to perform to another person unless the parties have agreed to the contrary or unless the other party has a substantial interest in having the original obligor perform the acts required by the contract. The key factor used in determining whether the obligee has such a substantial interest is the degree to which performance is dependent on the individual traits, skill, or judgment of the person who owes the duty to perform. For example, if Jansen hires Skelton, an artist, to paint her portrait, Skelton

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could not effectively delegate the duty to paint the portrait to another artist. Similarly, an employee could not normally delegate her duties under an employment contract to some third person because employment contracts are made with the understanding that the person the employer hires will perform the work. The situation in which a person hires a general contractor to perform specific work is distinguishable, however. In that situation, the person hiring the general contractor would normally understand that at least part of the work would be delegated to subcontractors. In the Johnson case, which appears below, the court must decide whether a contractual duty was delegable.

Johnson v. Bank of America, N.A.   

2010 U.S. Dist. LEXIS 38080 (D.S.C. Apr. 16, 2010)

Carl Johnson was a customer of Bank of America’s (BofA) retail banking services. BofA’s Online Service Agreement, to which customers must agree in order to use BofA’s online banking services, allows an account holder to use its “Bill Pay” service. The Agreement grants BofA the option to complete a Bill Pay request by one of three means: (1) an electronic transmission, (2) a corporate check, or (3) a personal check. BofA deducts electronic transmissions and corporate checks from the customer’s checking account on the scheduled day of delivery. A personal check, though, results in a debit from the customer’s account when the payee presents the check for payment. In other words, if a personal check is issued, the customer retains the funds in his or her account for a few extra days during which those funds can accrue interest. BofA has contracted with a vendor, Fiserv, to handle Bill Pay transactions. Johnson claims that he requested Bill Pays to several retail shops in Columbia, South Carolina. These shops were not equipped to receive electronic transmissions. BofA debited the account for those purchases on the day that the checks were scheduled for delivery, even though the payees did not present them until between 3 and 10 days later. Thus, Fiserv issued a corporate check rather than a personal check and deprived Johnson of the benefit of holding the funds in his checking account for those extra days. Johnson filed a class action lawsuit against BofA alleging that delegating the discretion to select the payment method, combined with Fiserv’s financial motive to deprive customers of interest, constitutes breach of contract. BofA filed a motion to dismiss Johnson’s complaint. Joseph F. Anderson Jr., Judge Johnson alleges that BofA’s assignment of rights and delegation of duties to Fiserv effects a breach of the implied duty of good faith and fair dealing implicit in every contract. Specifically, Johnson argues that Fiserv improperly caused Johnson to incur losses when it prematurely debited his account. As an initial matter, the court notes that an assignee or delegatee stands in the shoes of the assignor or delegator. Accordingly, if the agreement allows or requires BofA to act or not act in a certain way, it also allows or requires Fiserv to conduct itself in the same manner. The Agreement provides [BofA], incident to its Bill Pay services, the discretion to effect payment through one of three methods. The contract states:

You authorize us to make payments in the manner we select from the following methods:

• Electronic transmission. Most payments are made by electronic transmission.

• Corporate check. This is a check drawn on our account or the account of our vendor. If a Payee on a corporate check fails to negotiate the check within 90 days, we will stop payment on the check and recredit your account for the amount of the payment. • Personal check. This is a check drawn on your account based on your authorization under this Agreement. The Agreement further provides that: For payments made by electronic transmission or corporate check, the payment amount will be debited from, or charged

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Part Three Contracts

to the account you designate on the scheduled delivery date. . . . For payments made by personal check, the account you designate will be debited when the check is presented to us for payment. Johnson alleges that the Agreement governs the relationship between the parties. He does not allege that the Agreement is somehow invalid or that some other agreement defines the relationship of the parties. In his complaint, Johnson alleges that BofA’s vendor, Fiserv, issued a corporate check to satisfy Johnson’s outstanding accounts at several Columbia, South Carolina, establishments that have not elected to receive electronic transmissions. Johnson alleges that by issuing a corporate check on Fiserv’s account, and at Johnson’s behest, BofA deprived Johnson of interest he is entitled to. The plain language of the Agreement states that BofA has the discretion to choose between three methods of payment. The agreement also indicates that a corporate check may be drawn on the account of its vendor and sets forth the relative dates on which a customer should expect his account to be charged for payments he requests BofA fulfill on his behalf. The court finds that the complaint alleges that BofA, through its assignee or delegatee Fiserv, “has done what provisions of the [Agreement] expressly gave [it] the right to do.” Adams v. G.J. Creel and Sons, Inc., 465 S.E.2d 84 (S.C. 1995). Further, Johnson fails to adequately allege how BofA’s actions run afoul of reasonable commercial standards, or how BofA’s conduct contravenes the plain language of the Agreement. Johnson also alleges that BofA’s assignment of the right to choose payment methods breaches the implied covenant of good faith and fair dealing because the assignment materially alters the contractual arrangement between Johnson and BofA. In South Carolina, executory contracts, those that have not been fully performed, are assignable, . . . and “[a]n assignee stands in the shoes of its assignor.” Moore v. Weinberg, 373 S.C. 209, 644 S.E.2d 740 (S.C. App. 2007). That is to say that the assignee has the same rights and privileges under the contract as the assignor. However, rights arising out of a contract cannot be transferred if they are coupled with liabilities or with contracts for personal services, or if they involve a relationship of personal credit and confidence. . . . Similarly, contract duties are generally delegable, unless prohibited by statute, public policy, the terms of the contract, or

Language Creating a Delegation No special, formal language is necessary to create an effective delegation of duties. In fact, because parties frequently confuse the terms assignment and delegation, one of the problems frequently presented to courts is determining whether the parties intended an assignment only or both an assignment

if they involve the personal qualities or skills of the obligor. 29 Richard A. Lord, Williston on Contracts, § 74:27 (4th ed. 2009); Restatement (Second) of Contracts § 318. To the extent that Johnson asserts that BofA’s assignment and delegation to Fiserv was improper, his argument lacks merit. As noted above, assignments and delegations are generally valid unless prohibited by law or the terms of the contract, or where the effect of the assignment effects a change in the terms of the contract, as can the case in a contract for personal services. Johnson cites to no statute or case that suggests BofA’s assignment and delegation violates the law of South Carolina. Instead, Johnson argues in his response to BofA’s motion to dismiss that the assignment and delegation changes the underlying basis of the bargain between BofA and Johnson because, Johnson argues, Fiserv has an improper financial motive to maximize the period in which it can earn interest. However, argument of the existence of an improper motive in a response to a motion to dismiss is a different animal than an allegation in a complaint that Fiserv acts on this motive. Simply stating that an American corporation is motivated by a desire to make money does little more than restate a bedrock principle of capitalism. Both BofA and Fiserv could reasonably be expected to make an attempt to turn a profit in providing banking services. If BofA, rather than Fiserv, executed the Bill Pay requests it would have exactly the same motivations as Fiserv: to minimize the risk incurring loss due to insufficient funds, to lower transactions cost, and to accrue interest from money in its possession. Johnson’s argument to the contrary fails to show how his complaint sufficiently alleges that there is any difference between BofA and Fiserv in the execution the Bill Pay requests. Such failure proves fatal to Johnson’s argument at the motion to dismiss stage. In sum, Johnson fails to adequately allege how the assignment and delegation materially changes the benefit of the bargain under the contract or that Johnson has any interest in BofA, rather than Fiserv, performing the contract. Accordingly, the court finds that BofA’s assignment and delegation to Fiserv valid, and that Fiserv stands in the shoes of BofA with respect to the rights and duties created by the Agreement. Because the court finds that neither BofA nor Fiserv, as BofA’s assignee, violated the terms of the contract or breached the implied duty of good faith and fair dealing, the court GRANTS BofA’s motion to dismiss.

and a delegation. Unless the agreement indicates a contrary intent, courts tend to interpret assignments as including a delegation of the assignor’s duties. Both the UCC §2-210(4) and section 328 of the Restatement (Second) of Contracts provide that, unless the language or the circumstances indicate to the contrary, general language of assignment such



Chapter Seventeen Rights of Third Parties

as language indicating an assignment of “the contract” or of “all my rights under the contract” is to be interpreted as creating both an assignment and a delegation.

Assumption of Duties by Delegatee A

delegation gives the delegatee the right to perform the duties of the delegator. The mere fact that duties have been delegated does not always place legal responsibility on the delegatee to perform. The delegatee who fails to perform will not be liable to either the delegator or the obligee unless the delegatee has assumed the duty by expressly or impliedly undertaking the obligation to perform. However, both section 2-210(4) of the UCC and section 328 of the Restatement (Second) provide that an assignee’s acceptance of an assignment is to be construed as a promise by her to perform the duties under the contract, unless the language of the assignment or the circumstances indicate to the contrary. Frequently, a term of the contract between the delegator and the delegatee provides that the delegatee assumes responsibility for performance. A common example of this is the assumption of an existing mortgage debt by a purchaser of real estate. Suppose Morgan buys a house from Friedman, agreeing to assume the outstanding mortgage on the property held by First Bank. By this assumption, Morgan undertakes personal liability to both Friedman and First Bank. If Morgan fails to make the mortgage payments, First Bank has a cause of action against Morgan personally. An assumption does not release the delegator from liability, however. Rather, it creates a situation in which both the delegator and the assuming delegatee owe duties to the obligee. If the assuming delegatee fails to pay, the delegator

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can be held liable. Thus, in the example described above, if Morgan fails to make mortgage payments and First Bank is unable to collect the debt from Morgan, Friedman would have secondary liability. Friedman, of course, would have an action against Morgan for breach of their contract. This resolution makes sense because Friedman was the one who introduced Morgan into the relationship. Therefore, she ought to be the one who ultimately bears the risk of Morgan’s nonperformance.

Discharge of Delegator by Novation As

you have seen, the mere delegation of duties—even when the delegatee assumes those duties—does not release the delegator from his legal obligation to the obligee. A delegator can, however, be discharged from performance by novation. A novation is a particular type of substituted contract in which the obligee agrees to discharge the original obligor and to substitute a new obligor in his place. The effects of a novation are that the original obligor has no further obligation under the contract and the obligee has the right to look to the new obligor for fulfillment of the contract. A novation requires more than the obligee’s consent to having the delegatee perform the duties. In the example used above, the mere fact that First Bank accepted mortgage payments from Morgan would not create a novation. Rather, there must be some evidence that the obligee agrees to discharge the old obligor and substitute a new obligor. As you will see in the following Russell case, the Alabama Supreme Court strictly adheres to this principle.

The Industrial Development Board of the City of Montgomery v. Russell    124 So. 3d 127 (Ala. 2013)

In September 2001, various state and local officials, including officials from the City of Montgomery (the City), the City’s Industrial Development Board (IDB), the Montgomery County Commission (the County), and the Montgomery Area Chamber of Commerce, worked to secure the options to purchase property in the Montgomery, Alabama, area for the purpose of creating an incentive package to persuade Hyundai Motor Manufacturing to build a vehicle assembly plant there. An essential part of the incentive package included a large parcel of “free” land upon which Hyundai could build the plant. Although the funds to purchase the land would be provided by the City and the County, the IDB was the contracting party to all of the options because that was necessary for the deals to comply with laws governing tax breaks and industry incentives. The IDB secured options to purchase 328 acres from the Russells, 54 acres from the McLemore group, 320 acres from Southdale LLC, and 807 acres from Wheeler/Phillips. The options were identical, providing for a period of 120 days and setting a purchase price floor of $4,500 per acre. Moreover, the options included a “most-favored-nation” or “price-escalation” clause whereby it guaranteed that no landowner would be paid a lower price per acre than that “paid to any other landowner included in the project planned for the Property.” Joy Shelton was also approached about selling her land as part of the project, but she refused. The IDB and the State sent the incentive package to Hyundai without including the Shelton property, having determined that the Shelton property was unnecessary. However,

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in response to the package, Hyundai indicated that it needed to secure rail access to the site, which would require acquiring the Shelton property after all. The now-increased urgency of acquiring the Shelton property would likely drive up the cost of all properties due to the most-favorednation clauses if the IDB were to try to secure it. In that case, the project cost would increase by roughly $10 million. Therefore, the parties considered a number of approaches that did not involve the IDB, including having rail company CSX Transportation try to secure the option to purchase the Shelton property. Thereafter, the IDB provided notice to the Russell, McLemore, Southdale, and Wheeler/Phillips property owners that it would exercise its options on those properties and assigned the options to the City and County. The City and County purchased the properties for $4,500 per acre. CSX entered a real estate purchase agreement with Shelton on the property for $12,000 per acre. CSX assigned that agreement to Hyundai, and the State provided Hyundai with the funds to pay for the Shelton property, rather than Hyundai financing the purchase on its own. The various property owners each filed separate breach-of-contract actions in the Montgomery Circuit Court against the IDB and Hyundai, as well as other parties, alleging that the IDB and Hyundai had violated the most-favored-nation clauses by not paying them $12,000 per acre for their properties. Even though IDB was not a party to the option or purchase of the Shelton property, the other property owners argued that Shelton was “a landowner included in the project,” thus triggering the most-favored-nation clause. Throughout the proceedings, the IDB contended that it was an improper party to the litigation and moved for summary judgment. After a complicated procedural history during which a number of the claims involving various parties were consolidated for consideration on appeal and remanded to the trial court for reconsideration, IDB sought an interlocutory appeal to the Alabama Supreme Court to answer the following question: “Were the obligations under the option contracts signed by the Plaintiffs and the IDB assumed by the City of Montgomery and Montgomery County, thus barring any claims for breach of contract against the IDB?” If the Supreme Court answered that question in the affirmative, the IDB would be entitled to summary judgment on the claims against it. Murdock, Justice The IDB bases its argument that its assignment of the option agreements to the City relieved it of any liability under those agreements on the following portion of [a prior opinion dealing with these claims]: The City first argues that the City was not a party to the option agreements executed by the IDB and therefore was not liable for breach of contract because, it argues, the IDB was not acting as the City’s agent. Under such circumstances, the City says, it is not liable under any breach-of-contract theory. We disagree. Pursuant to Resolution No. 111-2002, adopted by the City in June 2002 in conjunction with the Hyundai project, “the IDB did exercise the purchase options, but assigned its rights to purchase thereunder to the City and Montgomery County (the ‘County’), and the City and County each have issued debt to provide the necessary funds and have acquired the Parcels.” As the IDB’s assignee, the City assumed the obligations and liabilities of the assigned contracts. Meighan v. Watts Constr. Co., 475 So. 2d 829, 834–35 (Ala. 1985).

Congress Life Ins. Co. v. Barstow, 799 So. 2d 931, 937 (Ala. 2001). . . . [The Plaintiffs] cannot prove the first required element—the existence of a valid contract binding the parties to this action. This is because the City of Montgomery assumed all of the obligations under the options. The IDB no longer has any duties, obligations, rights or remedies under the option contracts.

Because the City of Montgomery assumed all of the obligations under the option contracts, there can be no liability for breach of contract on the part of the IDB. To establish a breach of contract, [the Plaintiffs] must show

The IDB essentially argues that, because this Court stated in [the prior opinion] that the City, as the assignee of the option agreements, is potentially liable for breach of contract, the Court impliedly held that the IDB is not liable. We reject this argument for several reasons. First, the portion of the [prior] opinion relied upon by the IDB addressed the City’s potential liability for breach of contract; it did not address, much less determine, the IDB’s potential liability for breach of contract. [T]he IDB cites no authority for its proposition that the assignment of rights under a contract relieves the assignor of any potential for liability for duties not performed under the assigned contract. Moreover, the law provides no support for such a proposition and, indeed, supports the contrary proposition. In a dissent in DuPont v. Yellow Cab Co. of Birmingham, Inc., 565 So. 2d 190, 193 (Ala. 1990), Justice Jones explained the distinction between assignment and delegation:

(1) the existence of a valid contract binding the parties to the action, (2) [their] own performance under the contract, (3) the defendant’s nonperformance, and (4) damages.

In the instant case, there exist both an assignment of rights and a delegation of duties. The assignment-delegation distinction is relatively straightforward: rights are assigned; duties

[Emphasis added.] In its principal brief, the IDB argues:



Chapter Seventeen Rights of Third Parties

are delegated. When a party to a contract transfers his rights under the contract to a third party, he has made an assignment. If a party to the contract appoints a third party to render performance under the contract, he has made a delegation. Generally speaking, upon assignment of a right, the assignor’s interest in that right is extinguished; however, upon the delegation of a contractual duty, the delegating party remains liable under the contract, unless the contract provides otherwise or there is a novation. Calamari and Perillo’s Hornbook on Contracts, § 18-25 (3d ed. 1987). Professor Knapp analogizes the assignment-delegation distinction thusly: “If assigning a right is like passing a football, then delegating a duty resembles more the dissemination of a catchy tune or a communicable disease: Passing it on is not the same as getting rid of it.” C. Knapp, Problems in Contract Law 1161 (1976). (Footnote omitted.) See also Restatement (Second) of Contracts § 318 (1981). [T]he IDB assigned to the City and the County its rights under the option agreements. Assuming that this assignment of rights carried with it a delegation of the duties owed by the IDB under the agreements, the IDB nonetheless also would have had to demonstrate either (1) that the terms of the contracts allowed

Third-Party Beneficiaries Explain the concept of third-party beneficiary and

LO17-3 distinguish among the three kinds of third-party

beneficiaries.

There are many situations in which the performance of a contract would constitute some benefit to a person who was not a party to the contract. Despite the fact that a nonparty may expect to derive advantage from the performance of a contract, the general rule is that no one but the parties to a contract or their assignees can enforce it. In some situations, however, parties contract for the purpose of benefiting some third person. In such cases, the benefit to the third person is an essential part of the contract, not just an incidental result of a contract that was really designed to benefit the parties. Where the parties to a contract intended to benefit a third party, courts will give effect to their intent and permit the third party to enforce the contract. Such third parties are called third-party beneficiaries.

Intended Beneficiaries versus Incidental Beneficiaries For a third person (other than an

assignee) to have the right to enforce a contract, she must be able to establish that the contract was made with the

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the IDB to relieve itself of contractual liability by way of such a delegation or (2) that the parties had entered into novations pursuant to which [the Plaintiffs] agreed that the IDB’s obligations had changed. See generally, e.g., Marvin’s, Inc. v. Robertson, 608 So. 2d 391, 393 (Ala. 1992) (explaining that “[a] novation is the substitution of one contract for another, which extinguishes the pre-existing obligation and releases those bound thereunder. . . . In addition, the party alleging a novation has the burden of proving that such was the intention of the parties.” (quoting Pilalas v. Baldwin County Sav. & Loan Ass’n, 549 So. 2d 92, 94–95 (Ala. 1989) (emphasis omitted))). The IDB does not assert or demonstrate either condition. Accordingly, the trial court’s denial of the IDB’s motion for a summary judgment is not due to be reversed on this ground.

Conclusion The trial court’s order denying the IDB’s motion for a summary judgment, in which the trial court rejected the IDB’s arguments that the IDB should be relieved from liability based on its assignment of [its] rights under the option agreements . . . is due to be affirmed.

intent to benefit her. A few courts have required that both parties must have intended to benefit the third party. Most courts, however, have found it to be sufficient if the person to whom the promise to perform was made (the promisee) intended to benefit the third party. In ascertaining intent to benefit the third party, a court will look at the language used by the parties and all the surrounding circumstances. One factor that is frequently important in determining intent to benefit is whether the party making the promise to perform (the promisor) was to render performance directly to the third party. For example, if Allison contracts with Jones Florist to deliver flowers to Kirsch, the fact that performance was to be rendered to Kirsch would be good evidence that the parties intended to benefit Kirsch. This factor is not conclusive, however. There are some cases in which intent to benefit a third party has been found even though performance was to be rendered to the promisee rather than to the third party. Intended beneficiaries are often classified as either creditor or donee beneficiaries. These classifications are discussed in greater detail below. A third party who is unable to establish that the contract was made with the intent to benefit her is called an incidental beneficiary. A third party is classified as an incidental beneficiary when the benefit derived by that third party was merely an unintended by-product of a contract that was created for the benefit of those who were parties to it. Incidental

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Part Three Contracts

beneficiaries acquire no rights under a contract. For example, Hutton contracts with Long Construction Company to build a valuable structure on his land. The performance of the contract would constitute a benefit to Keller, Hutton’s next-door neighbor, by increasing the value of Keller’s land. The contract between Hutton and Long was made for the purpose of benefiting themselves, however. Any advantage derived by Keller is purely incidental to their primary purpose. Thus, Keller could not sue and recover damages if either Hutton or Long breaches the contract. As a general rule, members of the public are held to be incidental beneficiaries of contracts entered into by their

municipalities or other governmental units in the regular course of carrying on governmental functions. A member of the public cannot recover a judgment in a suit against a promisor of such a contract, even though all taxpayers will suffer some injury from nonperformance. A different result may be reached, however, if a party contracting with a governmental unit agrees to reimburse members of the public for damages or if the party undertakes to perform some duty for individual members of the public. In the following Wallis case, the court explores whether a member of the public is a third-party beneficiary of a contract as a result of that kind of public duty analysis.

Wallis v. Brainerd Baptist Church   509 S.W.3d 886 (Tenn. 2016) Brainerd Baptist Church (the Church) owned and operated a fitness and recreation facility, Brainerd Crossroads or BX (BX). Sandra and Jerry Wallis were members of BX. On August 20, 2011, Mr. Wallis participated in an indoor cycling class at BX. After exiting the cycling room, Mr. Wallis collapsed. The instructor of the class, Kelly Casey, as well as two off-duty police officers, attended to Mr. Wallis while awaiting the arrival of an ambulance and paramedics. When Casey observed Mr. Wallis, he was lying on the floor on his side, his body rigid, his eyes open, and his head lifted off the floor. Casey heard him breathing and saw his chest rising and falling, and after checking his wrist, she determined that he had a pulse. Based on those observations, Casey believed Mr. Wallis was having a seizure, and she placed towels beneath his head for support. The off-duty police officers asked Casey if BX had an automated external defibrillator device (an AED), which Casey retrieved. However, no one used the AED on Mr. Wallis, apparently because they did not believe he was having a coronary event. Eventually, the ambulance and paramedics arrived and transported Mr. Wallis to the hospital, where he later died. Mrs. Wallis ultimately sued the Church, claiming Mr. Wallis’s death was the result of negligence. In addition, Mrs. Wallis sued ExtendLife Inc., the seller of BX’s AED device, claiming in part that Mr. Wallis was a third-party beneficiary of the contract between the Church and ExtendLife. Mrs. Wallis alleged that the contract obligated ExtendLife to ensure that the Church complied with all federal, state, and local regulations regarding AEDs and to ensure that the Church’s employees and agents were properly trained in the use of AEDs. She asserted that ExtendLife had failed to perform these contractual obligations, that Mr. Wallis was a third-party beneficiary of the contract, and that ExtendLife’s breach of contract caused Mr. Wallis’s death. Indeed, although ExtendLife had provided several training classes for the Church and BX personnel in 2009, no one who attended those trainings was present on the day Mr. Wallis collapsed. ExtendLife moved for summary judgment on Mrs. Wallis’s third-party beneficiary claim; however, the trial court denied that motion. ExtendLife was granted permission to seek an interlocutory appeal of that ruling. The intermediate appellate court refused to hear the interlocutory appeal, but the Supreme Court of Tennessee took up the appeal. Cornelia A. Clark, Justice B. Plaintiff’s Third-Party Beneficiary Claim “A contract is an agreement between two or more persons that creates obligations that are legally enforceable by the contracting parties.” West v. Shelby Cnty. Healthcare Corp., 459 S.W.3d 33, 46 (Tenn. 2014). A contract is presumed to be executed for the benefit of the contracting parties and not for the benefit of third parties. Id.; Owner-Operator Indep. Drivers Ass’n v. Concord EFS, Inc., 59 S.W.3d 63, 68 (Tenn. 2001) [hereinafter Owner-Operator]. Nevertheless, a third party may seek to recover under a contract, but the third party bears the burden

of proving, from the terms of the contract or the circumstances surrounding its execution, that, at the time of contracting, he was an intended third-party beneficiary of the contract. If the contractual benefits flowing to the third party are merely incidental, rather than intended, the third party may not recover under the contract. Determining whether a contract was intended to benefit a third party is a matter of contract construction. Thus, the usual rules of contract interpretation apply, including the cardinal principle of ascertaining and effectuating the intent of the parties to the contract. Consistent with these general rules, a nonparty may



Chapter Seventeen Rights of Third Parties

be deemed “an intended third-party beneficiary of a contract . . . entitled to enforce the contract’s terms,” if: (1) The parties to the contract have not otherwise agreed; (2) Recognition of a right to performance in the [third party] is appropriate to effectuate the intention of the parties; and (3) The terms of the contract or the circumstances surrounding performance indicate that either: (a) the performance of the promise will satisfy an obligation or discharge a duty owed by the promisee to the [third party]; or (b) the promisee intends to give the [third party] the benefit of the promised performance. Owner-Operator, 59 S.W.3d at 70. Part (1) of the foregoing test “honor[s] any expression of intent by the parties to reserve to themselves the benefits of the contract.” Id. Part (2) “ensures that third-party beneficiaries will be allowed to enforce the contract only when enforcement would further the parties’ objectives in making the agreement.” Id. In applying part (2), courts must “look to what the parties intended to accomplish by their agreement” and refuse to grant a nonparty intended third-party beneficiary status if doing so “would undermine the parties’ purposes.” Id. at 70–71. Part (3) “provides guidance for differentiating between intended and incidental beneficiaries” by “focus[ing] upon the promisee’s intent, and not the promisor’s.” Id. at 71. Subsection (a) of part (3) “focuses upon the promisee’s intent to ‘discharge a duty . . . to the beneficiary[,]” and may be applied “even though the duty [the promisee] owed to the beneficiary is not easily convertible into money.” Id. As this Court explained in Owner-Operator: contracting parties in [part (3),] subsection (a) cases will not necessarily express a direct desire to confer a benefit upon the third party, for the promisee often may be motivated by a selfinterested intent to discharge the duty owed to the third party. As noted in one California case, “in contracts of [this] type the main purpose of the promisee is not to confer a benefit on the third[-]party beneficiary, but to secure the discharge of his debt or performance of his duty to the third party.” Regardless of self-interest, however, a clear expression of intent to discharge a duty owed by the promisee to the third party will satisfy subsection (a). Under [part (3),] subsection (b), the analysis more directly centers upon whether the promisee actually intends to confer a benefit upon the third party. Part [(3), subsection] (b) analysis will encompass those [nonparty] beneficiaries who . . . clearly were intended by the parties to receive the primary benefit of the contract. Id. at 71 (emphases added) (citations omitted). Evidence of the promisee’s intent to discharge a duty to, or confer a benefit upon, the third party must be clear and direct before the third party

17-15

may avail himself of the exceptional remedy of recovering on an agreement to which he was not a party. To be deemed an intended third-party beneficiary, all three parts of the foregoing analysis must be satisfied. Here, part (1) is satisfied because the parties did not expressly exclude third parties from the benefits of the contract. We need not consider whether part (2) is satisfied in these circumstances, because the undisputed facts fail to establish satisfaction of part (3). At the time of contracting, when third-party status is determined, the undisputed material facts fail to establish that ExtendLife’s contractual obligations to the Church were intended to “satisfy an obligation or discharge a duty” the Church owed to Mr. Wallis. 1. Statutory Duties Like many states, Tennessee has adopted statutes intended to increase the availability of AEDs . . . and the aim of these statutes is “[to] minimize the number of deaths from sudden cardiac arrest,” Hudson v. Town of Jasper, No. M2013-00620-COA-R9CV, 2013 WL 5762224, at *4 (Tenn. Ct. App. Oct. 22, 2013). Importantly for purposes of the issue in this appeal, however, Tennessee’s AED statutes only encourage businesses and other entities to acquire and make AEDs available for use in emergency situations. They do not impose any mandatory duty on businesses to do so, nor do they mandate that businesses use AEDs after they are acquired. To the contrary, after an AED is acquired, statutory prerequisites must be satisfied “[i]n order for [the] entity to use or allow the use of [the AED].” Tenn. Code Ann. § 68-140-404. These post-acquisition statutory prerequisites relate to training, maintenance, registration, and program development, all of which must be accomplished in compliance with rules adopted by the Tennessee Department of Health. . . . In summary, while Tennessee statutes encourage entities to acquire AEDs and make them available for use, these statutes do not impose any affirmative or mandatory duty on businesses to do so, nor do these statutes mandate use of AEDs that are acquired. Furthermore, businesses that acquire AEDs, comply with statutory prerequisites, and use AEDs receive immunity from liability for negligence. Accordingly, at the time of contracting, the Church had no statutory duty to Mr. Wallis to acquire and make an AED available for use, nor did the Church have a statutory duty to use the AED it had already acquired. 2. Common Law Duties We next consider whether, under the common law, the Church owed Mr. Wallis a duty to acquire and make an AED available for use at BX or to use the AED it had acquired. To answer this question, we begin with the well-established principle, that, “[w]hile individuals have an obligation to refrain from acting in a way that creates an unreasonable risk of harm to others, the law generally does not impose on individuals an affirmative duty to aid or protect others.” Downs ex rel. Downs v. Bush, 263 S.W.3d

17-16

Part Three Contracts

812, 819 (Tenn. 2008) (emphasis added) (citations omitted). “As a means of mitigating the harshness of the common law rule, exceptions have been created for circumstances in which the defendant has a special relationship with either the individual who is the source of the danger or the person who is at risk.” Giggers v. Memphis Hous. Auth., 277 S.W.3d 359, 364 (Tenn. 2009). One of these “long-recognized special relationship[s] . . . is that between a business owner and patron.” Cullum v. McCool, 432 S.W.3d 829, 833 (Tenn. 2013). Tennessee courts have turned to section 314A of the Restatement (Second) of Torts and decisions from other jurisdictions to define the scope of the duty to render aid created by such special relationships. Generally, this duty requires a business entity to take reasonable action to protect or aid a patron who sustains injury or becomes ill on business premises. [A business entity] is not required to give aid to one whom he has no reason to know to be ill. [A business entity] will seldom be required to do more than give such first aid as [it] reasonably can, and take reasonable steps to turn the sick person over to a doctor or to those who will look after him until one can be brought. And business entities “are not required to give aid to persons whom they have no reason to know to be ill or injured or whose illness or injury does not appear to be serious or life-threatening.” McCammon v. Gifford, No. M2001-01357-COA-R3-CV, 2002 WL 732272, at *4 (Tenn. Ct. App. 2002). Furthermore, a business entity’s “duty to render aid does not extend to providing all medical care that a business could reasonably foresee might be needed by its patrons or to provide the sort of aid that requires special training to administer.” Id. In this case, Mrs. Wallis seeks to recover based on a theory that the Church’s duty to render aid to her husband included utilizing an AED. We agree that the special relationship exception applies here, because Mr. Wallis was a patron of BX. However, no Tennessee court has previously considered whether a business entity’s duty to aid and protect its patrons requires it to acquire

and make an AED available for use or to use an AED that has already been acquired. . . . The law in other jurisdictions concerning the duty of business entities to render aid and the acquisition and use of AEDs is still developing. Although our research has revealed no other case in which a lawsuit has been brought against the seller of an AED, we note that every state appellate court to consider the issue has held that the common law duty a business entity owes to patrons does not require a business to acquire and make an AED available for use. . . . Furthermore, research reveals that a majority of appellate courts, and particularly those in jurisdictions that, like Tennessee, apply section 314A of the Restatement (Second) of Torts, have held that even after a business acquires an AED, the business’s common law duty to render aid to patrons does not include use of the AED. These decisions are consistent with current Tennessee law and the law of this State at the time of the 2008 contract. . . . Accordingly, we hold that the Church had no common law duty to Mr. Wallis to acquire an AED or to make it available for use, or to use it. Accordingly, the Church did not, by its contract with ExtendLife, intend to discharge a duty it owed to Mr. Wallis. And, in the absence of any such duty on the part of the Church, which the contract was intended to satisfy, Mrs. Wallis cannot prevail on her claim that Mr. Wallis was an intended third-party beneficiary of the contract between ExtendLife and the Church. ExtendLife, therefore, is entitled to summary judgment on Mrs. Wallis’s second amended complaint.

Creditor Beneficiaries If the promisor’s performance is intended to satisfy a legal duty that the promisee owes to a third party, the third party is a creditor beneficiary. The creditor beneficiary has rights against both the promisee (because of the original obligation) and the promisor. For example, Smith buys a car on credit from Jones Auto Sales. Smith later sells the car to Carmichael, who agrees to pay the balance due on the car to Jones Auto Sales. (Note that Smith is delegating his duty to pay to Carmichael, and Carmichael is assuming the personal obligation to do so.) In this case, Jones Auto Sales is a creditor beneficiary of the contract between Smith and Carmichael. It has rights

against both Carmichael and Smith if Carmichael does not perform.

*** Conclusion For the reasons stated herein, we reverse the judgment of the trial court and remand the case to the trial court for entry of summary judgment in favor of ExtendLife. . . .

Donee Beneficiaries If the promisee’s primary purpose in contracting is to make a gift of the agreed-on performance to a third party, that third party is classified as a donee beneficiary. If the contract is breached, the donee beneficiary will have a cause of action against the promisor, but not against the promisee (donor). For example, Miller contracts with Perpetual Life Insurance Company, agreeing to pay premiums in return for which Perpetual agrees to pay $100,000 to



Chapter Seventeen Rights of Third Parties

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CONCEPT REVIEW Third-Party Beneficiaries Type of Third-Party Beneficiary

Distinguishing Feature

Can Enforce Contract Against

Incidental beneficiary

Contract was not made with the intent to benefit him/her

Neither promisor nor promisee

Donee beneficiary

Contract was made with the intent to benefit him/her and performance was intended to be a gift

Promisor only

Creditor beneficiary

Contract was made with the intent to benefit him/her and performance was intended to satisfy a legal obligation that the promisee owes to him/her

Both promisor and promisee

Miller’s husband when Miller dies. Miller’s husband is a donee beneficiary and can bring suit and recover judgment against Perpetual if Miller dies and Perpetual does not pay.

Vesting of Beneficiary’s Rights Another

possible threat to the interests of the third-party beneficiary is that the promisor and the promisee might modify or discharge their contract so as to extinguish or alter the beneficiary’s rights. For example, Gates, who owes $500 to Sorenson, enters into a contract with Connor whereby Connor agrees to pay the $500 to Sorenson. What happens if, before Sorenson is paid, Connor pays the money to Gates and Gates accepts it or Connor and Gates otherwise modify the contract? Courts have held that there is a point at which the rights of the beneficiary vest—that is, the beneficiary’s rights cannot be lost by modification or discharge. A modification or discharge that occurs after the beneficiary’s

rights have vested cannot be asserted as a defense to a suit brought by the beneficiary. The exact time at which the beneficiary’s rights vest differs from jurisdiction to jurisdiction. Some courts have held that vesting occurs when the contract is formed, while others hold that vesting does not occur until the beneficiary learns of the contract and consents to it or does some act in reliance on the promise. The contracting parties’ ability to vary the rights of the third-party beneficiary can also be affected by the terms of their agreement. A provision of the contract between the promisor and the promisee stating that the duty to the beneficiary cannot be modified would be effective to prevent modification. Likewise, a contract provision in which the parties specifically reserved the right to change beneficiaries or modify the duty to the beneficiary would be enforced. For example, provisions reserving the right to change beneficiaries are very common in insurance contracts.

Ethics and Compliance in Action Westendorf bought her friend an Apple iPad, which, at her request, Apple delivered directly to her friend Myers. Several months later, Myers made a similar generous gift by purchasing an Apple iPad, which he requested be delivered directly to Westendorf. Westendorf received and kept that iPad. In the shipment, Apple included its Standard Terms and Conditions Agreement, which contains an arbitration clause. Westendorf allegedly began experiencing

numerous and serious difficulties when attempting to use the Siri voice-activated components of the iPad. She brought a class action against Apple. Westendorf argues that she is not bound by the arbitration clause because as a nonpurchasing user of the iPad, she never expressly agreed to arbitration. Is it ethical to obligate a donee beneficiary such as Westendorf to the arbitration clause that was part of the contract between Myers, who gave her the iPad, and Apple?

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Part Three Contracts

Problems and Problem Cases 1. Schauer and Erstad went shopping for an engagement ring on August 15, 1999. After looking at diamonds in premier jewelry establishments such as Tiffany and Company and Cartier, they went to Mandarin Gem’s store, where they found a ring that salesperson Joy said featured a 3.01 carat diamond with a clarity grading of “SI1.” Erstad bought the ring the same day for $43,121.55. The following month, for insurance purposes, Mandarin Gem provided Erstad a written appraisal verifying the ring had certain characteristics, including an SI1 clarity rating and an average replacement value of $45,500. Lam, a graduate gemologist with the European Gemological Laboratory (EGL), signed the appraisal. The couple’s subsequent short-term marriage was dissolved in a North Dakota judgment awarding each party “the exclusive right, title and possession of all personal property . . . which such party now owns, possesses, holds or hereafter acquires.” Schauer’s personal property included the engagement ring given to her by Erstad. On June 3, 2002, after the divorce, Schauer had the ring evaluated by the Gem Trade Laboratory, which gave the diamond a rating of “SI2” quality, an appraisal with which other unidentified jewelers, including one at Mandarin Gem’s store, agreed. Schauer alleged that the true clarity of the diamond and its actual worth are some $23,000 less than what Erstad paid for it. Schauer sued Mandarin Gems on several theories, alleging that she was a third-party beneficiary of Erstad’s contract with Mandarin Gems. Is she correct? 2. In March 2004, White was stopped in her van when Berkenheuer, driving a Penske truck in the course of his job with Taylor Distributing Company, hit her, causing her serious injury. White settled a first-party action with her no-fault insurer, Amex Insurance, which provided: IN CONSIDERATION of the payment to the undersigned, . . . [plaintiff] does hereby release and forever discharge AMEX INSURANCE COMPANY, and their officers, employees, principals, shareholders, executors, administrators, agents, successors, insurers and assigns of and from any and all actions, causes of action, claims, demands, damages, costs, loss of services, expenses and/or compensation on account of, or in any way growing out of, any and all known and unknown personal injuries and property damage resulting or to result from an accident that occurred on or about March 15, 2004.

IT IS expressly agreed that this Release also refers to any and all (past, present and future) claims/benefits arising or that may arise from the March 15, 2004 accident.

This release identified Amex and its agents in great detail, but made no mention of Berkenheuer, Taylor, and ­Penske. In a later lawsuit by White against Berkenheuer, Taylor, and Penske, the defendants claimed that they were third-party beneficiaries to this release and that they “stood in the shoes of the promisee (Amex).” Is this a good argument? 3. Ramirez loaned Regalado $75,000. In return, Regalado assigned $65,000 of his eventual recovery in a workers’ compensation matter on which Bloom represented him. Bloom signed the assignment along with Ramirez and Regalado, agreeing “to disburse the proceeds of the aforementioned settlement, award or judgment in accordance with the terms” of the assignment. When the matter settled, however, Bloom paid the proceeds to Regalado despite the terms of the assignment because a relevant state law expressly prohibited the assignment of funds due or received from a workers’ compensation claim. Regalado never turned the funds over to Ramirez. Ramirez sued Bloom and Regalado for breach of contract, arguing (as the claims related to Bloom) that the policy is in favor of free assignability. Is this argument correct? 4. In February 1980, Mary Pratt entered into a contract to buy a Dairy Queen restaurant from Harold and Gladys Rosenberg. The terms of the contract for the franchise, inventory, and equipment were a purchase price totaling $62,000, a $10,000 down payment, and $52,000 due in quarterly payments at 10 percent interest over a 15-year period. The sales contract also contained a provision denying the buyer a right of prepayment for the first five years of the contract. In October 1982, Pratt assigned her rights and delegated her duties under this contract to Son Inc. The assignment between Pratt and Son contained a “Consent to Assignment” clause, which was signed by the Rosenbergs. It also contained a “save harmless” clause, in which Son promised to indemnify Pratt for any claims, demands, or actions that might result from Son’s failure to perform the agreement. After this transaction, Pratt moved to Arizona and had no further knowledge of or involvement with the Dairy Queen business. Also following the assignment, the Dairy Queen was moved from the mall to a different location. Son assigned the contract to Merit Corporation in June 1984. This assignment did not include a consent clause, but the Rosenbergs knew of the assignment and



Chapter Seventeen Rights of Third Parties

apparently acquiesced in it. They accepted a large prepayment from Merit, reducing the principal balance to $25,000. After the assignment, Merit pledged the inventory and equipment of the Dairy Queen as collateral for a loan from Valley Bank and Trust. Payments from Merit to the Rosenbergs continued until June 1988, at which time the payments ceased, leaving an unpaid principal balance of $17,326.24 plus interest. The Rosenbergs attempted to collect the balance from Merit, but Merit filed bankruptcy. The business assets pledged as collateral for the loan from Valley Bank and Trust were repossessed. The Rosenbergs brought an action for collection of the outstanding debt against Son and Pratt, claiming that they were still obligated on the contract and that there was no novation in either case. Are Son and/or Pratt liable to the Rosenbergs given Merit’s breach or was either or both released by the assignments and subsequent circumstances? 5. Jones paid Sullivan, the chief of the Addison Police Department, $6,400 in exchange for Sullivan’s cooperation in allowing Jones and others to bring marijuana by airplane into the Addison airport without police intervention. Instead of performing the requested service, Sullivan arrested Jones. The $6,400 was turned over to the district attorney’s office and was introduced into evidence in the subsequent trial in which Jones was tried for and convicted of bribery. After his conviction, Jones assigned his alleged claim to the $6,400 to Melvyn Bruder. Based on the assignment, Bruder brought suit against the state of Texas to obtain possession of the money. Will he be successful? 6. Locke, a physical education teacher, served as an umpire for high school baseball games for a number of years. He was a member of the Southeast Alabama Umpires Association (SAUA), which provides officials to athletic events sponsored by the Alabama High School Athletic Association (AHSAA). In March 1999, Locke was serving as the head umpire in a baseball game between Carroll High School and George W. Long High School. The game was being played at Carroll High School, and the principal and the athletic director of Carroll High School were in attendance; however, Carroll High School did not provide police protection or other security personnel for the game. After the baseball game, the parent of one of the baseball players for Carroll High School attacked Locke, punching him three times in the face—in his right eye, on the right side of his face, and on the left side of his neck. As a result, Locke sustained physical injuries to his neck and face that caused him

17-19

pain, discomfort, scarring, and blurred vision. Locke sued the Ozark City Board of Education, alleging breach of contract. Locke specifically alleged that because Carroll High School, through the Board, is a member of the AHSAA, it is therefore required to follow the rules and regulations of the AHSAA. According to Locke, the AHSAA Directory provides that all school principals have the duty to “insure good game administration and supervision by providing for . . . adequate police protection” at athletic events. Locke alleged that, by not fulfilling its duty under the Directory, the Board breached its contract with the AHSAA by failing to provide police protection at the baseball game, that he was an intended third-party beneficiary of the contract, and that he was injured as a result of the Board’s breach of the contract. Is this a good argument? 7. Alegent, the owner of a hospital, staffed its emergency room by contracting with Premier Health, which supplied ER physicians from New Century Physicians of Nebraska, each as independent contractors. Though the New Century ER physicians were “seamlessly integrated” in the Alegent health care system and, by all appearances (including their employee ID tags), looked to be part of Alegent, the agreement between Alegent and Premier Health was clear that the parties were independent entities contracting solely for the purposes of the agreed services and that “[n]either of the parties . . . shall have the authority to bind the other or shall be deemed or construed to be the agent, employee or representative of the other.” Podraza’s appendix ruptured after treatment in Alegent’s ER, and Podraza and her husband began talks with Alegent about compensation. Premier Health and New Century did not participate in the settlement negotiations. Alegent and the Podrazas reached a settlement involving forgiveness of the hospital bill and payment of additional money in exchange for which the Podrazas released “the said Released Parties, and all others directly or indirectly liable or claimed to be liable” from all claims and demands. The Podrazas later sued New Century, and New Century moved for summary judgment on the ground that they were protected by the release as third-party beneficiaries. Was New Century correct? 8. Eagle Mountain City entered into a contract with Cedar Valley Water Association to share in any recovery from a legal malpractice action against the City’s attorneys, Parsons Kinghorn & Harris P.C. Parsons Kinghorn represented the City in the negotiation and management of an agreement with Cedar Valley for the

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Part Three Contracts

purchase of a well. That deal fell apart, largely because Parsons Kinghorn (allegedly negligently) advised the City that certain conditions that were a prerequisite to the City’s performance failed to occur. Cedar Valley sued the City for breach of the well contract. Now represented by other legal counsel, the City agreed to settle the claim with Cedar Valley. The settlement agreement included the assignment to Cedar Valley of its interest in the malpractice action against Parsons Kinghorn. In response, Parsons Kinghorn argued that the assignment was ineffective because it was contrary to a strong public policy against voluntary assignment of legal malpractice claims because of concerns about commoditizing or merchandising such claims, the effect such assignments would have on the sanctity of the attorney–client relationship, and the possibility that such assignments would create an incentive for parties to collude against the losing party’s attorney (by agreeing to artificially inflated damages in return for the right to collect on the subsequent malpractice claim). Were these concerns sufficient to overcome the strong presumption in favor of assignability? 9. The Flomers were divorced in 2001. At the time of their divorce, they negotiated a settlement agreement containing the following postminority-educational-support provision for the benefit of their then minor daughter, Jessica: For the support and maintenance of the [daughter], [the father] shall pay and be responsible for all reasonable costs of her post-secondary education. The [parents] agree to make reasonable efforts to obtain grants and/or scholarships for the [daughter].

The parents’ agreement was incorporated into the divorce judgment entered by the court. In 2006, in a custody modification/contempt proceeding involving the Flomers’ other minor child, the court entered a judgment that stated in part, “Father shall continue to pay for the daughter’s . . . college tuition, books and fees.” Jessica began her college studies at Auburn University in Montgomery in 2003. She completed the prerequisites for pharmacy school and then transferred to pharmacy school at Auburn University in 2004. She graduated

from pharmacy school in 2008. In 2008, Jessica sent her father a letter informing him that her student loans were about to come due and seeking $62,000 plus interest for tuition that had not been covered by scholarships or grants. Jessica ultimately filed a petition in court to have her father held in contempt for his failure to comply with the postminority-educational-support provision of her parents’ divorce judgment. Was Jessica entitled to enforce that provision against her father? 10. The Wattses contracted to sell real estate to MW Development in a contract that specified July 31 as the date for the closing. MW paid the Wattses a down payment and contracted to pay them 8 percent interest on the balance if it failed to close on time. Simpson was not a party to the real estate contract between the Wattses and MW, but he had loaned MW the money for the down payment. As security for this loan, MW executed a promissory note and assignment pursuant to which MW assigned all of its interest in the real estate it was buying from the Wattses. When Simpson saw this note, he realized that it did not become due until August 4 and, in addition, provided for a 10-day grace period before he could enforce his rights against MW. This left Simpson vulnerable to losing the deposit money. As a result, Simpson entered an agreement with the Wattses in which the Wattses agreed to a 14-day period during which Simpson would have the exclusive right to purchase the property on the same terms of MW, including credit for the down payment, should MW default. MW failed to buy the property, and the Wattses sued MW, Simpson, and others. In their claim against Simpson, the Wattses argued that the assignment contract between MW and Simpson obligated Simpson to perform the promises set forth in the real estate contract between the Wattses and MW. Given these facts, did Simpson assume the duties MW owed to the Wattses by becoming MW’s assignee such that he was obligated to buy the Wattses property upon MW’s default?

CHAPTER 18

Performance and Remedies

T

he Warrens hired Denison, a building contractor, to build a house on their property for $73,400. Denison’s construction deviated somewhat from the project’s specifications. These deviations were presumably unintentional, and the cost of repairing them was $1,941.50. The finished house had a market value somewhat higher than the market value would have been without the deviations. The Warrens refused to pay the $48,400 balance due under the contract, alleging that Denison had used poor workmanship in building the house and they were under no obligation to perform further duties under the contract. • Do the Warrens have the right to withhold all further payment? • What are the consequences of Denison’s breach of contract? • What are the appropriate remedies for Denison’s breach of contract? • Are the Warrens under an ethical duty to pay Denison?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 18-1 Explain the effect of conditions on the duty to perform a contract and identify contract language that is likely to be considered an express condition. 18-2 Distinguish strict performance and substantial performance standards and determine which is likely to be applied to a given contract duty.

CONTRACTS ARE GENERALLY FORMED before either of the parties renders any actual performance to the other. A person may be content to bargain for and receive the other person’s promise at the formation stage of a contract because this permits him to plan for the future. Ultimately, however, all parties bargain for the performance of the promises that have been made to them. In most contracts, the parties carry out their promises and are discharged (released from any other contractual obligations) when their performances are complete.

18-3 Explain the possible effects of breach of contract. 18-4 List and explain the circumstances that can excuse performance of a contract. 18-5 Distinguish the various remedies for breach of contract and identify the circumstances under which each remedy is appropriate.

Sometimes, however, a party fails to perform or performs in an unsatisfactory manner. In such cases, courts often must determine the parties’ respective rights and duties. This frequently involves deciding such questions as whether performance was due, whether the contract was breached, to what extent it was breached, and whether performance was excused. This task is made more difficult by the fact that contracts often fail to specify the consequences of nonperformance or defective performance. In deciding questions involving the performance of contracts and remedies for breach of contract, courts draw on a

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Part Three Contracts

variety of legal principles that attempt to do justice, prevent forfeiture and unjust enrichment, and effectuate the parties’ presumed intent. This chapter presents an overview of the legal concepts that courts use to resolve disputes arising in the performance stage of contracting. It describes how courts determine whether performance is due and what kind of performance is due, the consequences of contract breach, and the excuses for a party’s failure to perform. It also includes a discussion of the remedies that courts use when a contract has been breached.

such as when one party’s performance of a duty under the contract is a condition of the other party’s duty to perform.

Conditions

1. Condition precedent. A condition precedent is a future, uncertain event that creates the duty to perform. If the condition does not occur, performance does not become due. If the condition does occur, the duty to perform arises. In the Killian case, which appears shortly, you will see an example of a condition precedent.

Explain the effect of conditions on the duty to perform a

LO18-1 contract and identify contract language that is likely to be

considered an express condition.

Nature of Conditions One issue that frequently

arises in the performance stage of a contract is whether a party has the duty to perform. Some duties are unconditional or absolute—that is, the duty to perform does not depend on the occurrence of any further event other than the passage of time. For example, if Root promises to pay Downing $100, Root’s duty is unconditional. When a party’s duty is unconditional, he has the duty to perform unless his performance is excused. (The various excuses for nonperformance will be discussed later in this chapter.) When a duty is unconditional, the promisor’s failure to perform constitutes a breach of contract. In many situations, however, a promisor’s duty to perform depends on the occurrence of some event that is called a condition. A condition is an uncertain, future event that affects a party’s duty to perform. For example, if Melman contracts to buy Lance’s house on condition that First Bank approve Melman’s application for a mortgage loan by January 10, Melman’s duty to buy Lance’s house is conditioned on the bank’s approving his loan application by January 10. When a promisor’s duty is conditional, his duty to perform is affected by the occurrence of the condition. In this case, if the condition does not occur, Melman has no duty to buy the house. His failure to buy it because of the nonoccurrence of the condition will not constitute a breach of contract. Rather, he is discharged from further obligation under the contract. Almost any event can be a condition. Some conditions are beyond the control of either party, such as when Morehead promises to buy Pratt’s business if the prime rate drops by a specified amount. Others are within the control of a party,

Types of Conditions There are two ways of classify-

ing conditions. One way of classifying conditions focuses on the effect of the condition on the duty to perform. The other way focuses on the way in which the condition is created. Classifications of Conditions Based on Their Effect on the Duty to Perform As Figure 18.1 illustrates, conditions vary in their effects on the duty to perform.

2. Concurrent condition. When the contract calls for the parties to perform at the same time, each person’s performance is conditioned on the performance or tender of performance (offer of performance) by the other. Such conditions are called concurrent conditions. For example, if Martin promises to buy Johnson’s car for $5,000, the parties’ respective duties to perform are subject to a concurrent condition. Martin does not have the duty to perform unless Johnson tenders his performance, and vice versa. 3. Condition subsequent. A condition subsequent is a future, uncertain event that discharges the duty to perform. When a duty is subject to a condition subsequent, the duty to perform arises but is discharged if the future, uncertain event occurs. For example, Wilkinson and Jones agree that Wilkinson will begin paying Jones $2,000 per month, but that if XYZ Corporation dissolves, Wilkinson’s obligation to pay will cease. In this case, Wilkinson’s duty to pay is subject to being discharged by a condition subsequent. The major significance of the distinction between conditions precedent and conditions subsequent is that the plaintiff bears the burden of proving the occurrence of a condition precedent, while the defendant bears the burden of proving the occurrence of a condition subsequent. Classifications of Conditions Based on the Way in Which They Were Created Another way of classifying conditions is to focus on the means by which the condition was created. 1. Express condition. An express condition is a condition that is specified in the language of the parties’ contract. For example, if Grant promises to sell his regular season



Chapter Eighteen Performance and Remedies

18-3

Figure 18.1 Effect of Conditions Condition fails to occur

Duty to perform is discharged

Condition occurs

Duty to perform arises

Condition fails to occur

Duty to perform is discharged

Condition occurs

Duty to perform arises

Condition fails to occur

Duty to perform continues

Condition occurs

Duty to perform is discharged

Duty subject to condition precedent

Duty subject to concurrent condition

Duty subject to condition subsequent (performance is due)

Killian v. Ricchetti   2016 WL 6471245 (E.D. Pa. Oct. 31, 2016) David J. Killian and Christopher Ricchetti became friends in 2011, based on their shared interest in real estate development. Each owned a property in Philadelphia that, together, they believed they could leverage to co-develop a mixed-used condominium and retail project. From September 2011 into early 2012, they exchanged ideas on how they could use Killian’s condo on Pine Street to generate cash income to use for construction loans to develop the condo/retail project on a vacant lot Ricchetti owned at 2nd and Brown Street. In order to move forward, the 2nd and Brown Street property needed to be rezoned for mixed commercial use, and a number of other permits and construction arrangements needed to be made. With regard to the Pine Street condo, the idea was that Ricchetti would buy a senior mortgage on the condo and foreclose on it to give Killian the cash to participate in the 2nd and Brown Street development. On February 6 and 8, 2012, the two exchanged e-mails setting out much of these plans in detail. However, that e-mail exchange left several important terms unresolved, and the messages were best characterized as an offer and counteroffer. No acceptance took place. Following that, on February 19, Ricchetti initiated a different e-mail chain by asking Killian four questions about the Pine Street condo mortgage, namely, how the loan would be split, the value of the mortgage, legal review of the mortgage, and the timing of the Pine Street condo sale. Ricchetti proposed, “when the Pine is clear title we form an LLC with an equal partnership of 50% and [w]e do so only [to] develop that property as planned with 10 or more units, 6 floors and retail bottom. We both agree that we have no [other] plans but to develop that property this year, and cost are equal for us, as well as profit when we agree to sell. We both have rights to see and obtain all cost

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information records related to 2nd and [B]rown. If one of us is found and proven stealing from the other or the business the[y] [l]ose their half of the property.” On February 20, Killian responded, “OF COURSE” to Ricchetti’s proposal. Killian also answered Ricchetti’s questions about the Pine Street condo mortgage and told Ricchetti he was waiting for Prudential’s attorney, the lender for Pine Street, to get back to him so they could close on the Pine Street condo mortgage. Thereafter, both Richetti and Killian undertook a number of steps to move their plans forward, including working with the Philadelphia Streets Department for approval of a curb cut and discussing the zoning code parking requirements for the 2nd and Brown Street location. They worked to get the rezoning approval. They secured an architect for the development. They organized a civic meeting to get neighborhood support for the project. And they moved forward with the purchase and sale of the Pine Street condo. Ricchetti paid Prudential $100,000 to assign its mortgage to him, and he instituted foreclosure proceedings. Ricchetti never successfully foreclosed on the condo, however, because Wells Fargo, which held a junior lien on the condo, was “adamant” in asserting its position, and Ricchetti decided not to fight the legal battle necessary to overcome Wells Fargo’s position. Despite the substantial progress the two made on the plans for the 2nd and Brown Street development (including ultimately securing Zoning Board approval for the mixed-use building) and despite holding themselves out to everyone as partners on the project, Ricchetti sold the 2nd and Brown Street property as a vacant lot for $740,000 several months after the Zoning Board approval. He did not share any of the proceeds from the sale of 2nd and Brown Street with Killian. Killian sued Richetti for breach of contract, alleging damages in excess of $50,000. Ricchetti moved for summary judgment arguing that no contract existed as a matter of law. Kearney, District Judge The e-mails exchanged between Killian and Ricchetti on February 19th and February 20th do form a contract but it could not be breached, as a matter of law, because the required condition never occurred. . . . The February 19th and February 20th e-mails evidence a “meeting of the minds” but because the contract is based on a condition precedent which never occurs, the contract never matures. “It is well settled that if a contract contains a condition precedent, the condition precedent must occur before a duty to perform under the contract arises.” The February 19th and February 20th e-mails evidence a meeting of the minds on the defined terms. Ricchetti and Killian agree they will have a deal when Ricchetti receives clear title to Killian’s Pine Street condo. Once Ricchetti receives clear title, Ricchetti and Killian agree they will form a partnership shared fifty/fifty to develop 2nd and Brown Street. They agree developing 2nd and Brown Street is the only project for their partnership this

football tickets to Carson on condition that Indiana University wins the Rose Bowl, Indiana’s winning the Rose Bowl is an express condition of Grant’s duty to sell the tickets. When the contract expressly provides that a party’s duty is subject to a condition, courts take it very seriously. When a duty is subject to an express condition, that condition

year and both Ricchetti and Killian will share profits, costs, and an equal right to see financial information. Ricchetti and Killian also agreed if one partner is proven to have stolen from the partnership, he will lose his share of the partnership. Ricchetti and Killian’s agreement is based on the condition precedent of Ricchetti receiving clear title on Killian’s Pine Street condo. Ricchetti’s offer opens with, “when the Pine is clear title.” The parties do not dispute Ricchetti never received clear title to Killian’s Pine Street condo because of Wells Fargo’s unexpected intransigence. There is no evidence either party interfered with performing the condition precedent. Because the condition precedent never occurred, the contract never matured and the parties’ duty to perform under the contract never arose. *** Conclusion We grant Ricchetti’s motion for summary judgment as to Killian’s breach of contract claim as a matter of law.

must be strictly complied with in order to give rise to the duty to perform. The Macomb Mechanical case that follows this discussion provides an example of a harsh application of a particular type of express condition, a “pay if paid” clause. The case also illustrates that courts will limit the operation of the condition to only those duties under the contract to which they apply.



Chapter Eighteen Performance and Remedies

2. Implied-in-fact condition. An implied-in-fact condition is one that is not specifically stated by the parties but is implied by the nature of the parties’ promises. For example, if Summers promises to unload cargo from Knight’s ship, the ship’s arrival in port would be an implied-in-fact condition of Summer’s duty to unload the cargo. 3. Constructive condition. Constructive conditions (also known as implied-in-law conditions) are conditions that are imposed by law rather than by the agreement of the parties. The law imposes constructive conditions to do

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justice between the parties. In contracts in which one of the parties is expected to perform before the other, the law normally infers that performance is a constructive condition of the other party’s duty to perform. For example, if Thomas promises to build a house for King, and the parties’ understanding is that King will pay Thomas an agreed-on price when the house is built, King’s duty to pay is subject to the constructive condition that Thomas complete the house. Without such a constructive condition, a person who did not receive the performance promised him would still have to render his own performance.

Macomb Mechanical, Inc. v. LaSalle Group, Inc.    2015 WL 1880189 (Mich. Ct. App. Apr. 23, 2015)

As a subcontractor hired by general contractor LaSalle Group, Inc., Macomb Mechanical, Inc. performed plumbing and mechanical work on a dining facility construction project at Fort Sill in Oklahoma. The U.S. Army Corps of Engineers (USACE) owned the project, and Veterans Enterprise Technology Services (VETS) oversaw it as the prime contractor. Macomb’s work was originally scheduled to take about six months, but complications caused Macomb’s work to extend for 15 months. In addition, Macomb alleged that the project’s scope changed after it entered the subcontract. Though Macomb performed the work associated with the change in scope, LaSalle refused to sign change orders related to it. LaSalle failed to pay Macomb for some of the work clearly described in the subcontract, as well as the extra work Macomb claimed to have done. Macomb sued LaSalle for breach of contract, but LaSalle argued that it was excused from paying Macomb because a condition precedent to its duty to perform on the subcontract had not occurred, namely, LaSalle had not yet been paid by USACE or VETS. LaSalle pointed to a series of “pay if paid” clauses in the subcontract to establish that payment to LaSalle was a condition precedent to its duty to pay Macomb. The particular clauses included the following: 2.1 Subje\ct to approval by Contractor, and approval as required by the Subcontract Documents, Contractor will pay Subcontractor monthly progress payments provided as a condition precedent that Owner has paid Contractor. 2.7 Contractor will use Owner funds to pay Subcontractor within ten (10) days after receipt and Contractor shall have no obligation to pay Subcontractor for the Subcontract work, or any claims related thereto, unless and until Owner pays Contractor for the same. Receipt of funds by payment from Owner for specific payment to the subcontractor, shall be a condition precedent to Contractor’s obligation to pay Subcontractor. 2.9 Conditioned upon precedent payment by Owner, Contractor will pay to Subcontractor the final payment for the Subcontract work within ten (10) days after receipt thereof from the Owner. The trial court agreed with LaSalle and summarily dismissed Macomb’s claims. Macomb appealed.

PER CURIAM Pay-if-Paid Clauses Macomb . . . challenges the [trial court’s] dismissal of its claim for $21,589.20 remaining due for work indisputably covered by the subcontract, and $172,049 for allegedly extracontractual work for which Macomb had requested change orders and additional work related to alleged discrepancies in project drawings. We

agree that summary disposition was improper with respect to the second category of charges because genuine issues of material fact exist concerning those claims. But the [trial court] properly granted summary disposition to defendants with respect to the amount owed on the subcontract itself because the “pay if paid” clauses bar recovery for that amount until the USACE or VETS compensates LaSalle. As noted, several contractual provisions indicate that LaSalle’s duty to pay Macomb for subcontract work is conditioned

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on the USACE’s or VETS’s payment to LaSalle for that work. LaSalle Chief Executive Officer Steve Palermo submitted an affidavit stating that LaSalle had not been paid by VETS for the monies sought by Macomb for work performed on the project or for Macomb’s requested extra compensation. According to Palermo, LaSalle had submitted a claim to VETS, which incorporated various payment requests, including those made by Macomb, into a final billing for the USACE. Palermo indicated that VETS filed suit against the USACE, which is apparently still pending, in federal court regarding payment for the project. This Court has upheld the applicability of pay-if-paid clauses. In Berkel & Co. Contractors v. Christman Co., 533 N.W.2d 838 (Mich. Ct. App. 1995), this Court found no ambiguity in a contractual clause providing that “all payments to the subcontractor [were] to be made only from equivalent payments received by” the general contractor from the project owner. This Court continued: Berkel next argues that even if considered operative, a “pay when paid” clause is merely a provision that postpones payment for a reasonable amount of time, not indefinitely. Again, we disagree. As indicated earlier, the trial court quite properly found that Christman was not required to pay Berkel until it received payment from the owner. Failure to satisfy a condition precedent prevents a cause of action for failure of performance.  .  .  . The contract contains no language limiting the condition precedent to any “reasonable time.” Although such clauses are valid, there is a limit. A contracting party who prevents or renders impossible the satisfaction of a condition precedent may not rely on that condition to defeat liability. The subcontract unambiguously provides that the owner’s payment to LaSalle is a condition precedent to Macomb’s right to receive payment from LaSalle. Palermo has sworn that neither the USACE nor VETS has paid LaSalle any of the monies sought by Macomb in this case. There is no evidence that LaSalle has taken any action to prevent satisfaction of the condition precedent. There is no evidence contradicting that VETS has filed a federal lawsuit against the USACE for payments, and that if VETS is successful, part of the judgment would benefit Macomb. Therefore, Macomb is not entitled to recover from LaSalle the amount indisputably owed under the subcontract. Yet Macomb created a genuine issue of material fact that $172,049 of its requested compensation fell outside the parameters of the subcontract. If this fact is ultimately proven, the subcontract would not apply to those amounts, including the pay-if-paid clauses. This allegedly extracontractual work was

documented in Macomb’s requested change orders. . . . LaSalle refused to issue those change orders and therefore did not submit them to VETS or the USACE for payment. Macomb asserts that changes in the project drawings and specifications after Macomb submitted its bid caused it to incur additional costs that were not part of the subcontract, prompting it to present the change orders to LaSalle. Had LaSalle issued the change orders, Macomb concedes that the work would have become part of the subcontract. The failure to do so, according to Macomb, means this work was never incorporated into the parties’ agreement. If the work is not governed by the subcontract’s pay-if-paid clause, then any payment owed to Macomb would have been due within a reasonable time. LaSalle, of course, disagrees with Macomb’s position. LaSalle denied Macomb’s proposed change orders . . . , claiming that the underlying work was part of the base subcontract, negating Macomb’s claim for extra compensation. LaSalle argues that there is no evidence that the parties entered into a separate contract with respect to the alleged extracontractual work. Therefore, LaSalle contends, its refusal to issue the change orders does not prevent the application of the subcontract’s pay-if-paid clause. Macomb presented evidence creating a genuine issue of material fact that proposed change orders . . . covered extracontractual work. Macomb’s project manager, Morris, described at his deposition that LaSalle failed to follow the “chain of command” and directly ordered Macomb’s foremen to engage in work under the guise of the subcontract. Macomb management only learned of the work after it was underway and was forced to belatedly draft change orders. . . . Overall, the evidence is conflicting regarding the extent to which the project drawings changed after Macomb bid on the project and the amount of additional work and costs necessitated by those changes. Therefore, a genuine issue of material fact exists regarding Macomb’s claim that it was not provided updated drawings, thereby requiring Macomb to provide additional work and incur further expenses. Because no change order was issued with respect to the additional work and costs allegedly necessitated by the drawing discrepancies, the additional work and costs may reasonably be found to fall outside the scope of the subcontract and therefore not be subject to the subcontract’s pay-if-paid clause. LaSalle would then be required to pay Macomb within a reasonable time. *** We affirm in part, reverse in part, and remand for further proceedings consistent with this opinion.



Chapter Eighteen Performance and Remedies

Creation of Express Conditions Although

no particular language is required to create an express condition, the conditional nature of promises is usually indicated by such words as provided that, subject to, on condition that, if, when, while, after, and as soon as. The process of determining the meaning of conditions is not a mechanical one. Courts look at the parties’ overall intent as indicated in language of the entire contract. The following discussion explores two common types of express conditions. Example of Express Condition: Satisfaction of Third Parties It is common for building and construction contracts to provide that the property owner’s duty to pay is conditioned on the builder’s production of certificates to be issued by a specific architect or engineer. These certificates indicate the satisfaction of the architect or engineer with the builder’s work. They are often issued at each stage of completion, after the architect or engineer has inspected the work done. The standard usually used to determine whether the condition has occurred is a good-faith standard. As a general rule, if the architect or engineer is acting honestly and has some good-faith reason for withholding a certificate, the builder cannot recover payments due. In legal terms, the condition that will create the owner’s duty to pay has not occurred. If the builder can prove that the withholding of the certificate was fraudulent or done in bad faith (as a result of collusion with the owner, for example), the court may order that payment be made despite the absence of the certificate. In addition, production of the certificate may be excused by the death, insanity, or incapacitating illness of the named architect or engineer. Example of Express Condition: Personal Satisfaction  Contracts sometimes provide that a promisor’s duty to perform is conditioned on his personal satisfaction with the promisee’s performance. For example, Moore commissions Allen to paint a portrait of Moore’s wife, but the contract provides that Moore’s duty to pay is conditioned on his personal satisfaction with the portrait. In determining which standard of satisfaction to apply, courts distinguish between cases in which the performance bargained for involves personal taste and comfort and cases that involve mechanical fitness or suitability for a particular purpose. If personal taste and comfort are involved, as they would be in the hypothetical case described above, a promisor who is honestly dissatisfied with the promisee’s performance has the

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right to reject the performance without being liable to the promisee. If, however, the performance involves mechanical fitness or suitability, the court will apply a reasonable person test. If the court finds that a reasonable person would be satisfied with the performance, the condition of personal satisfaction has been met and the promisor must accept the performance and pay the contract price.

Excuse of Conditions In most situations involv-

ing conditional duties, the promisor does not have the duty to perform unless and until the condition occurs. There are, however, a variety of situations in which the occurrence of a condition will be excused. In such a case, the person whose duty is conditional will have to perform even though the condition has not occurred. One ground for excusing a condition is that the party benefiting from the condition prevented or hindered the occurrence of the condition. For example, Connor hires Ingle to construct a garage on Connor’s land, but when Ingle attempts to begin construction, Connor refuses to allow Ingle access to the land. In this case, Connor’s duty to pay would normally be subject to a constructive condition that Ingle build the garage. However, because Connor prevented the occurrence of the condition, the condition will be excused, and Ingle can sue Connor for damages for breach of contract even though the condition has not occurred. Other grounds for excuse of a condition include waiver and estoppel. When a person whose duty is conditional voluntarily gives up his right to the occurrence of the condition (waiver), the condition will be excused. Suppose that Buchman contracts to sell his car to Fox on condition that Fox pay him $2,000 by June 14. Fox fails to pay on June 14, but, when he tenders payment on June 20, Buchman accepts and cashes the check without reservation. Buchman has thereby waived the condition of payment by June 14. When a person whose duty is conditional leads the other party to rely on his noninsistence on the condition, the condition will be excused because of estoppel. For example, McDonald agrees to sell his business to Brown on condition that Brown provide a credit report and personal financial statement by July 17. On July 5, McDonald tells Brown that he can have until the end of the month to provide the necessary documents. Relying on McDonald’s assurances, Brown does not provide the credit report and financial statement until July 29. In this case, McDonald would be estopped (precluded) from claiming that the condition did not occur. A condition may also be excused when performance of the act that constitutes the condition becomes

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impossible. For example, if a building contract provides that the owner’s duty to pay is conditioned on the production of a certificate from a named architect, the condition would be excused if the named architect died or became incapacitated before issuing the certificate.

Performance of Contracts Distinguish strict performance and substantial LO18-2 performance standards and determine which is likely to be applied to a given contract duty.

When a promisor has performed his duties under a contract, he is discharged. Because one party’s performance constitutes the occurrence of a constructive condition, the other party’s duty to perform is also triggered, and the person who has performed has the right to receive the other party’s performance. In determining whether a promisor is discharged by performance and whether the constructive condition of performance has been fulfilled, courts must consider the standard of performance they expect.

Level of Performance Expected of the Promisor In some situations, no deviation from the

promisor’s promised performance is tolerated; in others, lessthan-perfect performance will be sufficient to discharge the promisor and trigger the right to recover under the contract. Strict Performance Standard A strict performance standard requires virtually perfect compliance with the contract terms. Remember that when a party’s duty is subject to an express condition, that condition must be strictly and completely complied with in order to give rise to a duty of performance. Thus, when a promisor’s performance is an express condition of the promisee’s duty to perform, that performance must strictly and completely comply with the contract in order to give rise to the other promisee’s duty to perform. For example, if McMillan agrees to pay Jester $500 for painting his house “on condition that” Jester finish the job no later than June 1, 2020, a standard of strict or complete performance would be applied to Jester’s performance. If Jester does not finish the job by June 1, his breach will have several consequences. First, because the condition precedent to McMillan’s duty to pay has not occurred, McMillan does not have a duty to pay the contract price. Second, because it is now too late for the condition to occur, McMillan is discharged. Third, McMillan can sue Jester for breach of contract. The law’s commitment to freedom of contract justifies such results in cases in which

the parties have expressly bargained for strict compliance with the terms of the contract. The strict performance standard is also applied to contractual obligations that can be performed either exactly or to a high degree of perfection. Examples of this type of obligation include promises to pay money, deliver deeds, and, generally, deliver goods. A promisor who performs such promises completely and in strict compliance with the contract is entitled to receive the entire contract price. The promisor whose performance deviates from perfection is not entitled to receive the other party’s performance if he does not render perfect performance within an appropriate time. He may, however, be able to recover the value of any benefits that he has conferred on the other party under a theory of quasi-contract. Substantial Performance Standard A substantial performance standard is a somewhat lower standard of performance that applies to duties that are difficult to perform without some deviation from perfection if performance of those duties is not an express condition. A common example of this type of obligation is a promise to erect a building. Other examples include promises to construct roads, to cultivate crops, and to render some types of personal or professional services. Substantial performance is performance that falls short of complete performance in minor respects. It does not apply when a contracting party has been deprived of a material part of the consideration that party bargained for. When a substantial performance standard is applied, the promisor who has substantially performed is discharged. The promisor’s substantial performance triggers the other party’s duty to pay the contract price less any damages resulting from the defects in the promisor’s performance. The obvious purpose behind the doctrine of substantial performance is to prevent forfeiture by a promisor who has given the injured party most of what was bargained for. Substantial performance is generally held to be inapplicable to a situation in which the breach of contract has been willful, however. The Harrison case, which appears shortly, involves a project for which substantial performance is the applicable standard.

Good-Faith Performance One

of the most significant trends in modern contract law is that courts and legislatures have created a duty to perform in good faith in an expanding range of contracts.1 The Uniform

This trend is discussed in Chapter 9.

1



Chapter Eighteen Performance and Remedies

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CONCEPT REVIEW Substantial Performance Definition

Application

Effects

Limitation

Performance that falls short of complete performance in some minor respect but that does not deprive the other party of a material part of the consideration for which the party bargained

Applies to performance that (1) is not an express condition of the other party’s duty to perform and (2) is difficult to do perfectly

Triggers other party’s duty to perform; requires other party to pay the contract price minus any damages caused by defects in performance

Breach cannot have been willful

Commercial Code specifically imposes a duty of good faith in every contract within the scope of any of the articles of the UCC [1-203]. A growing number of courts have applied the duty to use good faith in transactions between lenders and their customers as well as insurance contracts, employment contracts, and contracts for the sale of real property. This obligation to carry out a contract in good faith is usually called the implied covenant of good faith and fair dealing. It is a broad and flexible duty that is imposed by law rather than by the agreement of the parties. It generally means that neither party to a contract will do anything to prevent the other from obtaining the expected benefits from the parties’ agreement or their contractual relationship. The law’s purpose in imposing such a term in contracts is to prevent abuses of power and encourage ethical behavior. Breach of the implied covenant of good faith gives rise to a contract remedy. In some states, it can also constitute a tort, depending on the severity of the breach. A court is more likely to recognize a tort action for breach of the implied covenant of good faith when a contract involves a special relationship of dependency and trust between the parties or where the public interest is adversely affected by a contracting party’s practices. Numerous cases exist, for example, in which insurance companies’ bad-faith refusal to settle claims or perform duties to their insured and lenders’ failure to exercise good faith in their dealings with their customers have led to large damage verdicts. Likewise, in states in which the implied duty of good faith has been held applicable to contracts of employment, employers who discharge employees in bad faith have been held liable for damages.2 This is discussed in Chapter 51.

2

Breach of Contract LO18-3 Explain the possible effects of breach of contract.

When a person’s performance is due, any failure to perform that is not excused is a breach of contract. Not all breaches of contract are of equal seriousness, however. Some are relatively minor deviations, whereas others are so extreme that they deprive the promisee of the essence of what he bargained for. The legal consequences of a given breach depend on the extent of the breach. At a minimum, a party’s breach of contract gives the nonbreaching party the right to sue and recover for any damages caused by that breach. When the breach is serious enough to be called a material breach, further legal consequences ensue.

Effect of Material Breach A material breach oc-

curs when the promisor’s performance fails to reach the level of performance that the promisee is justified in expecting under the circumstances. In a situation in which the promisor’s performance is judged by a substantial performance standard, a claim that the promisor failed to give substantial performance is equivalent to a claim that the promisor materially breached the contract. The party injured by a material breach has the right to withhold performance, is discharged from further obligations under the contract, and may cancel the contract. The nonbreaching party also has the right to sue for damages for total breach of contract. Effect of Nonmaterial Breach By contrast, when the breach is not serious enough to be material, the

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nonbreaching party may sue for only those damages caused by the particular breach. The nonbreaching party does not have the right to cancel the contract. Rather, a nonmaterial breach gives the nonbreaching party the right to suspend performance until the breach is remedied. Once the breach is remedied, however, the nonbreaching party must go ahead and render performance, minus any damages caused by the breach.

than is one that occurs after an extended period of performance. Courts also consider the extent to which the injured party can be adequately compensated by the payment of damages.

Time for Performance A party’s failure to perform on time is a breach of contract that may be serious enough to constitute a material breach, or it may be relatively trivial under the circumstances. Determining the Materiality of the Breach  At the outset, it is necessary to determine when perforThe standard for determining materiality is a flexible one mance is due. Some contracts specifically state the time that takes into account the facts of each individual case. for performance, which makes it easy to determine the The key question is whether the breach deprives the injured time for performance. In some contracts that do not speparty of the benefits that the party reasonably expected. cifically state the time for performance, such a time can be For example, Norman, who is running for mayor, orders inferred from the circumstances surrounding the contract. campaign literature from Prompt Press, to be delivered in In the Norman and Prompt Press campaign literature exSeptember. Prompt Press’s failure to deliver the literature ample, the circumstances surrounding the contract probuntil after the election in November deprives Norman of ably would have implied that the time for performance the essence of what he bargained for and would be considwas some time before the election, even if the parties had ered a material breach. not specified the time for performance. In still other conIn determining materiality, courts take into account the tracts, no time for performance is either stated or implied. extent to which the breaching party will suffer forfeiture When no time for performance is stated or implied, perif the breach is held to be material. They also consider formance must be completed within a “reasonable time,” the magnitude (amount) of the breach and the breaching as judged by the circumstances of each case. In the folparty’s willfulness or good faith. The timing of the breach lowing Harrison case, the court addresses whether it can can also be important. A breach that occurs early on in the determine if a reasonable time has passed as a matter of parties’ relationship is more likely to be viewed as material law in response to a motion for summary judgment.

Harrison v. Family Home Builders, LLC   84 So. 3d 879 (Ala. Ct. App. 2011) Gary and Patsy Harrison hired Family Home Builders, LLC (FHB) to remodel their house. The Harrisons planned remodeling and additions of bedrooms and bathrooms, an addition of an outdoor kitchen, an outdoor pavilion, and the installation of a concrete pad. Kyle Gean, a subcontractor of FHB who was employed to supervise the work at the Harrisons’, met with them prior to commencing the work and estimated that the project would take around four months and cost approximately $109,000. FHB entered a contract with the Harrisons for the remodel. The contract stated no specific date for completion of the work and did not indicate that time was of the essence. Moreover, the contract did not include a total price, but rather required the Harrisons to pay all of the costs of the work to be done plus a 13 percent contractor’s fee to FHB on all such costs. Finally, it required FHB to follow the plans and specifications provided by the Harrisons and to comply with applicable local building codes. According to the Harrisons, almost every aspect of the project was botched by FHB. In their eventual responses to FHB’s discovery requests, the Harrisons outlined a number of these problems. The concrete slab was not level and allowed water to stand on it, was excessively cracked, and had an uneven and splotchy color, among other problems. The brickwork outside was faulty. The framing of bedrooms, bathrooms, the outdoor pavilion, and windows in many rooms was done incorrectly. Improper or incorrect materials were ordered and installed. They further claimed that Gean was often absent, failed to order materials in a timely manner, scheduled subcontractors prior to when the work could be done, and ignored the plans and directions provided by decorator Madelyn Hereford and architect Robert Weber.



Chapter Eighteen Performance and Remedies

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FHB disputed the Harrisons’ claims. In contrast, FHB claimed that the Harrisons and Hereford made significant changes to the original plans during the project, including those that changed the sizes of various features, added elements to the job, and modified others. According to FHB, those changes required additional time and increased costs. FHB argued that it was entitled to a reasonable amount of time to complete the work, which the Harrisons refused to provide. By mid-April (three months into the project), the total cost of the project was between $135,000 and $145,000, and Gary Harrison asked FHB to commit to a May 18 completion date. When FHB refused, the Harrisons terminated the contract and hired Coffman Custom Homes to correct, repair, and complete the work. All parties agree the work was about half done at that point. Derrick Coffman, owner of Coffman Custom Homes, testified at a deposition that FHB’s work did not conform to any known building code’s standards of good workmanship. He testified that the cost of repairing FHB’s poor work was $151,411.55. He admitted, though, that changes in plans and specifications cause delays in projects and that his estimation was that the Harrisons’ remodel was a “one year project at minimum.” In July (six months after the remodel had commenced), the Harrisons filed a lawsuit claiming FHB breached the contract, as well as committed negligence and fraud. As to the breach of contract claim, the Harrisons alleged that FHB failed to complete the work in accordance with the plans and specifications, failed to complete some of the work, and did not comply with applicable building codes, among other claims. After discovery, FHB moved the trial court for summary judgment on all claims, which the trial court granted. The Harrisons appealed.

Bryan, Judge The Harrisons argue that the trial court erred in granting the summary-judgment motion with respect to their breach-of-contract claim insofar as that claim is based on (1) the allegation that FHB failed to perform the work in accordance with the plans and specifications provided by the Harrisons, (2) the allegation that FHB failed to perform the work in a workmanlike manner, and (3) the allegation that FHB failed to complete the work. “[N]ot every partial failure to comply with the terms of a contract by one party . . . will entitle the other party to abandon the contract at once.” Birmingham News Co. v. Fitzgerald, 133 So. 31, 32 (Ala. 1931) [(internal quotations omitted)]. In the case now before us, in order for the Harrisons to establish that they had the right to unilaterally terminate the contract on May 4, 2007, they bore the burden of proving that FHB had committed a breach of the contract that was “of so material and substantial a nature as would constitute a defense to an action brought by [FHB] for [the Harrisons’] refusal to proceed with the contract.” Id. (quoting 3 Williston on Contracts § 1467). . . . In order for FHB’s breach of the contract to constitute a defense to an action brought by FHB based on the Harrisons’ refusal to proceed with the contract, the breach must be sufficient to establish that FHB had not rendered substantial performance of the contract. See John D. Calamari & Joseph M. Perillo, The Law of Contracts § 11.18(b) (4th ed. 1998) (“Substantial performance is the antithesis of material breach. If a breach is material, it follows that substantial performance has not been rendered.”). “Substantial performance of a contract does not contemplate exact performance of every detail but performance of all important parts.” Mac Pon Co. v. Vinsant Painting & Decorating Co., 423 So. 2d 216, 218 (Ala. 1982).

The Harrisons’ [discovery responses], the testimony regarding defects in the concrete contained in Coffman’s affidavit, and the testimony regarding defects in the concrete and the framing contained in Coffman’s deposition testimony constituted substantial evidence tending to prove that FHB had failed to perform some of its work in a workmanlike manner. We conclude that the question whether that evidence indicates that FHB committed a material breach of the contract that entitled the Harrisons to terminate the contract unilaterally is a question of fact to be determined by a jury. [Citation omitted.] Therefore, we reverse the summary judgment with respect to the breach-of-contract claim insofar as that claim is based on the allegation that FHB failed to perform the work in a workmanlike manner. Insofar as their breach-of-contract claim is based on the allegation that FHB failed to perform the work in accordance with the plans and specifications, the Harrisons argue that the trial court erred in granting the summary-judgment motion because, they say, (1) Madelyn Hereford, their decorator, testified that FHB installed plumbing pipes and electrical wiring in the wall to the left of a sliding pocket door instead of to the right as specified by the plans, which required that those pipes and wires be torn out and reinstalled, and (2) Gary Harrison testified in his affidavit that “Mr. Gean did not follow the drawings, plans and directions of Madelyn Hereford, our interior decorator, and Robert Weber, our architect.” That testimony of Gary Harrison is a mere conclusory statement that cannot be considered in ruling upon a summary-judgment motion. [Citation and quotes omitted.] Hereford’s testimony tended to prove one instance of FHB’s failure to follow the plans and specifications. However, in order for that one instance of FHB’s failure to follow the

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plans and specifications to constitute a material breach of the contract, it would have to be sufficient to establish that FHB had failed to render substantial performance of the contract. We conclude that that one instance alone is not sufficient to establish that FHB failed to render substantial performance of the contract. Therefore, we affirm the summary judgment with respect to the breach-of-contract claim insofar as that claim is based on the allegation that FHB failed to follow the plans and specifications. Insofar as their breach-of-contract claim is based on the allegation that FHB failed to complete the work, the Harrisons argue that the trial court erred in granting the summary-judgment motion because, they say, (1) Gean testified that, before the contract was signed, he had estimated that it would take three to four months to complete the work; (2) Gary Harrison testified that FHB could have completed the work by mid-April 2007 if it had performed the work properly; and (3) Hereford testified as follows: [By FHB’s attorney] Q. In your judgment, with all the changes that were made—and it goes up—in your notes, up until April the 1st, between April 1st and 6th. Due to those changes, this job couldn’t be completed by March or April of 2007; is that fair? A. Yes—no—wait a minute. Is it fair that it was not completed by March or April? Q. Due to the changes? A. I see no reason that it could not have been completed. Q. Okay. Even changes that were still made in March and April, huh?

Consequences of Late Performance After a court determines when performance was due, it must determine the consequences of late performance. In some contracts, the parties expressly state that “time is of the essence” or that timely performance is “vital.” This means that each party’s timely performance by a specific date is an express condition of the other party’s duty to perform. Thus, in a contract that contains a time is of the essence provision, any delay by either party normally constitutes a material breach. Sometimes, courts will imply such a term even when the language of the contract does not state that time is of the essence. A court would be likely to do this if late performance is of little or no value to the promisee. For example, Schrader contracts with the local newspaper to run an advertisement for Christmas trees from December 15, 2010, to December 24, 2010, but the newspaper does

A. Well, look at the changes that were made. We changed from a jetted tub to spa. That—I believe that is—the space was already there. The framing could have been done. Because the contract neither specified a date for completion of the work nor stated that time was of the essence, FHB was entitled to a reasonable time to perform the contract. . . . Although Coffman, who testified as an expert witness on behalf of the Harrisons, testified in his deposition that it would take a minimum of a year to perform the work, the Harrisons submitted sufficient evidence to establish a genuine issue of material fact regarding whether the Harrisons afforded FHB a reasonable time to perform the work before terminating the contract on May 4, 2007. . . . Moreover, we conclude that, if a jury should find that the Harrisons afforded FHB a reasonable time to complete the work, it would also be a jury question whether FHB’s failure to complete the work by May 4, 2007, constituted a material breach of the contract that would entitle the Harrisons to terminate the contract unilaterally. [Citation omitted.] Therefore, we reverse the summary judgment with respect to the breach-of-contract claim insofar as that claim is based on the allegation that FHB failed to complete the work. Affirmed in Part; Reversed in Part; and Remanded.

————————— [Note: In a portion of the opinion not reproduced here, the court addressed the negligence and fraud claims, reversing summary judgment on the negligence claim on several theories and affirming the summary judgment on the fraud claim.]

not run the ad until December 26, 2010. In this case, the time for performance is an essential part of the contract and the newspaper has committed a material breach. When a contract does not contain language indicating that time is of the essence and a court determines that the time for performance is not a particularly important part of the contract, the promisee must accept late performance rendered within a reasonable time after performance was due. The promisee is then entitled to deduct or set off from the contract price any losses caused by the delay. Late performance is not a material breach in such cases unless it is unreasonably late.

Anticipatory Repudiation One

type of breach of contract occurs when the promisor indicates before the time for performance an unwillingness or inability to carry



Chapter Eighteen Performance and Remedies

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CONCEPT REVIEW Time for Performance Contract Language

Time for Performance

Consequences of Late Performance

“Time is of the essence”  or similar language

The time stated in the contract

Material breach

Specific time is stated in or implied by the contract and later performance would have little or no value

The time stated in or implied by the contract

Material breach

Specific time is stated in or implied by the contract, but the time for  performance is a relatively  unimportant part of the contract

The time stated in or implied by the contract

Not a material breach unless performance is unreasonably late

No time for performance is stated in or implied by the contract

Within a reasonable time

Not material breach unless performance is unreasonably late

out the contract. This is called anticipatory repudiation or anticipatory breach. Anticipatory breach generally constitutes a material breach of contract that discharges the promisee from all further obligation under the contract. In determining what constitutes anticipatory repudiation, courts look for some unequivocal statement or voluntary act that clearly indicates that the promisor cannot or will not perform. This may take the form of an express statement by the promisor. The promisor’s intent not to perform could also be implied from the promisor’s actions. For example, if Ross, who is obligated to convey real estate to Davis, conveys the property to some third person instead, Ross has repudiated the contract. When anticipatory repudiation occurs, the promisee is faced with several choices. For example, Marsh and Davis enter a contract in which Davis agrees to deliver a quantity of bricks to Marsh on September 1, 2014, and Marsh agrees to pay Davis a sum of money in two installments. The agreement specifies that Marsh will pay 50 percent of the purchase price on July 15, 2014, and 50 percent of the purchase price within 30 days after delivery. On July 1, 2014, Davis writes Marsh and unequivocally states that he will not deliver the bricks. Must Marsh go ahead and send the payment that is due on July 15? Must he wait until September 1 to bring suit for total breach of contract? The answer to both questions is no. When anticipatory repudiation occurs, the nonbreaching party is justified in withholding performance and suing for

damages right away, without waiting for the time for performance to arrive.3 A nonbreaching party who was ready, willing, and able to perform can recover damages for total breach of the contract. The nonbreaching party is not obligated to do this, but may instead wait until the time for performance in case the other party decides to perform.

Recovery by a Party Who Has Committed Material Breach A party who has materially

breached the contract (i.e., has not substantially performed) does not have the right to recover the contract price. If a promisor who has given some performance to the promisee cannot recover under the contract, however, the promisor will face forfeiture and the promisee will have obtained an unearned gain. There are two possible avenues for a party who has committed material breach to obtain some compensation for the performance conferred on the nonbreaching party. 1. Quasi-contract. A party who has materially breached a contract might recover the reasonable value of any benefits conferred on the promisee by bringing an action under quasi-contract.4 This would enable the promisor to obtain Uniform Commercial Code rules regarding anticipatory repudiation in contracts for the sale of goods are discussed in Chapter 21. 4 Quasi-contract is discussed in Chapter 9. It involves the use of the remedy of restitution, which is discussed later in this chapter. 3

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Part Three Contracts

Ethics and Compliance in Action Marsh, a contractor, enters into a contract with Needmore Tree Farm to build a structure on Needmore’s property that Needmore plans to use as a sales office for selling Christmas trees to the public. The contract provides that Needmore will pay Marsh $110,000 for the structure, with 50 percent of the payment in advance and 50 percent upon completion. It also provides that Marsh will complete the construction and have the structure ready for occupation by December 1. With regard to this last provision, the contract states, “time is of

compensation for the value of any performance that has benefited the nonbreaching party. Some courts take the position that a person in material breach should not be able to recover for benefits conferred, however. 2. Partial performance of a divisible contract. Some contracts are divisible; that is, each party’s performance can be divided in two or more parts and each part is exchanged for some corresponding consideration from the other party. For example, if Johnson agrees to mow Peterson’s lawn for $20 and clean Peterson’s gutters for $50, the contract is divisible. A promisor who performs one part of the contract but materially breaches another part can recover at the contract price for the part the promisor did perform. For example, if Johnson breached his duty to clean the gutters but fully performed his obligation to mow the lawn, he could recover at the contract price for the lawn-mowing part of the contract.

Excuses for Nonperformance LO18-4

List and explain the circumstances that can excuse performance of a contract.

Although nonperformance of a duty that has become due will ordinarily be a breach of contract, there are some situations in which nonperformance is excused because of factors that arise after the formation of the contract. When this occurs, the person whose performance is made impossible or impracticable by these factors is discharged from further obligation under the contract. The following discussion concerns the most common grounds for excuse of nonperformance.

the essence.” The December 1 date is significant to Needmore because it wanted to be sure to have the sales office ready for Christmas season. On December 1, the construction has progressed substantially, but the structure is not going to be ready for occupation for several more weeks. Needmore fires Marsh and refuses to pay him the remaining 50 percent due under the contract. Assuming that Marsh has materially breached the contract, does Needmore have an ethical duty to pay Marsh for the benefit that Marsh has conferred on it?

Impossibility When

performance of a contractual duty becomes impossible after the formation of the contract, the duty will be discharged on grounds of impossibility. This does not mean that a person can be discharged merely because of an inability to perform on the contract or because doing so will cause hardship or difficulty. Impossibility in the legal sense of the word means “it cannot be done by anyone” rather than “I cannot do it.” Thus, promisors who find that they have agreed to perform duties that are beyond their capabilities or that turn out to be unprofitable or burdensome are generally not excused from performance of their duties. This principle is illustrated in the World of Boxing case, which follows and which involves a promise that famous boxing promoter Don King was unable to perform. Impossibility will provide an excuse for nonperformance, however, when some unexpected event arises after the formation of the contract and renders performance objectively impossible. The event that causes the impossibility need not have been entirely unforeseeable. But normally the event will be one that the parties would not have reasonably thought of as a real possibility that would affect performance. There are a variety of situations in which a person’s duty to perform may be discharged on grounds of impossibility. The three most common situations involve illness or death of the promisor, supervening illegality, and destruction of the subject matter of the contract. Illness or Death of Promisor Incapacitating illness or death of the promisor excuses nonperformance when the promisor has contracted to perform personal services. For example, if Pauling, a college professor who has a contract with State University to teach for an academic year, dies



Chapter Eighteen Performance and Remedies

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World of Boxing LLC v. King   56 F. Supp. 3d 507 (S.D.N.Y. 2014) On May 17, 2013, professional boxers Guillermo Jones and Denis Lebedev fought in a Cruiserweight Title Fight in Moscow, sanctioned by the World Boxing Association (WBA), which Jones won by knockout in the 11th round. After the bout, however, Jones’s urine tested positive for furosemide, prompting an investigation by the WBA. On October 17, 2013, the WBA found Jones guilty of using a banned substance, stripped him of the Cruiserweight title, and suspended him from WBA-sanctioned bouts for six months. On January 28, 2014, Vladimir Hrunov and Andrey Ryabinskiy, doing business as World of Boxing LLC (WOB), and Don King— the representatives of Lebedev and Jones, respectively—finalized terms for a second administration of the Cruiserweight Title match between Lebedev and Jones. In the Agreement, King represented that he “holds the exclusive promotional rights for Jones,” and he promised to “cause Jones . . . to participate” in the rematch. The Agreement also imposed the following restrictions on Jones: Jones must arrive in Moscow a minimum of 7 days before the Event and shall remain in Moscow until the Event. Jones also undertakes to be subjected to drug testing before and after the fight, in compliance with the rules of the WBA and the [2013 WBA Resolution]. The purpose of these provisions, as King has explained by affidavit, was to “preclude another . . . positive drug test.”  The rematch was set for April 25, 2014. On April 23, 2014, urine samples were collected from both Jones and Lebedev and submitted for testing. On April 25, 2014—the day the bout was supposed to take place—a report was issued, finding that Lebedev’s sample was clean but that Jones’s sample tested positive for furosemide. When WOB and Lebedev learned of this news, Lebedev withdrew from the bout. On April 28, 2014, the WBA issued a letter deeming Lebedev’s withdrawal “justifiabl[e]” on the basis that “[t]he WBA would not, and could not, sanction a championship bout when it was aware of Jones’ positive test as this would violate WBA rules, may cause unnecessary harm to [Lebedev], and would otherwise compromise the nature of WBA world title bouts.” On May 23, 2014, after reviewing the test results more carefully, the WBA issued a resolution (1) affirming the finding that Jones’s urine contained furosemide, (2) suspending Jones from WBA-sanctioned bouts for two years, and (3) naming Lebedev Cruiserweight champion. WOB sued King for breach of contract for failing to “cause Jones . . . to participate” in the bout. In response to WOB’s motion for summary judgment on the issue of King’s liability for breach of contract, King responded by pleading that he did not breach the contract and, even if he did, his nonperformance was excused by the doctrine of impossibility. Shira A. Scheindlin, District Judge DISCUSSION A. King Breached the Contract The Agreement required King to “cause [Jones] to participate in a 12 Round WBA Cruiserweight World Title match [against Lebedev].” King argues that this clause is ambiguous, and that its meaning depends on unresolved factual questions, making summary judgment inappropriate. But the relevant facts are not in dispute. Under WBA rules— which the Agreement incorporates by reference—any boxer who tests positive for a banned, performance-enhancing substance is disqualified from WBA-sponsored bouts for no less than six months. Both parties agree that Jones ingested furosemide,and there is no question that having tested positive for furosemide, Jones could not participate in the bout. This ends the inquiry. If Jones could not participate in the bout, it follows a fortiori that King could not have caused Jones to participate in the bout. Therefore, King breached the Agreement. King protests that this interpretation of the Agreement yields “unreasonable and illogical” results. It would require of King

“nothing less than . . . personal supervision of Jones’s every action between the execution of [the Agreement] and the scheduled date of the [bout against Lebedev].” Indeed, in order to avoid liability, King avers that he would have had “to imprison Jones to prevent him from having any access to a banned substance”— clearly an untenable outcome. While these arguments might have force, they are addressed to the wrong issue. King could be right: under the circumstances, it is possible that his contractual obligations were too onerous to be enforceable. But that question goes to whether King’s failure to perform may be excused, not to whether King in fact failed to perform. As to the latter, Jones’s disqualification plainly put King in breach. B. Impossibility Does Not Excuse King’s Breach In general, “contract liability is strict liability.” Nevertheless, failure to perform can be excused if “destruction of . . . the means of performance makes performance objectively impossible.” In this vein, King likens his plight to that of a singing troupe manager who signed a contract with a theater owner, promising that the troupe would play for two weeks, only to have the lead singer fall ill on the eve of the first show. When the theater owner sued for

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Part Three Contracts

breach, the New York Court of Appeals excused the manager’s non-performance on the grounds that “[c]ontracts for personal services”—contracts that require action by a specific person—“are subject to [the] implied condition that . . . if [the person] dies, or without fault on the part of the covenantor becomes disabled, the obligation to perform is extinguished.” Likewise here, argues King: by ingesting furosemide, Jones “disabled” himself from participating in a WBA-sponsored bout, thereby “extinguishing” King’s obligation to perform. New York law is very clear, however, that an impossibility defense is only available if the frustration of performance was “produced by an unanticipated event that could not have been foreseen or guarded against in the contract.” In this case, two key facts compel the conclusion that Jones’s ingestion of furosemide was not “unanticipated”—i.e., that King should have foreseen the possibility of Jones testing positive and guarded against it in the contract. First, Jones had a history of doping. The result of the first Cruiserweight Title match between Jones and Lebedev—in May 2013—had to be vacated because Jones tested positive for furosemide after the fact. Second, the Agreement provided for mandatory pre-bout drug testing, as required by the 2013 WBA Resolution. King tries to turn these facts around. Noting how “stunned” and “shocked” he was to learn of the positive drug test on April 25, 2014, King reports that “it defie[d] belief, that Jones, aware that he would be subjected to pre-bout drug testing due to his previous positive result, would again test positive for the same banned substance.” Put otherwise, King “believed that the mandatory drug testing provision . . . would preclude another potential positive drug test, because [Jones] knew that [he] would be subject to random testing.” Therefore, in King’s view, he should not be punished for failing to foresee such a “plainly remote and unlikely event.”

While King’s dismay is understandable—it is stunning that Jones was foolish enough to test positive for the same drug twice—his argument misconstrues the term “unanticipated event.” King casts the question in terms of probability: an event is “unanticipated,” in his view, if it is unlikely to occur. What the case law has in mind, however, are not improbable events, but events that fall outside the sphere of what a reasonable person would plan for. Even assuming that King is right about the likelihood of a second positive test, it strains credibility to call the event “unanticipated.” King’s own testimony proves the point. By way of explaining why the Agreement was silent about what to do in the event of a second positive test, King admits that he thought the “mandatory drug testing provision” would “preclude” Jones from ingesting furosemide. No doubt he did. From this testimony, however, no one could reasonably conclude that King had not anticipated the possibility of a second positive test. Rather, the inescapable conclusion is that King had anticipated such a possibility—and having anticipated it, he believed the threat of a mandatory drug test would ward it off. That King’s belief turned out to be mistaken is no basis for relieving him of his contract obligations. In essence, King argues that he should not be held liable because Jones’s decision to take furosemide was outside of King’s control: short of “imprison[ing] Jones,” there was no way for him to perform. But this argument ignores what was in King’s control: the decision not to bargain for more protective contract terms.

before the completion of the contract, her estate will not be liable for breach of contract. The promisor’s death or illness does not, however, excuse the nonperformance of duties that can be delegated to another, such as the duty to deliver goods, pay money, or convey real estate. For example, if Odell had contracted to convey real estate to Ruskin and died before the closing date, Ruskin could enforce the contract against Odell’s estate.

from performing. Statutes or regulations that merely make performance more difficult or less profitable do not, however, excuse nonperformance.

Supervening Illegality If a statute or governmental regulation enacted after the creation of a contract makes performance of a party’s duties illegal, the promisor is excused

*** CONCLUSION For the foregoing reasons, WOB’s partial motion for summary judgment as to liability is GRANTED.

Destruction of the Subject Matter of the Contract If something that is essential to the promisor’s performance is destroyed after the formation of the contract through no fault of the promisor, the promisor is excused from performing. For example, Woolridge contracts to sell his car to Rivkin. If an explosion destroys the car after the contract has been formed but before Woolridge has made delivery, Woolridge’s nonperformance will be excused.



Chapter Eighteen Performance and Remedies

The destruction of nonessential items that the promisor intended to use in performing does not excuse nonperformance if substitutes are available, even though securing them makes performance more difficult or less profitable. Suppose that Ace Construction Company had planned to use a particular piece of machinery in fulfilling a contract to build a building for Worldwide Widgets Company. If the piece of machinery is destroyed but substitutes are available, destruction of the machinery before the contract is performed would not give Ace an excuse for failing to perform.

Commercial Impracticability Section

2-615 of the Uniform Commercial Code has extended the scope of the common law doctrine of impossibility to cases in which unforeseen developments make performance by the promisor highly impracticable, unreasonably expensive, or of little value to the promisee. Rather than using a standard of impossibility, then, the UCC uses the more relaxed standard of impracticability. Despite the less stringent standard applied, cases actually excusing nonperformance on grounds of impracticability are relatively rare. To be successful in claiming excuse based on impracticability, a promisor must be able to establish that the event that makes performance impracticable occurred without the promisor’s fault and that the contract was made with the basic assumption that this event would not occur. This basically means that the event was beyond the scope of the risks that the parties contemplated at the time of contracting and that the promisor did not expressly or impliedly assume the risk that the event would occur. Case law and official comments to UCC section 2-615 indicate that neither increased cost nor collapse of a market for particular goods is sufficient to excuse nonperformance because those are the types of business risks that every promisor assumes. However, drastic price increases or severe shortages of goods resulting from unforeseen circumstances such as wars and crop failures can give rise to impracticability. If the event causing impracticability affects only a part of the seller’s capacity to perform, the seller must allocate production and deliveries among customers in a “fair and reasonable” manner and must notify them of any delay or any limited allocation of the goods. You can read more about commercial impracticability in Chapter 21, Performance of Sales Contracts.

Other Grounds for Discharge Earlier in this chapter, you learned about several situations in which a party’s duty to perform could be discharged

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even though that party had not performed. These include the nonoccurrence of a condition precedent or concurrent condition; the occurrence of a condition subsequent; material breach by the other party; and excuse from performance by impossibility, impracticability, or frustration. The following discussion deals with additional ways in which a discharge can occur.

Discharge by Mutual Agreement Just

as contracts are created by mutual agreement, they can also be discharged by mutual agreement. An agreement to discharge a contract must be supported by consideration to be enforceable.

Discharge by Accord and Satisfaction  An accord is an agreement whereby a promisee who has an existing claim agrees with the promisor to accept some performance different from that which was originally agreed on. When the promisor performs the accord, that is called a satisfaction.5 When an accord and satisfaction occurs, the parties are discharged. For example, Root contracts with May to build a garage on May’s property for $30,000. After Root has performed his part of the bargain, the parties then agree that instead of paying money, May will transfer a one-year-old Porsche to Root. When this is done, both parties are discharged.

Discharge by Waiver A party to a contract may

voluntarily relinquish any right he has under a contract, including the right to receive return performance. Such a relinquishment of rights is known as a waiver. If one party tenders an incomplete or defective performance and the other party accepts that performance without objection, knowing that the defects will not be remedied, the party to whom performance was due has waived the right to enforce complete or perfect performance. For example, a real estate lease requires Long, the tenant, to pay a $5 late charge for late payments of rent. Long pays his rent late each month for five months, but the landlord accepts it without objection and without assessing the late charge. In this situation, the landlord has probably waived his right to collect the late charge. To avoid waiving rights, a person who has received defective performance should give the other party prompt notice that she expects complete performance and will seek damages if the defects are not corrected.

Discharge by Alteration If the contract is represented by a written instrument, and one of the parties Accord and satisfaction is also discussed in Chapter 12.

5

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Part Three Contracts

intentionally makes a material alteration in the instrument without the other’s consent, the alteration acts as a discharge of the other party. If the other party consents to the alteration or does not object to it when he learns of it, he is not discharged. Alteration by a third party without the knowledge or consent of the contracting parties does not affect the parties’ rights.

Discharge by Statute of Limitations Courts

have long refused to grant a remedy to a person who delays bringing a lawsuit for an unreasonable time. All of the states have enacted statutes known as statutes of limitations, which specify the period of time in which a person can bring a lawsuit. The time period for bringing a contract action varies from state to state, and many states have shorter periods for cases involving oral contracts than those for cases concerning written contracts. Section 2-725 of the Uniform Commercial Code provides for a four-year statute of limitations for contracts involving the sale of goods. The statutory period ordinarily begins to run from the date of the breach. It may be delayed if the party who has the right to sue is under some incapacity at that time (such as minority or insanity) or if the breaching party is beyond the jurisdiction of the state. If the nonbreaching party chooses not to bring a lawsuit before the statutory period runs out, the party who breached the contract will not be liable.

Discharge by Decree of Bankruptcy The

contractual obligations of a debtor are generally discharged by a decree of bankruptcy. Bankruptcy is discussed in Chapter 30.

Remedies for Breach of Contract Distinguish the various remedies for breach of contract

LO18-5 and identify the circumstances under which each remedy

is appropriate.

Our discussion of the performance stage of contracts so far has focused on the circumstances under which a party has the duty to perform or is excused from performing. In situations in which a person is injured by a breach of contract and is unable to obtain compensation by a settlement out of court, a further important issue remains: What remedy will a court fashion to compensate for breach of contract?

Contract law seeks to encourage people to rely on the promises made to them by others. Contract remedies focus on the economic loss caused by breach of contract, not on the moral obligation to perform a promise. The objective of granting a remedy in a case of breach of contract is simply to compensate the injured party.

Types of Contract Remedies There are a variety of ways in which an injured party can be compensated. The basic categories of contract remedies include: 1. Legal remedies (money damages). 2. Equitable remedies. 3. Restitution. The usual remedy is an award of money damages that will compensate for the losses suffered by the injured party. This is called a legal remedy or remedy at law because the imposition of money damages in our legal system originated in courts of law. Less frequently used but still important are equitable remedies such as specific performance. Equitable remedies are those remedies that had their origins in courts of equity rather than in courts of law.6 Today, they are available at the discretion of the judge. A final possible remedy is restitution, which requires the defendant to pay the value of the benefits that the plaintiff has provided to the defendant.

Interests Protected by Contract Remedies Remedies for breach of contract protect one or more of the following interests that a promisee may have:7

1. Expectation interest. The expectation interest is the objective or opportunity for gain that the promisee bargained for and “expected” from the contract. Courts attempt to protect this interest by formulating a remedy that will place the promisee in the position he would have been in if the contract had been performed as promised. 2. Reliance interest. The reliance interest is a promisee’s interest in being compensated for losses suffered as a result of relying on the other party’s promise. In some cases, such as when a promise is unable to prove the value of the expectation interest with reasonable certainty, the promisee may seek reliance damages rather than expectation damages. 3. Restitution interest. The restitution interest represents the amount by which the breaching party was enriched or benefited. Both the reliance and restitution interests The nature of equitable remedies is also discussed in Chapter 1. Restatement (Second) of Contracts § 344.

6 7



Chapter Eighteen Performance and Remedies

involve promisees who have changed their position. The difference between the two is that the reliance interest involves a loss to the promisee that does not benefit the promisor, whereas the restitution interest involves a loss to the promisee that does constitute an unjust enrichment to the promisor. A remedy based on restitution enables a party who has performed or partially performed and has benefited the other party to obtain compensation for the value of the benefits conferred on the other party.

Legal Remedies (Damages) Limitations on Recovery of Damages in Contract Cases  An injured party’s ability to recover damages in a contract action is limited by three principles: 1. A party can recover damages only for those losses proven with reasonable certainty. Losses that are purely speculative are not recoverable. Thus, if Jones Publishing Company breaches a contract to publish Powell’s memoirs, Powell may not be able to recover damages for lost royalties (her expectation interest) because she may be unable to establish, beyond speculation, how much money she would have earned in royalties if the book had been published. (Note, however, that Powell’s reliance interest might be protected here; she could be allowed to recover provable losses incurred in reliance on the contract.) 2. A breaching party is responsible for paying only those losses that were foreseeable to the breaching party at the time of contracting. A loss is foreseeable if it would ordinarily be expected to result from a breach or if the breaching party had reason to know of particular circumstances that would make the loss likely. For example, if Prince Manufacturing Company renders late performance in a contract to deliver parts to Cheatum Motors without knowing that Cheatum is shut down waiting for the parts, Prince will not have to pay the business losses that result from Cheatum’s having to close its operation. 3. Plaintiffs injured by a breach of contract have the duty to mitigate (avoid or minimize) damages. A party cannot recover for losses that could have been avoided without undue risk, burden, or humiliation. For example, an employee who has been wrongfully fired would be entitled to damages equal to his wages for the remainder of the employment period. The employee, however, has the duty to minimize the damages by making reasonable efforts to seek a similar job elsewhere. Compensatory Damages Subject to the limitations discussed above, a person who has been injured by a breach

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of contract is entitled to recover compensatory damages. In calculating the compensatory remedy, a court will attempt to protect the expectation interest of the injured party by giving him the “benefit of his bargain” (placing him in the position he would have been in had the contract been performed as promised). To do this, the court must compensate the injured person for the provable losses he has suffered as well as for the provable gains that he has been prevented from realizing by the breach of contract. Normally, compensatory damages include one or more of three possible items: loss in value, any allowable consequential damages, and any allowable incidental damages. 1. Loss in value. The starting point in calculating compensatory damages is to determine the loss in value of the performance that the plaintiff had the right to expect. This is a way of measuring the expectation interest. The calculation of the loss in value experienced by an injured party differs according to the sort of contract involved and the circumstances of the breach. In contracts involving nonperformance of the sale of real estate, for example, courts normally measure loss in value by the difference between the contract price and the market price of the property. Thus, if Willis repudiates a contract with Renfrew whereby Renfrew was to purchase land worth $20,000 from Willis for $10,000, Renfrew’s loss in value was $10,000.8 Where a seller has failed to perform a contract for the sale of goods, courts may measure loss in value by the difference between the contract price and the price that the buyer had to pay to procure substitute goods.9 In cases in which a party breaches by rendering defective performance—say, by breaching a warranty in the sale of goods—the loss in value would be measured by the difference between the value of the goods if they had been in the condition warranted by the seller and the value of the goods in their defective condition.10 2. Consequential damages. Consequential damages (also called special damages) compensate for losses that occur as a consequence of the breach of contract. Consequential losses occur because of some special or unusual circumstances of the particular contractual relationship of the parties. For example, Apex Trucking Company buys a computer system from ABC Computers. The system fails

In this example, Renfrew may also be able to seek specific performance as a remedy. Specific performance is discussed later in this chapter. 9 Remedies under Article 2 of the Uniform Commercial Code are  discussed in detail in Chapter 22. 10 See Chapter 20 for further discussion of the damages for breach of warranty in the sale of goods. 8

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to operate properly, and Apex is forced to pay its employees to perform the tasks manually, spending $10,000 in overtime pay. In this situation, Apex might seek to recover the $10,000 in overtime pay in addition to the loss of value that it has experienced. Lost profits flowing from a breach of contract can be recovered as consequential damages if they are foreseeable and can be proven with reasonable certainty. It is important to remember, however, that the recovery of consequential damages is subject to the limitations on damage recovery discussed earlier.

The following George case involves the requirements for consequential damages. 3. Incidental damages. Incidental damages compensate for reasonable costs that the injured party incurs after the breach in an effort to avoid further loss. For example, if Smith Construction Company breaches an employment contract with Brice, Brice could recover as incidental damages those reasonable expenses he must incur in attempting to procure substitute employment, such as the reasonable cost of travel to his interviews for other jobs.

George v. Al Hoyt & Sons, Inc.   27 A.3d 697 (N.H. 2011) Adelaide George, doing business as Homes by George, was the developer of a residential real estate development known as Esther’s Estates. Esther’s Estates was financed by loans from EML Builders, which were secured by a mortgage on the property. In December 2001, George’s son, Rick, entered into a written contract on behalf of Homes by George to hire Al Hoyt & Sons to perform work on the development, including the building of a road. The agreed contract price was $79,278.31. In January and February 2002, Hoyt began doing the work on Esther’s Estates. On February 15, Homes by George paid Hoyt $10,500 as a deposit for a bridge that was necessary to complete the road, and ultimately the development of Esther’s Estates. Homes by George had a wetlands permit that required the bridge to be installed by July 2002. In June 2002, a disagreement arose between the parties as to whether the contract required Hoyt to construct and install the bridge as part of the road construction. That same month, Hoyt informed Homes by George that it would not construct and install the bridge. Shortly thereafter, Homes by George entered into a contract with another company to provide the bridge for $21,140, but learned that it would take three months for the bridge to be built. As a result of the delay in installation of the bridge, Homes by George was forced to return deposits to two prospective purchasers of homes to be built in Esther’s Estates and to void their respective purchase and sale agreements. Homes by George had planned to use the profits from these sales to pay down the mortgage with EML Builders and continue with the project. However, EML Builders learned that the bridge would not be installed in July and “called the note” because “performance wasn’t being done.” Consequently, on August 22, Homes by George transferred Esther’s Estates to EML Builders via a deed in lieu of foreclosure for the amount of $300,000. Homes by George sued Hoyt for breach of contract, among other claims. A jury ultimately awarded Homes by George $500,000 on its breach of contract claim. The trial court set aside the award and instead awarded Homes by George $56,580 on its other claims. Homes by George appealed.

Hicks, Judge Homes by George argues that the failure to build the bridge was a breach of the contract between the parties, and, therefore, they “were entitled not only to the return of the deposit, but the cost of the . . . bridge in addition to consequential damages flowing from the breach.” They contend “that there was competent evidence from [them] on the issue of consequential damages,” including evidence of the cost of the bridge deposit, the total bridge cost, lost profits and the value of the development at the time they deeded the property to EML Builders in lieu of foreclosure. We have held that consequential damages that could have been reasonably anticipated by the parties as likely to be caused by the defendant’s breach are properly awarded to the non-breaching

party in a contract action. The requirement of ­reasonable foreseeability may be satisfied in either of two ways: (1) as a matter of law if the damages follow the breach in the ordinary course of events; or (2) by the claimant specifically proving that the breaching party had reason to know the facts and to foresee injury. The goal of damages in actions for breach of contract is to put the non-breaching party in the same position it would have been if the contract had been fully performed. In this case, George testified that, after Hoyt informed Homes by George that it would not install the bridge, Homes by George lost the sales and hence the profit from two houses that were to be built on lots in Esther’s Estates. She presented uncontroverted testimony that Hoyt knew from the start that Homes by George



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had those two lots under contract and that Homes by George “had to have the bridge in in June.” Thus, Hoyt should have realized that the failure to install the bridge in a timely manner could result in lost profits for Homes by George. The trial court found that the jury’s verdict was unreasonable, in part, because “there was no testimony as to how much lost profit specifically was applicable to the two lots that were the subject of this award.” New Hampshire law, however, does not require that damages be calculated with mathematical certainty, and the method used to compute them need not be more than an approximation. We will uphold an award of damages for lost profits if sufficient data existed indicating that profits were reasonably certain to result. Here, George testified that the two purchase and sale contracts were for $277,900 and $276,900 and that the expected profit on each of the two houses was between $100,000 and $125,000

but no less than $100,000. She further testified that Homes by George had already built thirteen houses in the earlier phases of Esther’s Estates and that the profit margin for those houses was at least $100,000. Based upon this evidence, we find that HBG’s lost profits on these two houses were reasonably certain. There is evidence in the record from which a reasonable jury could have found lost profit damages between $200,000 to $250,000. However, the jury’s $500,000 verdict is unsustainable unless Homes by George proved that they were entitled to damages for the value of the property Homes by George lost on the deed transfer. The trial court’s ruling with respect to this portion of damages is unclear. We remand on this issue for a determination whether the record supports an award of damages beyond the lost profits on the lost home sales.

Alternative Measures of Damages The foregoing discussion has focused on the most common formulation of damage remedies in contracts cases. The normal measure of compensatory damages is not appropriate in every case, however. When it is not appropriate, a court may use an alternative measure of damages. For example, a party who has suffered losses by performing or preparing to perform might seek damages based on reliance interest instead of expectation interest. In such a case, the party would be compensated for the provable losses suffered by relying on the other party’s promise. This measure of damages is often used in cases in which a promise is enforceable under promissory estoppel.11

to operate a retail clothing store. She must make improvements in the space before opening the store, and it is very important to her to have the store opened for the Christmas shopping season. She hires Ace Construction Company to construct the improvements. The parties agree to include in the contract a liquidated damages provision stating that, if Ace is late in completing the construction, Murchison will be able to recover a specified sum for each day of delay. Such a provision is highly desirable from Murchison’s point of view because, without a liquidated damages provision, she would have a difficult time establishing the precise losses that would result from delay. Courts scrutinize these agreed-on damages carefully, however. If the amount specified in a liquidated damages provision is reasonable and if the nature of the contract is such that actual damages would be difficult to determine, a court will enforce the provision. When liquidated damages provisions are enforced, the amount of damages agreed on will be the injured party’s exclusive damage remedy. If the amount specified is unreasonably great in relation to the probable loss or injury, however, or if the amount of damages could be readily determined in the event of breach, the courts will declare the provision a penalty and refuse to enforce it. In the Garden Ridge case, the court explains and applies the UCC test for differentiating an enforceable liquidated damages clause from an unenforceable penalty clause.

Nominal Damages Nominal damages are very small damage awards that are given when a technical breach of contract has occurred without causing any actual or provable economic loss. The sums awarded as nominal damages typically vary from 2 cents to a dollar. Liquidated Damages The parties to a contract may expressly provide in their contract that a specific sum shall be recoverable if the contract is breached. Such provisions are called liquidated damages provisions. For example, Murchison rents space in a shopping mall in which she plans 11

Promissory estoppel is discussed in Chapters 9 and 12.

Vacated and remanded in favor of Homes by George.

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Garden Ridge, L.P. v. Advance International, Inc.    403 S.W.3d 432 (Tex. Ct. App. 2013) Garden Ridge is a Houston-based chain of housewares and home décor stores. Advance International is one of Garden Ridge’s vendors. In 2009, Advance sent Garden Ridge quote sheets for lighted inflatable holiday snowmen, which included a color photo of each item and described its cost, weight, dimensions, and packaging. The two snowmen on the quote sheets each wore a scarf, held a broom that stated “Merry Christmas” on it, and waved; one stood eight feet tall, and the other stood nine feet tall. Advance then sent two sample snowmen to Garden Ridge; one of the samples did not match its quote sheet. The sample eight-foot snowman wore a Santa-type hat and held a “Merry Christmas” banner. Garden Ridge sent Advance two purchase orders, one for approximately 950 nine-foot waving snowmen (PO ’721), and the other for approximately 3,500 eight-foot waving snowmen (PO ’743), based on the quote sheets. Five days before Thanksgiving, Garden Ridge realized that the eight-foot snowmen that Advance sent were not waving snowmen, but instead were banner snowmen. The nine-foot snowmen that Advance sent were waving snowmen. There were no customer complaints, and both the eight-foot banner snowmen and the nine-foot waving snowmen sold well. Garden Ridge made approximately $113,000 in profit on the snowmen it received from Advance and made all the money it would have made if the snowmen were delivered exactly as ordered. Nonetheless, based on liquidated-damages provisions in the parties’ contract, Garden Ridge assessed chargebacks against Advance for its alleged noncompliance violations. For Advance’s “purchase order” violation—that is, sending the eight-foot banner snowman instead of the waving snowman—Garden Ridge charged back the entire merchandise cost plus the cost of freight on PO ’743 as an “unauthorized substitution” chargeback, which totaled $49,176.00. In addition to paying nothing for the eight-foot banner snowmen, Garden Ridge paid nothing for the nine-foot waving snowmen despite the fact that those snowmen complied with PO ’721. Garden Ridge charged back the entire merchandise cost plus the cost of freight on the nine-foot waving snowmen as a “merchant initiated” chargeback, which totaled $29,178.00. Advance demanded payment for its snowmen. The parties filed claims and counterclaims against each other for breach of contract. Of particular importance here, Advance argued that Garden Ridge’s claims were barred because the chargeback provisions were unenforceable penalty clauses. A jury found that Garden Ridge violated the contract and assessed damages despite Garden Ridge’s argument that Advance had first breached the contract and excused Garden Ridge from performance. Garden Ridge appealed.

Tracy Christopher, Judge The parties agree that this case is governed by the Uniform Commercial Code, as adopted by Texas, which applies to transactions involving goods. TEX. BUS. & COM. CODE ANN. § 2.102 (West 2009). The parties agree that section 2.718(a) of the UCC, on liquidation of damages, governs the enforceability of the chargeback provisions in this case. Section 2.718(a) provides: (a) 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 non-feasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty. Id. § 2.718(a). The parties also agree that if the chargeback provisions governing Advance’s noncompliance violations at issue are unenforceable as penalties, Garden Ridge no longer has any basis to argue that Advance committed any prior material breach. But what the parties do not agree on is the

proper analysis by which courts determine the legal question of whether a liquidated-damages provision is unenforceable as a penalty.

a. Determining whether a liquidated-damages provision constitutes a penalty “Liquidated damages” ordinarily refers to an acceptable measure of damages that parties stipulate in advance will be assessed in the event of a contract breach. “The common law and the Uniform Commercial Code have long recognized a distinction between liquidated damages and penalties.” Flores v. Millennium Interests, Ltd., 185 S.W.3d 427, 431 (Tex. 2005). Section 2.718(a) codified the common-law distinction between liquidated damages and penalties as part of Texas’ adoption of the UCC’s article on sales. Id. at 432. In Phillips v. Phillips, the Texas Supreme Court restated the common-law test for determining whether to enforce a liquidateddamages provision. “In order to enforce a liquidated damages clause, the court must find: (1) that the harm caused by the breach is incapable or difficult of estimation, and (2) that the



Chapter Eighteen Performance and Remedies

amount of liquidated damages called for is a reasonable forecast of just compensation.” Phillips v. Phillips, 820 S.W.2d 785, 788 (Tex. 1991). The Phillips court explained that one way a party can “show that a liquidated damages provision is unreasonable” is by showing that “the actual damages incurred were much less than the amount contracted for,” which requires the party “to prove what those actual damages were.” Id. . . . The common-law test as described in Phillips closely tracks the language of section 2.718(a) of the UCC. . . . We therefore conclude that the common-law test as described in Phillips and the UCC test as outlined in 2.718(a) reflect the same essential factors and the same type of reasonableness test.

b. Do actual damages matter Garden Ridge argues that the test is conducted entirely on an ex ante basis. That is, if, at the time the contract is formed, actual damages are difficult to estimate and the amount specified in the contract is a reasonable forecast of just compensation, a liquidated-damages term is enforceable. Garden Ridge contends that the test contains no ex post actual-harm assessment to determine reasonableness. Thus, according to Garden Ridge, Advance could only show that the chargeback provisions were unenforceable as penalties if, ex ante, actual damages are easy to estimate or the liquidated damages are based on an unreasonable forecast. Garden Ridge asserts that Advance did not meet its burden because Garden Ridge’s CFO, Bill Uhrig, testified that the chargeback schedule was created because actual damages from noncompliance violations are difficult to calculate, and that the schedule was based on computations and estimations by Garden Ridge’s executive and purchasing staff. . . . This court also has recognized that actual harm factors into the test to determine whether a liquidated-damages provision is an enforceable penalty. In Chan v. Montebello Development Co., we described the Phillips test as follows: “The test for determining whether a provision is valid and enforceable as liquidated damages is (1) if the damages for the prospective breach of the contract are difficult to measure; and (2) the stipulated damages are a reasonable estimate of actual damages.” Chan v. Montebello Dev. Co., 2008 Tex. App. LEXIS 5980, at *3 (Tex. App. July 31, 2008). Further, we stated: In order to meet this burden, the party asserting the defense is required to prove the amount of the other parties’ actual damages, if any, to show that the liquidated damages are not an approximation of the stipulated sum. If the liquidated damages are shown to be disproportionate to the actual damages, then the liquidated damages must be declared a penalty. . . . Id. at *3–4 (citations omitted). Most importantly, the UCC reasonableness test explicitly refers to actual harm, providing that one way a liquidated-damages provision can be invalidated is where the stipulated amount

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proves unreasonable in light of “the anticipated or actual harm caused by the breach.” TEX. BUS. & COM. CODE ANN. § 2.718(a) (emphasis added). In addition, the UCC expressly provides that “[a] term fixing unreasonably large liquidated damages is void as a penalty.” Id. In order to determine whether a term fixes unreasonably large liquidated damages, it follows that courts would need to consider what actual harm, if any, was caused by the breach and then compare it to the stipulated amount of liquidated damages. Thus, both the common law and the UCC allow for courts to determine the reasonableness of a liquidated-damages clause by considering whether the defendant has shown that the stipulated amount was “unreasonably large” compared to the actual damages. [Citations omitted.]

c. Comparing the amount of the chargebacks to Garden Ridge’s actual damages Advance argues that it proved that the harm anticipated from its alleged noncompliance was not difficult to estimate, that Garden Ridge did not even attempt to determine a chargeback amount that was reasonable in light of the anticipated or actual harm, and that the liquidated damages Garden Ridge assessed are disproportionate to its actual damages. We conclude Advance met its burden to show that the chargeback amounts constituted a disproportionate estimation of Garden Ridge’s actual damages; therefore, the chargeback provisions are void as penalties under the UCC. Advance elicited evidence from Garden Ridge employees . . . sufficient to prove that Garden Ridge suffered no actual damages as a result of Advance’s substitution of the eight-foot banner snowmen. The trial court also determined that Garden Ridge suffered no actual damages from any of Advance’s noncompliance violations when the court directed a verdict against Garden Ridge on its breach-of-contract claim; Garden Ridge does not challenge that ruling. And Garden Ridge itself acknowledges it argued no amount of actual damages other than zero and the record shows that Garden Ridge suffered no actual damages resulting from Advance’s noncompliance violations. Thus, Advance has shown that the chargebacks assessed by Garden Ridge for Advance’s “unauthorized substitution” and “merchant initiated” noncompliance violations—100% of the invoiced merchandise cost plus freight for the eight-foot banner snowmen and the nine-foot waving snowmen, for a total of $79,457.00—were unreasonably large when compared to Garden Ridge’s actual damages of zero. . . . Therefore, as a matter of law, we conclude that, under these circumstances, the chargeback amounts were unreasonable, and that the chargeback provisions are unenforceable as penalties under the UCC because they fixed unreasonably large liquidated damages. Accordingly, we . . . affirm the trial court’s judgment.

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Punitive Damages Punitive damages are damages awarded in addition to the compensatory remedy that are designed to punish a defendant for particularly reprehensible behavior and to deter the defendant and others from committing similar behavior in the future. The traditional rule is that punitive damages are not recoverable in contracts cases unless a specific statutory provision (such as some consumer protection statutes) allows them or the defendant has committed fraud or some other independent tort. A few states will permit the use of punitive damages in contracts cases in which the defendant’s conduct, though not technically a tort, was malicious, oppressive, or tortious in nature. Punitive damages have also been awarded in many of the cases involving breach of the implied covenant of good faith. In such cases, courts usually circumvent the traditional rule against awarding punitive damages in contracts cases by holding that breach of the duty of good faith is an independent tort. The availability of punitive damages in such cases operates to deter a contracting party from deliberately disregarding the other party’s rights. Insurance companies have been the most frequent target for punitive damages awards in bad-faith cases, but employers and banks have also been subjected to punitive damages verdicts.

Equitable Remedies In

exceptional cases in which money damages alone are not adequate to fully compensate for a party’s injuries, a court may grant an equitable remedy either alone or in combination with a legal remedy. Equitable relief is subject to several limitations, however, and will be granted only when justice is served by doing so. The primary equitable remedies for breach of contract are specific performance and injunction.12 Specific Performance Specific performance is an equitable remedy whereby the court orders the breaching party to perform contractual duties as promised. For example, if Barnes breached a contract to sell a tract of land to Metzger and a court granted specific performance of the contract, the court would require Barnes to deed the land to Metzger. (Metzger, of course, must pay the purchase price.) This remedy can be advantageous to the injured party because he is not faced with

Another equitable remedy, reformation, allows a court to reform or “rewrite” a written contract when the parties have made an error in expressing their agreement. Reformation is discussed, along with the doctrine of mistake, in Chapter 13.

the complexities of proving damages, he does not have to worry about whether he can actually collect the damages, and he gets exactly what he bargained for. However, the availability of this remedy is subject to the limitations discussed below. The Availability of Specific Performance Specific performance, like other equitable remedies, is available only when the injured party has no adequate remedy at law— in other words, when money damages do not adequately compensate the injured party. This generally requires a showing that the subject of the contract is unique or at least that no substitutes are available. Even if this requirement is met, a court will withhold specific performance if the injured party has acted in bad faith, if he unreasonably delayed in asserting his rights, or if specific performance would require an excessive amount of supervision by the court. Contracts for the sale of real estate are the most common subjects of specific performance decrees because every tract of real estate is presumed to be unique. Specific performance is rarely granted for breach of a contract for the sale of goods because the injured party can usually procure substitute goods. However, there are situations involving sales of goods contracts in which specific performance is given. These cases involve goods that are unique or goods for which no substitute can be found. Examples include antiques, heirlooms, works of art, and objects of purely sentimental value.13 What about a pet? That question is raised in the following Houseman case. Specific performance is not available for the breach of a promise to perform a personal service (such as a contract for employment, artistic performance, or consulting services). A decree requiring a person to specifically perform a personal-services contract would probably be ineffective in giving the injured party what he bargained for. It would also require a great deal of supervision by the court. In addition, an application of specific performance in such cases would amount to a form of involuntary servitude. Injunction Injunction is an equitable remedy used in many different contexts, sometimes as a remedy for breach of contract. An injunction is a court order requiring a person to do something (mandatory injunction) or ordering a person to refrain from doing something (negative injunction). Unlike legal remedies that apply only when the breach has already occurred, the equitable remedy of injunction can be invoked when a breach has merely been threatened.

12

Specific performance under § 2-716(1) of the UCC is discussed in Chapter 22. 13



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Houseman v. Dare   966 A.2d 24 (N.J. Super. Ct. 2009) Doreen Houseman and Eric Dare had been in a relationship for 13 years. In 1999, they bought a residence together, and in 2000, they became engaged. In 2003, they purchased a pedigree dog for $1,500, which they registered with the American Kennel Club, reporting that they both owned the dog. In May 2006, Dare decided to end the relationship. At that time, Dare wanted to stay in the house and buy Houseman’s interest in the property, so Houseman signed a deed transferring her interest in the house to Dare for $45,000. When she vacated the home, she took the dog and its paraphernalia with her. She left one of the dog’s jerseys and some photographs behind as mementos for Dare. According to Houseman, “from the minute [Dare] told [her they] were breaking up, he told [her she] could have” the dog. She and Dare agreed that she would get the dog and one-half the value of the house. Although she admitted that she would not have wanted more than one-half the value of their house if she were not taking the dog, she asserted that her primary concern during her negotiations with Dare was possession of their dog, and she accepted his representations that her share of the equity in the house was $45,000. Dare and Houseman did not have a written agreement about the dog, but after Houseman left the residence, she allowed him to take the dog for visits, after which he returned the pet to her. According to Houseman, when she asked Dare to put their agreement about the dog in a writing, he told her she could trust him and he would not keep the dog from her. In late February 2007, Houseman left the dog with Dare when she went on vacation. On March 4, 2007, she asked Dare for the dog, but the pet was not returned. Houseman sued Dare for breach of an oral contract and sought specific performance of the agreement. Prior to trial, Dare sold the residence and received equity in an amount greater than $90,000. The trial court determined that pets are personal property and lack the unique value essential to an award of specific performance. Houseman appealed.

Grall, Judge, Appellate Division At the conclusion of trial, the court found Houseman’s testimony to be “extremely” and “particularly credible.” The court noted that Houseman testified “without guile,” “was truthful” and answered even the “hard questions . . . in a way that would not have been advantageous to her.” On those grounds, the court accepted her testimony. In contrast, the court concluded that Dare took unfair advantage of Houseman by giving her only $45,000 for her interest in their residence. The court made the following findings relevant to the dog: I’m more than satisfied, hearing Ms. Houseman testify, that the dog was in no way related to the sale of the house. They may have an understanding about the dog. She thought she was getting the dog. He picked the dog up later. He has the dog. We know what the value of the dog is. The dog is worth $1,500. I believe it’s now in Mr. Dare’s possession. He’ll pay Ms. Houseman $1,500 [the full value stipulated by the parties] for the dog. The foregoing passage suggests that the court found that Houseman established an oral agreement under which she was to obtain possession and ownership of the dog. Despite that finding and solely on the ground that Dare had possession of the dog at that time, the court awarded Dare possession and Houseman the dog’s stipulated value. The court’s conclusion that specific performance is not, as a matter of law, available to remedy a breach of an oral agreement about possession of a dog reached by its joint owners is

not sustainable. The remedy of specific performance can be invoked to address a breach of an enforceable agreement when money damages are not adequate to protect the expectation interest of the injured party and an order requiring performance of the contract will not result in inequity to the offending party, reward the recipient for unfair dealing or conflict with public policy. Specific performance is generally recognized as the appropriate remedy when an agreement concerns possession of property such as heirlooms, family treasures, and works of art that induce a strong sentimental attachment. That is so because money damages cannot compensate the injured party for the special subjective benefits he or she derives from possession. The special subjective value of personal property worthy of recognition by a court of equity is sentiment explained by facts and circumstances—such as the party’s relationship with the donor or prior associations with the property—that give rise to the special affection. In a different context, this court has recognized that pets have special “subjective value” to their owners. Courts of other jurisdictions have considered the special subjective value of pets in resolving questions about possession. There is no reason for a court of equity to be more wary in resolving competing claims for possession of a pet based on one party’s sincere affection for and attachment to it than in resolving competing claims based on one party’s sincere sentiment for an inanimate object based upon a relationship with the donor. In both types of cases, a court of equity must consider the interests of the parties pressing competing claims for

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possession and public policies that may be implicated by an award of possession. In those fortunately rare cases when a separating couple is unable to agree about who will keep jointly held property with special subjective value, our courts are equipped to determine whether the assertion of a special interest in possession is sincere and grounded in facts and circumstances which endow the chattel with a special value or based upon a sentiment assumed for the purpose of litigation out of greed, or other sentiment or motive similarly unworthy of protection in a court of equity. We are less confident that there are judicially discoverable and manageable standards for resolving questions of possession from the perspective of a pet, at least apart from cases involving abuse or neglect contrary to public policies expressed in laws designed to protect animals.

Houseman’s evidence was adequate to require the trial court to consider the oral agreement and the remedy of specific performance. The special subjective value of the dog to Houseman can be inferred from her testimony about its importance to her and her prompt effort to enforce her right of possession when Dare took action adverse to her enjoyment of that right. And, Dare did not establish that an order awarding specific performance would be harsh or oppressive to him, reward Houseman for unfair conduct or violate public policy. To the contrary, assuming an oral agreement that Dare breached by keeping the dog after a visit, an order awarding him possession because he had the dog at the time of trial would reward him for his breach.

Injunctions are available only when the breach or threatened breach is likely to cause irreparable injury. In the contract context, specific performance is a form of mandatory injunction. Negative injunctions are appropriately used in several situations, such as contract cases in which a party whose duty under the contract is forbearance threatens to breach the contract. For example, Norris sells his restaurant in Gas City, Indiana, to Ford. A term of the contract of sale provides that Norris agrees not to own, operate, or be employed in any restaurant within 30 miles of Gas City for a period of two years after the sale.14 If Norris threatens to open a new restaurant in Gas City several months after the sale is consummated, a court could enjoin Norris from opening the new restaurant.

restitution, in which a court awards the plaintiff a sum of money that reflects the amount by which the plaintiff benefited the defendant. In an action for damages based on quasi-contract, substitutionary restitution would be the remedy.15 Restitution can be used in a number of circumstances. Sometimes, parties injured by breach of contract seek restitution as an alternative remedy instead of damages that focus on their expectation interest. In other situations, a breaching party who has partially performed seeks restitution for the value of benefits he conferred in excess of the losses he caused. In addition, restitution often applies in cases in which a person rescinds a contract on the grounds of lack of capacity, misrepresentation, fraud, duress, undue influence, or mistake. Upon rescission, each party who has been benefited by the other’s performance must compensate the other for the value of the benefit conferred. Another application of restitution occurs when a party to a contract that violates the statute of frauds confers a benefit on the other party. For example, Boyer gives Blake a $10,000 down payment on an oral contract for the sale of a farm. Although the contract is unenforceable (i.e., Boyer could not get compensation for his expectation interest), the court would give Boyer restitution of his down payment.

Restitution Restitution is

a remedy that can be obtained either at law or in equity. Restitution applies when one party’s performance or reliance has conferred a benefit on the other. A party’s restitution interest is protected by providing compensation for the value of benefits conferred on the other person. This can be done through specific restitution, in which the defendant is required to return the exact property conferred by the plaintiff, or substitutionary Ancillary covenants not to compete, or noncompetition agreements, are discussed in detail in Chapter 15.

Reversed and remanded in favor of Houseman.

14

15

Quasi-contract is discussed in detail in Chapter 9.



Chapter Eighteen Performance and Remedies

Problems and Problem Cases 1. The Grondas, who owned a party store along with land, fixtures, equipment, and a liquor license, entered into a contract to sell their liquor license and fixtures to Harbor Park Market in an agreement that was expressly conditioned on approval by the Grondas’ attorney. The Grondas submitted the contract to their attorney, but before the attorney had approved it, they received a second, better offer and submitted that contract to the attorney as well. The attorney reviewed both agreements and approved the second one. Harbor Park Market sued the Grondas for breach of contract. Will their suit succeed? 2. The Ewells bought a home in Seaford, Delaware. They planned to renovate it and reside in it later. The Ewells insured the house with an insurance company, Lloyd’s of London. Shortly after purchasing the house, the Ewells notified the insurance company that they intended to renovate the house. The insurance company thereupon issued a Special Use Form Policy that contained a single-page “Course of Construction/Renovation Endorsement.” The Fire Provision of the Endorsement stated:

In the event of any construction or renovation work at the premises described in the Declarations the following conditions shall apply: You must ensure that visible and accessible fire extinguishers be placed on each level of the dwelling. Failure to comply with this provision will render this insurance null and void.

The Ewells did not place any fire extinguishers in the house. The work on the house proceeded with the removal of plaster and gutting of the kitchen and another room. In the early morning hours of January 20, 2009, the house and its contents were destroyed by fire. At the time of the fire, the Ewells were sleeping in a shed that they had built in the back yard rather than in the house. They were awakened by the arrival of fire trucks. The Ewells informed the insurance company of the fire, and it assigned an adjuster to investigate the loss. The insurance company ultimately denied the claim because the Ewells had not complied with the condition requiring them to place fire extinguishers on each floor of the house, as required by the Endorsement. The Ewells sued the insurance company for breach of contract. They argued that the fire extinguisher provision was meaningless because no one was in the house at the time of the fire, so no one could have used a fire extinguisher if there had been one present. They also argue that the condition was not triggered because the work

18-27

that they were in the process of doing was demolition and they had not yet begun renovation. Will they win? 3. Smith and his coworkers signed an at-will employment agreement that promised a deferred salary of $15,000 “[i]n the event that Employee remains employed . . . for two years.” The agreement also provided that if the employees left before that date or were terminated for cause, the employees would forfeit the incentive payment and were responsible for paying the costs of returning to their home locations. The employees were terminated after the eight-week orientation period but within two years, when the project they had been hired to work on was withdrawn. They claimed the right to the $15,000 on the ground that they had not resigned and had not been terminated for cause. Were the employees entitled to the $15,000 deferred salary? 4. In 2006, M. Jay Carter hired Robert “Casey” Jones, a real estate agent at The Janet Jones Company, to represent him in a real estate transaction with Ernie and Karen Cline. Carter intended to purchase residential property located at 8 Longfellow Place in Little Rock, Arkansas. The real estate contract was signed on June 11, 2006. It contained a provision setting the purchase price for the property at $1,037,500, “subject to Buyer’s ability to obtain financing.” The contract also included a handwritten provision under this same subsection that the buyer was required to “provide a letter of approval within 10 business days.” On June 21, 2006, Pulaski Mortgage Company approved a loan for Carter to purchase the Longfellow property. The approval letter was conditioned upon, among other things, there being no material change in Carter’s financial condition that might adversely affect his current level of creditworthiness, credit score, debt, or income. Pursuant to this conditional approval, Carter was required to submit to Pulaski Mortgage prior to closing an employment certification providing evidence that his employment and income situation had not changed since his conditional approval. This approval letter from Pulaski Mortgage was submitted to Janet Jones Company within 10 business days as required by the contract, and closing was set for September 22, 2006. According to Carter and the documentation submitted to Pulaski Mortgage, Carter’s income began declining in July 2006. On September 8, 2006, Carter orally informed Pulaski Mortgage of his decline in income, and the company requested that Carter provide it with a year-to-date profit-and-loss statement and balance sheet. Carter also contacted Casey Jones on September 8, 2006, and told him that he had a decline in his third-quarter

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Part Three Contracts

income and that he had informed Pulaski Mortgage of his current financial situation. On September 11, 2006, Carter submitted to Pulaski Mortgage additional documentation. On September 11, 2006, Pulaski Mortgage sent a notice of adverse action to Carter advising him that his “recent application for an extension or renewal of credit has been denied.” The company informed him that “the decision to deny your application was based on the following reasons: . . . Excessive obligations . . . Insufficient income . . . Add[itional] current income information furnished by applicant.” On September 11, 2006, Casey Jones informed Shannon Treece, an independent contractor at Janet Jones Company and the Clines’ agent, that Carter would not be able to close the real estate transaction on the Longfellow property because he had lost his financing approval from Pulaski Mortgage. She then informed the Clines that Carter would be unable to close on their property. The Clines sued Carter for breach of contract. Should they succeed? 5. Arnhold and Argoudelis agreed to sell their farm to Ocean Atlantic with a closing date originally set for November 1997. After delay in satisfying conditions precedent and several postponements of the closing date over almost four years, the parties finally entered into a settlement agreement, which identified January 25, 2001, as a “drop dead” date. The closing did not occur by that time, and Arnhold and Argoudelis gave notice that the contract was terminated. Ocean Atlantic sued for specific performance. Was the failure to close on the drop dead date a material breach? 6. The Bassos contracted with Dierberg to purchase her property for $1,310,000. One term of the contract stated, “[t]he sale under this contract shall be closed . . . at the office of Community Title Company . . . on May 16, 1988 at 10:00  AM. . . . Time is of the essence of this contract.” After forming the contract, the Bassos assigned their right to purchase Dierberg’s property to Miceli and Slonim Development Corp. At 10:00 AM on May 16, 1988, Dierberg appeared at Community Title for closing. No representative of Miceli and Slonim was there, nor did anyone from Miceli and Slonim inform Dierberg that there would be any delay in the closing. At 10:20 AM, Dierberg declared the contract null and void because the closing did not take place as agreed, and she left the title company office shortly thereafter. Dierberg had intended to use the purchase money to close another contract to purchase real estate later in the day. At about 10:30 AM, a representative of Miceli and Slonim appeared at Community Title to begin the closing, but the representative did not have the funds

for payment until 1:30 PM. Dierberg refused to return to the title company, stating that Miceli and Slonim had breached the contract by failing to tender payment on time. She had already made alternative arrangements to finance her purchase of other real estate to meet her obligation under that contract. Miceli and Slonim sued Dierberg, claiming that the contract did not require closing exactly at 10:00 AM, but rather some time on the day of May 16. Will they prevail? 7. In 1992, White and J.M. Brown Amusement Co. entered into a contract giving Brown exclusive rights to place “certain coin-operated amusement machines” in 13 of White’s stores, all in Oconee and Anderson counties in South Carolina. The contract was for a term of 15 years. Under the contract, White agreed “not to allow other machines on the premises without the express written consent of [Brown].” Brown placed the machines in White’s stores as the contract provided. In 1993, the state legislature enacted a local option law as part of the Video Game Machines Act, permitting counties to hold an individual referendum to determine whether cash payouts for video gaming should remain legal. As a result of local referenda held in November 1994, 12 counties, including Oconee and Anderson, voted to ban cash payouts. The South Carolina Department of Revenue revoked the licenses required to operate the machines Brown had placed in White’s stores, effective July 1, 1995, as required by the act. Consequently, Brown removed the video poker machines from White’s stores. Brown did not replace the machines with any other coin-operated amusement machines. In November 1996, the South Carolina Supreme Court struck down the local option law contained in the act as unconstitutional. Given this court’s ruling, Brown planned to return the video poker machines to White’s stores, but White informed Brown that the contract was no longer valid. White then filed suit seeking to have the contract declared void and unenforceable so that he would be free to sign a contract with another provider of legal video and amusement machines. Approximately one month after filing suit, White entered into an agreement with Hughes Entertainment, Inc. giving Hughes exclusive rights to place “all video game terminals and all coin operated music and amusement machines” in 12 of the same stores listed in the Brown contract. Was White’s duty to perform the contract with Brown excused? 8. East Capitol hired Robinson on a one-year contract that stated that her continued employment would be based on her performance but said nothing about her



Chapter Eighteen Performance and Remedies

employment being based on funding. East Capitol discharged Robinson before the one-year term was over because it lost grant funding, without which it had insufficient funds to pay her. Robinson sued for breach of contract, and East Capitol claimed the defense of impossibility. Was East Capitol entitled to be excused from performance on the contract? 9. Einstein Moomjy Inc. is a large retail distributor of carpets. In August 1999, at an annual clearance sale held by Einstein Moomjy, Furst purchased five remnant carpets for his home for $10,139.68. One of these carpets was the “Mystery Ivory” carpet. Attached to the Mystery Ivory carpet at the time of its sale was a tag containing the following information: The Back Yd. Einstein Moomjy, The Carpet Department Store REMNANT REDUCED FOR CLEARANCE SIZE: 11′4″ × 31′ REGULAR PRICE $5,775– SALE PRICE $1,499– QUALITY: Mystery COLOR: Ivory Fibre: Wool Sale 1,199

When the Mystery Ivory carpet was delivered to his home, Furst noticed that the carpet was damaged and smaller than the size indicated on the sales invoice. He complained about the condition and size of the carpet to Einstein Moomjy, who offered either a refund of the sale price of $1,199.00 or a similar carpet at an additional price. Einstein Moomjy claimed that the Mystery Ivory carpet was a high-quality “Ireloom” white wool carpet that had been tagged mistakenly with the wrong sale price. Furst demanded that Einstein Moomjy comply with the warranty on the back of the sales invoice. The invoice promised that if the carpets purchased were not delivered by the scheduled delivery date, Furst had the choice of canceling the “order with a prompt full refund” or “accepting delivery at a specific later date.” Furst insisted on delivery of an undamaged Ireloom carpet at the size he ordered and at

18-29

the price he paid. When Einstein Moomjy refused to replace the Ireloom carpet at that price, Furst sued Einstein Moomjy. The court determined that Furst’s “ascertainable loss” was the fair market or replacement value of the carpet, but it would not permit him to introduce evidence of the price tag to prove replacement value. The trial court excluded the use of the unmarked-down regular price on the sales tag as evidence of the market value of the Ireloom carpet. The court also barred testimony from Furst’s interior decorator regarding her investigation of market prices and testimony from defendant Moomjy regarding the market value of the Ireloom carpet. Because Furst could not prove replacement value, the court awarded him the purchase price. Was this ruling correct? 10. Diamond Aircraft announced that it would build a single-engine light jet aircraft referred to as the “D-JET,” noting that it would select a powerplant and other equipment for the plane in the future and identifying a “projected price” of under $1 million. In April 2003, Diamond issued a press release in which it projected that the D-JET’s first flight would be scheduled in 2004, with initial deliveries to customers in 2006. In 2004, Barnes signed a “Reservation Agreement” with Diamond. The agreement made it clear that there was no existing aircraft to consider for purchase yet, and there were no specifications of the aircraft provided except for general descriptions such as “premium interior” and “glass cockpit.” It listed the “Manufacturer’s Suggested” price of $850,000 and provided that Barnes would be required to pay a 10 percent deposit within 30 days of “JAA IFR certification” in order to “keep the order position secured.” The parties also agreed to limit their liability to the return or forfeiture of the deposit in the event of breach. Barnes paid a deposit of $20,000 to reserve a place in line to purchase a D-JET, and Diamond assigned her the 52nd North American delivery position. Later, Diamond reconfigured the D-JET entirely and announced the new configuration and new pricing in 2006. It sent Barnes and other deposit holders a letter explaining that upgrades in the aircraft would cause it to be priced at $1.38 million. It gave deposit holders the choice of maintaining their delivery positions for a D-JET priced at $1.38 million or recovering their deposits and relinquishing their delivery positions. Barnes filed suit against Diamond, alleging breach of contract and seeking specific performance or money damages. Will she win?

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Chapter 19

Formation and Terms of Sales Contracts

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Chapter 20

Product Liability

Chapter 21

Performance of Sales Contracts

Chapter 22

Remedies for Breach of Sales Contracts

Pixtal/AGE Fotostock

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CHAPTER 19

Formation and Terms of Sales Contracts

P

aul Reynolds used the Trek website to purchase a racing bike with a frame utilizing a newly developed highstrength but lightweight alloy. He selected the model he wanted and provided the company with the necessary information to place the $2,200 purchase price and $75 shipping costs on his Visa card. The bicycle was damaged during shipment when the box was punctured by a forklift truck that was loading other boxes onto the carrier’s truck. Paul took the damaged bicycle to a local bicycle dealer to have it repaired. After the bicycle was repaired, but before Paul could pick it up, a clerk in the store, by mistake, sold the bicycle for $1,500 to Melissa ­ Stevenson, who bought it as a birthday gift for her boyfriend. This situation raises a number of legal issues that, among others, will be covered in this chapter, including: • Can a legally enforceable contract for the sale of goods be formed electronically? • Between Paul and Trek, who had the risk of loss or damage to the bicycle during the time it was under shipment to him? • Would Paul be entitled to recover possession of the bicycle from Melissa and her boyfriend? • Even if Melissa and her boyfriend are not legally required to return the bicycle to Paul, would returning it be the ethical thing to do?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 19-1 Analyze whether a transaction involves the sale of goods to which the Uniform Commercial Code (UCC) applies or whether common law principles apply to the transaction. 19-2 Recall the major provisions of the UCC that are applicable to the formation of contracts for the sale of goods, including the “gap fillers” that the UCC deems part of the contract when the parties omit critical terms or state them in an unclear manner. 19-3 Explain when title to goods passes from the seller to the buyer.

IN PART 3, CONTRACTS, we introduced the common law rules that govern the creation and performance of contracts generally. Throughout much of history, special rules, known as the law merchant, were developed to control

19-4 Explain what is meant by a voidable title and explain when a buyer can obtain better title to goods than the seller had. 19-5 Apply the UCC rules concerning risk of loss to determine who had the risk of loss in a given transaction where the goods that were the subject of a contract were lost or damaged before the buyer took possession. 19-6 Distinguish between sale or return and sales on approval and explain the ramifications those distinctions have for the rights of buyers and sellers. mercantile transactions in goods. Because transactions in goods commonly involve buyers and sellers located in different states—and even different countries—a common body of law to control these transactions can facilitate

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Part Four Sales

the smooth flow of commerce. To address this need, the Uniform Commercial Code (UCC) was prepared to simplify and modernize the rules of law governing commercial transactions. In 2003, the American Law Institute adopted a series of proposed amendments to Article 2 (Sales) of the UCC that are intended to further modernize and clarify some of its provisions. The amendments are not effective until they have been adopted by a state and incorporated into its version of Article 2. However, there has been controversy concerning the proposed amendments, and because at the time this book went to press they had not been adopted by any state, they are not incorporated in the discussion of Article 2 that follows. This chapter reviews some rules that govern the formation of sales contracts previously discussed. It also covers some key terms in sales contracts, such as delivery terms, title, and risk of loss. Finally, it discusses the rules governing sales on trial, such as sales on approval and consignments.

Sale of Goods Analyze whether a transaction involves the sale of goods

LO19-1 to which the Uniform Commercial Code (UCC) applies or

whether common law principles apply to the transaction.

The sale of goods is the transfer of ownership to tangible personal property in exchange for money, other goods, or the performance of services. The law of sales of goods is codified in Article 2 of the UCC. While the law of sales

is based on the fundamental principles of contract and personal property, it has been modified to accommodate current practices of merchants. In large measure, the UCC discarded many technical requirements of earlier law that did not serve any useful purpose in the marketplace and replaced them with rules that are consistent with commercial expectations. Article 2 of the UCC applies only to transactions in goods. Thus, it does not cover contracts to provide services or to sell real property. However, some courts have applied the principles set out in the UCC to such transactions. When a contract appears to call for the furnishing of both goods and services, a question may arise as to whether the UCC applies. For example, the operator of a hair salon may use a commercial solution intended to be used safely on humans that causes injury to a person’s head. The injured person then might bring a lawsuit claiming that there was a breach of the UCC’s warranty of the suitability of the solution. In such cases, the courts commonly ask whether the sale of goods is the predominant part of the transaction or merely an incidental part; where the sale of goods predominates, courts normally apply Article 2. The Janke v. Brooks case, which follows, illustrates the type of analysis courts use to determine whether a particular contract should be governed by the UCC. Thus, the first question you should ask when faced with a contracts problem is this: Is this a contract for the sale of goods? If it is not, then the principles of common law that were discussed in Part 3, Contracts, apply. If the contract is one for the sale of goods, then the UCC applies. This analysis is illustrated in Figure 19.1.

Figure 19.1 Choice of Law Services (also: real estate, stocks and bonds.)

Common law

Service element is predominant What is the nature of the transaction?

Mixture (goods and services) Goods element is predominant

Goods (tangible personal property)

Uniform Commercial Code*

*If there is no specific Uniform Commercial Code provision governing the transaction, use the common law.



Chapter Nineteen  Formation and Terms of Sales Contracts

19-5

Janke v. Brooks   77 UCC Rep. 2d 352 (D. Colo. 2012) Janke was the owner of a classic, 1957 Chevrolet Nomad. After seeing a feature on the ESPN program On The Block, he contacted Donald and Normandy Brooks about restoring the car. He traveled to the Brooks’ shop in Sparks, Nevada, to discuss the project. He received an estimate that included a series of price quotes and list sheets that contemplated the installation and/or repair of a number of parts as well as a number of items that were to be fabricated by the Brooks’ mechanic. If the items could have been fabricated or installed by any competent mechanic, there would not have been any need to ship the prized car to a specialty shop to remodel the vehicle. The parts and materials constituted slightly more than half of the quoted price, which was somewhat skewed by the fact there was a 50 percent markup on the price of new parts and materials. Janke then forwarded a deposit and had the Nomad shipped from his home in Wheatridge, Colorado, in September 2008. He informed the Brookses that he wanted the car to be ready in time to be entered in and displayed at the “Hot August Nights” classic car show in Reno, Nevada, in early August 2010. Despite assurances, when he arrived in Nevada on July 28, 2010, he learned that the car was not finished. Subsequently, he was advised that the car’s engine block was cracked and would have to be replaced. Donald Brooks assured Janke that the car would be fixed and shipped to him in Colorado. On November 17, 2010, the car was delivered to Janke in Wheatridge. The car broke down several times in the first 25 miles, after which Janke hired another mechanic to inspect and evaluate the build. He discovered a number of defects in the car, that the Brookses’ design strategy was unreasonable, that the car was not built consistently with the build sheet, and that the defects in the car could not have been corrected simply by replacing the defective parts. Janke brought an action against the Brookses for breach of contract as well as for breach of implied warranties under the Uniform Commercial Code.

Blackburn, District Judge By its express terms, the Uniform Commercial Code applies only to “transactions in goods,” and contracts “relating to the present or future sale of goods.” Moreover, and more relevant here, when the contract contemplates both the sale of goods and the performance of services, the controlling criterion should be the primary purpose of the contract: The test for inclusion or exclusion is not whether goods and services 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). Factors that may bear on this determination include (1) the language of the contract; (2) whether the contract lists a unitary price or bills discretely for goods and labor; (3) the ratio between the cost of goods and the overall contract price; and (4) whether the purchaser has a reasonable expectation of acquiring a property interest in the goods. The contract at issue here was just such a mixed contract. Considering these relevant factors, as well as case law from other jurisdictions and the overall thrust of the contract, I find and conclude that it was predominantly a contract for services. Thus, the warranties implied under the UCC are inapplicable.

The language of the series of price quotes and list sheets that constitute the contract in this case contemplates the installation and/or repair of a number of parts, while other items were to be fabricated by the Brooks’ mechanic himself. Nevertheless, the enumeration of these parts and materials was not an end unto itself, but rather a necessary prerequisite towards the ultimate end of restoring the car. If these items could have been fabricated by any competent mechanic, there would have been little reason for Janke to ship his prized car to a specialty provider far distant from his home. Although technically Janke acquired a property interest in all the parts and materials incorporated into the car, such was merely incidental to the overarching purpose to craft a wholly remodeled car. In other words, in this case, the sum was greater than the parts. Janke sought out the Brooks specifically for their expertise in rebuilding and customizing classic cars. Janke did not buy a car from the Brooks—he held title to the Chevy at all times relevant to this action. Nor did he simply contract for the Brooks to acquire the various parts listed in the quotes, which the Brooks did not manufacture or sell in any event, despite the fact that the purchase of such parts was a necessary prerequisite to the build. Instead, what the contract primarily contemplated was that the Brooks would bring their specialized knowledge and experience to bear in selecting and installing appropriate parts, repairing existing components, and generally refurbishing the car in such a way as to restore it to a show-worthy condition. Indeed, the primary shortcoming of the build as identified by Janke’s expert is that

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Part Four Sales

the Brooks “design strategy was unreasonable.” The application of skills necessary to create such a design strategy is undoubtedly a service. I, thus, conclude that the contract at issue in this case predominantly was one for services. The furnishing of such goods as

were necessary to complete the remodel was merely incidental to the provision of such services.

Leases

is a merchant for the purposes of the contract in question. So, if you buy a used car from a used-car dealer, the dealer is a merchant for the purposes of your contract. But if you buy a refrigerator from a used-car dealer, the dealer is probably not considered to be a merchant for purposes of that sale.

A lease of goods is a transfer of the right to possess and use goods belonging to another. Although the rights of one who leases goods (a lessee) do not constitute ownership of the goods, leasing is mentioned here because it can be an important way of acquiring the use of many kinds of goods, from automobiles to farm equipment. In most states, Article 2 and Article 9 of the UCC are applied to such leases by analogy. However, rules contained in these articles sometimes are inadequate to resolve special problems presented by leasing. For this reason, a new article of the UCC dealing exclusively with leases of goods, ­Article 2A, was written in 1987 and has been adopted by 49 states and the District of Columbia. You can access the UCC by visiting www.law.cornell.edu/ucc.

Higher Standards for Merchants The UCC recognized that buyers tend to place more reliance on professional sellers and that professionals are generally more knowledgeable and better able to protect themselves than nonprofessionals. Therefore, the UCC distinguishes between merchants and nonmerchants by holding merchants to a higher standard in some cases [Sections 2–201(2), 2–205, 2–207(2), and 2–314].1 The UCC defines merchant [2–104(1)] on a caseby-case basis.2 If a person regularly deals in the kind of goods being sold, or purports to have some special knowledge about the goods, or employs an agent in the sale who fits either of these two descriptions, that person The numbers in brackets refer to sections of the Uniform Commercial Code. 2 Under the UCC, a “merchant” is defined as a “person 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 or 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” [2–104(1)]. 1

Summary Judgment for the Brooks as to Janke’s claims for breach of implied warranties under the UCC.

UCC Requirements Recall the major provisions of the UCC that are applicable to the formation of contracts for the sale of goods, LO19-2 including the “gap fillers” that the UCC deems part of the contract when the parties omit critical terms or state them in an unclear manner.

The UCC requires that parties to sales contracts act in good faith and in a commercially reasonable manner. ­Further, when a contract contains an unfair or unconscionable clause, or the contract as a whole is unconscionable, the courts have the right to refuse to enforce the unconscionable clause or contract [2–302]. The UCC’s ­treatment of unconscionability is discussed in detail in Chapter 15, Illegality. A number of the UCC provisions concerning the sale of goods were discussed in the chapters on contracts. The Concept Review (on the next page) lists some of the important provisions discussed earlier, together with the chapters in the text where the discussion can be found.

Terms of Sales Contracts Gap Fillers The UCC recognizes the fact that par-

ties to sales contracts frequently omit terms from their agreements or state terms in an indefinite or unclear manner. The UCC deals with these situations by filling in the blanks with common trade practices, or by giving commonly used terms a specific meaning that is applied unless the parties’ agreement clearly indicates a contrary intent.



Chapter Nineteen  Formation and Terms of Sales Contracts

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CONCEPT REVIEW Formation of Contracts Offer and Acceptance  (Chapters 10 and 11)

1. A contract can be formed in any manner sufficient to show agreement, including conduct by both parties that recognizes the existence of a contract. 2. The fact that the parties did not agree on all the terms of their contract does not prevent the formation of a contract. 3. A firm written offer by a merchant that contains assurances it will be held open is irrevocable for a period of up to three months. 4. Acceptance of an offer may be made by any reasonable manner and is effective on dispatch. 5. A timely expression of acceptance creates a contract even if it contains terms different from the offer or states additional terms unless the attempted acceptance is expressly conditioned on the offeror’s agreement to the terms of the acceptance. 6. An offer inviting a prompt shipment may be accepted either by a prompt promise to ship or a prompt shipment of the goods.

Consideration ­(Chapter 12)

1. Consideration is not required to make a firm offer in writing by a merchant irrevocable for a period of up to three months. 2. Consideration is not required to support a modification of a contract for the sale of goods.

Statute of Frauds (Chapter 16)

1. Subject to several exceptions, all contracts for the sale of goods for $500 or more must be evidenced by a writing signed by the party against whom enforcement of the contract is sought. It is effective only as to the quantity of goods stated in the writing. 2. A signed writing is not required if the party against whom enforcement is sought is a merchant, received a written memorandum from the other party, and did not object in writing within 10 days of his receipt of it. 3. An exception to the statute of frauds is made for specially manufactured goods not suitable for sale to others on which the seller has made a substantial beginning in manufacturing or has entered into a binding contract to acquire. 4. An exception to the statute of frauds is made for contracts that a party admits the existence of in court testimony or pleadings. 5. If a party accepts goods or payment for goods, the statute of frauds is satisfied to the extent of the payment made or the goods accepted.

Unconscionability (Chapter 15)

If a court finds a contract for the sale of goods to be unconscionable, it can refuse to enforce it entirely, enforce it without any unconscionable clause, or enforce it in a way that avoids an unconscionable result.

Price Terms A fixed price is not essential to the cre-

ation of a binding sales contract. Of course, if price has been the subject of a dispute between the parties that has never been resolved, no contract is created because a “meeting of the minds” never occurred. However, if the parties

omitted a price term or left the price to be determined at a future date or by some external means, the UCC supplies a price term ­[2–305]. Under the common law, such contracts would have failed due to “indefiniteness.” If a price term is simply omitted, or if the parties agreed that

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the price would be set by some external agency (like a particular market or trade journal) that fails to set the price, the UCC says the price is a reasonable price at the time for delivery [2–305(1)]. If the agreement gives either party the power to fix the price, that party must do so in good faith [2–305(2)]. If the surrounding circumstances clearly indicate that the parties did not intend to be bound in the event a price was not determined in the agreed-upon manner, no contract results [2–305(4)]. some cases, the parties may state the quantity of goods covered by their sales contract in an indefinite way. Contracts that obligate a buyer to purchase a seller’s output of a certain item or all of the buyer’s requirements of a certain item are commonly encountered. These contracts caused frequent problems under the common law because of the indefiniteness of the parties’ obligations. If the seller decided to double its output, did the buyer have to accept the entire amount? If the market price of the item soared much higher than the contract price, could the buyer double or triple its demands?

For example, assume the Manhattan Ice Company enters into a five-year agreement with the Madison Square Garden Corporation to provide at a fixed, specified price all the ice required for the concession stands at Madison Square Garden. Manhattan Ice expands its capacity to make ice to fulfill the anticipated requirements and during the first two years of the contract delivers between 1.25 and 1.5 million pounds of ice to the Garden. If in the third year of the agreement, Madison Square Garden wants Manhattan Ice to deliver approximately twice that much ice so that it can be used at other arenas owned by the corporation, Manhattan Ice would not be obligated to provide the additional ice. Similarly, Madison Square Garden would not be able to reduce its request to 100,000 pounds of ice because it decides to make its own ice on the premises. In the latter case, it is obligated to continue to acquire all of its requirements for ice from Manhattan Ice. In the Noble Roman’s case that follows, the court looked to the contract and to the parties’ course of performance to conclude that the contract was a “requirements” contract and not an order for a specified number of pizza boxes.

Output and Needs Contracts In an “output”

Exclusive Dealing Contracts The UCC takes

Quantity Terms In

contract, one party is bound to sell its entire output of particular goods and the other party is bound to buy that output. In a “needs” or “requirements” contract, the quantity of goods is based on the needs of the buyer. In determining the quantity of goods to be produced or taken pursuant to an output or needs contract, the rule of good faith applies. Thus, no quantity can be demanded or taken that is unreasonably disproportionate to any stated estimate in the contract or to “normal” prior output or requirements if no estimate is stated [2–306(2)].

a similar approach to exclusive dealing contracts. Under the common law, these contracts were sources of difficulty due to the indefinite nature of the parties’ duties. Did the dealer have to make any effort to sell the manufacturer’s products, and did the manufacturer have any duty to supply the dealer? The UCC says that unless the parties agree to the contrary, sellers have an obligation to use their best efforts to supply the goods to the buyer and the buyers are obligated to use their best efforts to promote their sale [2–306(2)].

CYBERLAW IN ACTION Electronic Writings and the Statute of Frauds The Electronic Signatures in Global and National Commerce Act (the “E-Sign” act) was enacted by Congress and became effective in the United States on October 1, 2000. The E-Sign law covers many everyday transactions including sales transactions, even where the law of the state involved still has a version of Article 2 that requires a “signed writing” or another means of satisfying the Article 2 statute of frauds found in Section 2–201. Federal laws “preempt”—that is, displace— state laws if the two sets of laws are in conflict. If state law requires a signed writing or another indicator that the purported buyer and

seller actually intended to form a contract, E-Sign allows the parties to use electronic authentications instead of signed writings. E-mail messages and online orders sent by the buyer would suffice. States that have adopted the Uniform Electronic Transactions Act (UETA) also allow online communications to satisfy the Section 2–201 statute of frauds requirement. The hypothetical scenario at the beginning of this chapter poses the situation where a person uses a manufacturer’s website to purchase a bicycle and asks whether an enforceable contract for the sale of goods can be formed electronically. Given the preceding information, how would you answer the question?



Chapter Nineteen  Formation and Terms of Sales Contracts

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Noble Roman’s v. Pizza Boxes   57 UCC Rep. 2d 901 (Ind. Ct. App. 2005) Noble Roman’s is a franchisor of pizza restaurants, but the company does not own or operate any restaurants. Noble Roman’s franchisees order supplies approved by Noble Roman’s. Pizza Boxes is a broker that acts as an intermediary for vendors who manufacture pizza boxes. In 2002 William Gilbert, director of R&D and distribution for Noble Roman’s, e-mailed Michael Rosenberg, vice president of Pizza Boxes, regarding Noble Roman’s interest in “clamshell” boxes for use in a new “pizza-by-the-slice” program. Gilbert stated that the estimated usage at this stage is from 400,000 to a million units per year to start. After Noble Roman’s approved the box design, the parties worked out the details for the purchase. Gilbert explained that the pizza-by-the-slice program was just getting started at one of its franchise locations, but he anticipated that other locations would implement the program over time. The two agreed that 2.5 million boxes would be needed annually; that Multifoods, Noble Roman’s distributor, would submit orders for the boxes and pay the invoices; and that Multifoods would pick up the boxes after the orders were filled. On November 1, 2002, Rosenberg sent Gilbert a confirming letter, that stated: Dear Bill: Please sign in the space below to confirm the following order: Item: 18/6 Slice Box 220/case Quantity: 2,500,000 Print: Two colors Price: $101.45/M FOB: Bakersfield or Stockton, Ca. (in trailer load quantity—approx. 230,000 per load) To be picked up by Multifoods. PBI remits invoice Multifoods.  xtras for printing preps are included at $4,500 ($1.80/M) and amortized over the entire order. In the event that the total of E 2.5 million boxes are not manufactured, Noble Roman’s is responsible for any portion of the prep charge remaining. Gilbert signed and dated the letter and returned it to Rosenberg. On its own initiative, Pizza Boxes, through its vendor, Dopaco Inc., manufactured 519,200 boxes in anticipation of Multifoods’s future orders. Multifoods submitted an initial purchase order to Pizza Boxes for six cases (12,000 boxes), and Multifoods paid Pizza Boxes for that order. However, after the initial order, Multifoods did not order any more boxes. When Rosenberg called Multifoods to inquire why it had not ordered more boxes, he was told that the franchisees were “not using this product.” Pizza Boxes then asked Noble Roman’s to pay for approximately 500,000 boxes that Pizza Boxes had made but Multifoods had not ordered. Noble Roman’s responded that it was a franchisor and not an operator of restaurants that specifies and arranges for the manufacture of products and supplies sold by its franchisees, and that Noble Roman’s does not purchase any supplies or products. Once Noble Roman’s includes products or supplies in its specifications, then any purchase order is signed by the distributor who buys all of the supplies and distributes them to the franchisees who sign purchase orders with the distributor. Pizza Boxes then filed suit against Noble Roman’s alleging breach of contract, seeking $54,901.44 for the unpaid inventory and tooling charges. The trial court entered summary judgment in favor of Pizza Boxes and Noble Roman’s appealed. Najam, Judge Noble Roman’s contends that the trial court erred when it entered summary judgment in favor of Pizza Boxes. In particular, Noble Roman’s maintains that its only obligation under the ­November 1, 2002, letter was to pay the “printing prep” charges remaining in the event Pizza Boxes did not manufacture the 2.5 million boxes. We agree.

Initially, we note that Pizza Boxes’s complaint suggests that the November 1, 2002, letter is a purchase order, that is, “[a] document authorizing a seller to deliver goods with payment to be made later.” But the plain and ordinary meaning of the letter shows that it is a requirements contract. See UCC 2–306. The letter is not an order for 2.5 million boxes but, on its face, contemplates the possibility that not all 2.5 million boxes would

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be manufactured. Thus, it is not a purchase order. And, despite the inclusion in the letter of a specific estimate of quantity, it is clear that there was no meeting of the minds on how many boxes Pizza Boxes would ultimately produce under the requirements contract. Noble Roman’s contends, and we agree, that the letter is unambiguous and provides that it is only responsible for the unpaid “printing prep” charges “in the event that the total of 2.5  million boxes are not manufactured.” In interpreting an unambiguous contract, a court gives effect to the parties’ intentions as expressed in the four corners of the instrument, and clear, plain and unam­biguous terms are conclusive of that intent. Particular words and phrases cannot be read alone, and the parties’ intentions must be determined by reading the contract as a whole. The terms of the November 1 letter show that: (1) Multifoods would pick up the boxes; (2) Pizza Boxes would remit the invoices to Multifoods; and (3) Noble Roman’s was responsible for “any portion of the [printing] prep charges remaining in the event that not all 2.5 million boxes were manufactured.” While the terms regarding quantity and price might, at first glance, suggest the letter is a purchase order from Noble Roman’s for 2.5 million boxes, when the letter is read as a whole it shows that it is a requirements contract under which Multifoods, not Noble Roman’s, is the purchaser. In effect, Multifoods is a third-party beneficiary of the contract, in that Noble Roman’s established the specifications for the manufacture, and negotiated the price of the boxes for the benefit of Multifoods. In addition, the parties’ course of performance shows that Pizza Boxes did not expect that Noble Roman’s would be responsible for paying for the boxes. Indiana Code Section 2–208 provides in relevant part: Where the contract for sale involves repeated occasions for performance by either party with knowledge of the nature of the performance and opportunity for objection to it by the other, any course of performance accepted or acquiesced in without objection shall be relevant to determine the meaning of the agreement.

Time for Performance The UCC takes the same

position as the common law when the parties’ contract is silent about the time for performance. Performance in such cases must be tendered within a reasonable time [2–309(1)]. If the parties’ contract calls for a number of performances over an indefinite period of time (e.g., an open-ended requirements contract), the contract is valid for a reasonable time but may be terminated at any time by either party after giving reasonable notice [2–309(2) and (3)]. For example, Farmer Jack agrees to sell his entire

Indiana Code Section 2–202 provides in relevant part: Terms with respect to which the confirmatory memoranda of the parties agree or which are otherwise set forth in a writing intended by the parties as a final expression of their agreement with respect to such terms as are included therein may not be contradicted by evidence of any prior agreement or a contemporaneous oral agreement but may be explained or supplemented: (a) by course of dealing or usage of trade (1–205) or by course of performance (2–208). Here, the requirements contract involved “repeated occasions for performance” in that not all 2.5 million boxes would be ordered, manufactured, and purchased at once. Multifoods submitted a purchase order for sixty cases to Pizza Boxes; Pizza Boxes submitted an invoice to Multifoods; and Multifoods paid Pizza Boxes for the boxes. When Multifoods did not submit any subsequent orders, Rosenberg looked to Multifoods for an explanation and telephoned its buyer to ask why no other orders had been submitted. The conduct of Multifoods in submitting the order to Pizza Boxes and paying Pizza Boxes, and Pizza Boxes in submitting the invoice to Multifoods and contacting Multifoods to inquire about additional orders, establish a course of performance between them, consistent with the terms of the letter, all of which shows that Multifoods is the purchaser. Pizza Boxes did not suggest that the November 1, 2002, letter obligated Noble Roman’s until it realized that Multifoods was not going to submit any additional purchase orders. Noble Roman’s did not order the boxes in dispute and is entitled to summary judgment on Pizza Boxes’s breach of contract claim for the cost of the boxes as a matter of law. However, under the terms of contract, Noble Roman’s is liable to Pizza Boxes for the portion of the prep charges still owed for the boxes that were not manufactured. Judgment reversed in favor of Noble Roman’s and remanded with instructions.

output of peaches each fall to a cannery at the then-current market price. If the contract does not contain a provision spelling out how and when the contract can be terminated, Farmer Jack can terminate it if he gives the cannery a reasonable time to make arrangements to acquire peaches from someone else. Finally, the UCC also provides for the time and place of payment. Unless the parties agreed on some other payment terms, payment for the goods is due at the “time and place at which the buyer is to receive the goods” [2–310(a)].



Chapter Nineteen  Formation and Terms of Sales Contracts

Delivery Terms Unless the parties agree to the con-

trary, the UCC says that the goods ordered are to be delivered in a single-lot shipment [2–307]. If the contract is silent about the place for delivery, the goods are to be delivered at the seller’s place of business [2–308(a)]. The only exception to this rule is in the case of contracts dealing with identified goods that both parties at the time of contracting know are located someplace other than the seller’s place of business. In such a case, the site of the goods is the place for delivery [2–308(b)]. Standardized shipping terms that through commercial practice have come to have a specific meaning are customarily used in sales contracts. The terms FOB (free on board) and FAS (free alongside ship) are basic delivery terms. If the delivery term of the contract is FOB or FAS the place at which the goods originate, the seller is obligated to deliver to the carrier goods that conform to the contract and are properly prepared for shipment to the buyer, and the seller must make a reasonable contract for transportation of the goods on behalf of the buyer. Under such delivery terms, the goods are at the risk of the buyer during transit and he must pay the shipping charges. If the term is FOB destination, the seller must deliver the goods to the designated destination and they are at the seller’s risk and expense during transit. These terms will be discussed in more detail later in this chapter.

Title LO19-3

Explain when title to goods passes from the seller to the buyer.

UCC Changes The

UCC also deals with many important questions about the ownership (title) of the goods in sales contracts. This is important for several reasons. If the goods are lost, stolen, damaged, or destroyed, who must bear the risk of loss, the seller or the buyer? Whose creditors (the seller’s or the buyer’s) have the legal right to seize the goods to satisfy their claims? What are the rights of those who buy goods that are subject to the claims of third parties (e.g., their rightful owner or secured creditors)? Who has the insurable interest that the law requires before a party can purchase insurance protection for the goods? Under the common law, most problems concerning risk of loss, insurable interest, and the rights of various third parties to the goods were answered by determining who had

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title to the goods. The UCC, to clarify these questions, has specific rules that generally do not depend on who has title.

General Title Rule Physical Delivery The UCC does have a general title section. It provides that title passes to the buyer when the seller has completely performed his or her duties concerning physical delivery of the goods [2–401(2)]. So, if the contract merely requires the seller to ship the goods, title passes to the buyer when the seller delivers the goods to the carrier. If the contract requires delivery of the goods by the seller, title passes to the buyer when the goods are delivered and tendered to the buyer. Delivery without Moving the Goods If delivery is to be made without moving the goods, title passes at the time and place of contracting if the goods have been identified to the contract. Identification occurs when the surrounding circumstances make it clear that the goods are those “to which the contract refers” [2–501]. This may result from the contract description of the goods (if they are distinct from other goods in the seller’s possession) or from actions of the seller, such as setting aside or marking the goods. Negotiable Document of Title Sometimes when the goods are being shipped by a professional carrier, the parties will use a negotiable document of title. For instance, a seller may ship the goods to the buyer with payment due on delivery. The document of title (a negotiable bill of lading) serves as the contract between the seller and the shipper as well as identifies who has title and control of the goods. The document of title (signifying the right to control the goods) will not be surrendered to the buyer until she pays for the goods. If the contract calls for the seller to deliver a negotiable document of title to the goods (like a warehouse receipt or a bill of lading) to the buyer, title passes when the document of title is delivered. Buyer’s Rejection In some instances, the buyer will reject the goods, perhaps because he does not believe that they conform to the contractual specifications. Whatever the reason, if the buyer rejects tender of the goods, title will automatically be revested in the seller. The National Music Museum: America’s Shrine to Music case, which follows, illustrates the application of these rules concerning passage of title. In this case, the court held that title to a guitar never passed to the buyer despite the fact he had entered into a contract to purchase it because the seller never delivered the guitar to the buyer and he had never possessed it.

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CYBERLAW IN ACTION Buying Beer on the Internet While his parents were away from home on vacation, Hunter Butler, a minor, used a credit card in his name to order 12 bottles of beer through Beer Across America’s website. When his mother, Lynda Butler, returned home, she found several bottles from the shipment of beer remaining in the refrigerator. Lynda Butler then filed a civil lawsuit against Beer Across America seeking damages under Section 6–5–70 of the Alabama Civil Damages Act. The Civil Damages Act provides for a civil action by the parent or guardian of a minor against anyone who knowingly sells or furnishes liquor to the minor. A threshold issue in the lawsuit was whether the sale of the beer had taken place in Alabama so that a court in Alabama would have personal jurisdiction over Beer Across America. Beer Across America was an Illinois corporation involved in the marketing and sale of alcoholic beverages and other merchandise.

The beer was brought by carrier from Illinois to Alabama. The sales invoice and shipping documents provided that the sale was FOB the seller, with the carrier acting as the buyer’s agent. Moreover, the invoice included a charge for sales tax but no charge for beer tax; Alabama law requires that sales tax be collected for out-of-state sale of goods that are then shipped to Alabama but requires beer tax be collected only on sales within Alabama. The court held that the sale arranged over the Internet took place in Illinois. The court noted that under the versions of the Uniform Commercial Code in effect in both Illinois and Alabama, a sale consists in the passing of title from the seller to the buyer. Title to goods passes at the time and place of the shipment when the contract does not require the seller to make delivery at the destination. Accordingly, ownership to the beer passed to Hunter Butler upon tender of the beer to the carrier. The court then transferred the case to the U.S. District Court for the Northern District of Illinois. Butler v. Beer Across America, 40 UCC Rep. 2d 1008 (N.D. Ala. 2000).

National Music Museum: America’s Shrine to Music v. Johnson    904 F.3d 598 (8th Cir. 2018)

Robert Johnson and Larry Moss had known each other for 35 years and shared an interest in historic memorabilia. Whenever Johnson came across pieces he thought Moss would enjoy, he contacted him, and during that time, Moss had purchased 15–20 pieces of memorabilia. In the summer of 2007, Johnson contacted Moss about acquiring three guitars once owned by Elvis Presley, including a Martin D-35 guitar. Subsequent discussions finally led to an agreement on February 12, 2008, in which Moss agreed to pay Johnson $120,000 for four guitars, three of which were connected to Elvis. A written contract organized the transaction into two parts. Part one involved Moss paying Johnson $70,000 and taking immediate possession of two guitars. Part two required Johnson to deliver the two remaining guitars—one of which was the Martin D-35—by April 12, 2009. Upon delivery, Moss would pay Johnson $50,000. Moss was unable to take possession at the time the arrangement was finalized because the Martin D-35 guitar was on display at the Rock n’ Soul Museum in Memphis, Tennessee, under an agreement Johnson made to leave it there until January 2009. Moss promised Johnson he would not retrieve the guitar from Rock n’ Soul. Thus, the only way Moss could have taken possession of the Martin D-35 was by having Johnson deliver it to him. Moss expected Johnson to physically deliver the guitar. Toward the end of 2008, Johnson took the D-35 from Rock n’ Soul. Over the next five years, the parties corresponded by e-mail about the guitar, but Moss never asked Johnson to bring it to him or claimed he was the owner. Subsequently, in February 2013, Johnson entered into an agreement with the National Music Museum whereby it would pay Johnson $250,000 for a John Entwistle Gibson Korina Explorer guitar and would also receive seven enumerated donations from Johnson, one of which was the Martin D-35 guitar. On December 10, 2013, Moss contacted the National Music Museum and claimed he owned the Martin D-35 that had been donated to it. The National Music Museum brought suit against Moss and Johnson seeking a declaratory judgment that it was the legal owner of Martin D-35 previously owned by Elvis Pressley. The federal district court held that because the guitar had never been delivered to Moss, he never acquired title to it. Johnson still had title to the Martin D-35 when he transferred it to the Museum and, consequently, the Museum became the owner. Moss then appealed the district court decision to the U.S. Court of Appeals.



Chapter Nineteen  Formation and Terms of Sales Contracts

Wollman, Circuit Judge. Moss argues that title to the Martin D-35 guitar passed to him when he entered into the contract with Johnson on February 12, 2008. Moss claims that constructive delivery of the guitar was sufficient to pass title because the guitar was on display at the Rock n’ Soul Museum and Moss assured Johnson that he would allow it to remain there. Under Tennessee law, “unless otherwise explicitly agreed title passes to the buyer at the time and place at which the seller completes performance with reference to the physical delivery of the goods.” Section 2-401(2). “Where delivery is to be made without moving the goods,” however, title passes at the time of contracting “if the goods have been identified and no documents of title are to be delivered.” Section 2-401(3)(B). The February 12, 2008, contract between Moss and Johnson provided that Moss would pay $50,000 “upon delivery” of

Title and Third Parties LO19-4

Explain what is meant by a voidable title and explain when a buyer can obtain better title to goods than the seller had.

Obtaining Good Title A

fundamental rule of property law is that a buyer cannot receive better title to goods than the seller had. If Thief steals an iPad from Adler and sells it to Brown, Brown does not get good title to the iPad because Thief had no title to it. Adler would have the right to recover the iPad from Brown. Similarly, if Brown sold the iPad to Carroll, Carroll could get no better title to it than Brown had. Adler would have the right to recover the iPad from Carroll. Under the UCC, however, there are several exceptions to the general rule that a buyer cannot get better title to goods than his seller had. The most important exceptions include the following: (1) A person who has a voidable title to goods can pass good title to a bona fide purchaser for value, (2) a person who buys goods in the regular course of a retailer’s business usually takes free of any interests in the goods that the retailer has given to others, and (3) a person who buys goods in the ordinary course of a dealer’s business takes free of any claim of a person who entrusted those goods to the dealer.

Transfers of Voidable Title A seller who has a

voidable title has the power to pass good title to a good-faith

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the Martin D-35 and Sonny Burgess guitars. The contract further stated that “Johnson guarantees he will deliver to Moss both items . . . on or before April 12, 2008; and Moss guarantees that he will pay the balance of $50,000 when that delivery occurs.” Even assuming that Moss verbally agreed to the Martin D-35’s continued display at the Rock n’ Roll Museum, the contract required physical delivery of the guitar. Nothing in the contract indicated that delivery was to be made without physically moving the guitar. Because Johnson never delivered the Martin D-35 guitar to Moss, Moss never acquired title to it. Accordingly, we uphold the district court’s determination that Johnson had title to the Martin D-35 guitar when he transferred the guitar to the Museum and that the Museum owns the Martin D-35 guitar. The judgment is affirmed.

purchaser for value [2–403(1)]. A seller has a voidable title to goods if he has obtained his title through fraudulent representations. For example, a person would have a voidable title if he obtained goods by impersonating another person or by paying for them with a bad check or if he obtained goods without paying the agreed purchase price when it was agreed that the transaction was to be a cash sale. Under the UCC, good faith means “honesty in fact in the conduct or transaction concerned” [1–201(19)] and a buyer has given value if he has given any consideration sufficient to support a simple contract [1–201(44)]. For example, Jones goes to the ABC Appliance Store; convinces the clerk that he is really Clark, who is a good customer of ABC; and leaves with a Sony TV charged to Clark’s account. If Jones sells the Sony TV to Davis, who gives Jones value for it and has no knowledge of the fraud that Jones perpetrated on ABC, Davis gets good title to the Sony TV. ABC cannot recover the Sony TV from Davis; instead, it must look for Jones, the person who deceived it. In this situation, both ABC and Davis were innocent of wrongdoing, but the law considers Davis to be the more worthy of its protection because ABC was in a better position to have prevented the wrongdoing by Jones and because Davis bought the goods in good faith and for value. The same result would be reached if Jones had given ABC a check that later bounced and then sold the Sony TV to Davis, who was a good-faith purchaser for value. Davis would have good title to the Sony TV, and ABC would have

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to pursue its right against Jones on the bounced check. The primary reason for this exception is to place the burden of loss on the party who had the best opportunity to avoid the harm. Good-faith purchasers can do nothing to avoid injury. However, the rightful owners of goods at least have the opportunity to protect themselves by taking steps to assure themselves of the buyer’s identity, accepting only cash or certified checks, refusing to part with the goods until they have cash in hand, or taking steps to discover fraud before parting with the goods. In view of their greater relative fault, the UCC requires the original owners of the goods to bear the burden of collecting from their fraudulent buyers.

such commercial transactions. The exception also reflects the fact that the bank is more interested in the proceeds from the sale than in the inventory. Security interests and the rights of buyers in the ordinary course of business are discussed in more detail in Chapter 29, Security Interests in Personal Property.

Entrusting of Goods A third exception to the gen-

eral rule is that if goods are entrusted to a merchant who deals in goods of that kind, the merchant has the power to transfer all rights of the entruster to a buyer in the ordinary course of business [2–403(2)]. In the scenario presented at the beginning of this chapter, Paul takes his damaged Buyers in the Ordinary Course of Business   bicycle for repair to a shop that sells and repairs bicycles. The second exception made by the UCC concerns buyers in By mistake, a clerk in the bicycle shop sells the bicycle to the ordinary course of business. A buyer in ordinary course Melissa. The bicycle shop can pass good title to Melissa, is a person who in good faith and without knowledge that a buyer in the ordinary course of business. In such a case, the sale to him is in violation of the ownership rights of a Paul would have to sue the bicycle shop for damages for third party buys goods in the ordinary course of business of conversion of the bicycle; he could not get it back from a person selling goods of that kind, other than a pawnbroker Melissa. The purpose behind this rule is to protect com[1–201(9)]. Under the UCC, buyers in the ordinary course merce by giving confidence to buyers that they will get good take goods free of any security interest in the goods that their title to the goods they buy from merchants in the ordinary seller may have given a third party [9–307]. course of business. However, a merchant-seller cannot pass For example, Brown Buick may borrow money from good title to stolen goods even if the buyer is a buyer in the Bank in order to finance its inventory of new Buicks; in ordinary course of business. This is because the original turn, Bank may take a security interest in the inventory to owner did nothing to facilitate the transfer. secure repayment of the loan. If Carter buys a new Buick In the case that follows, Zaretsky v. William Goldberg Diafrom Brown Buick, he gets good title to the Buick free and mond Corp., where the owner of a diamond consigned it to clear of the bank’s security interest if he is a buyer in the a well-known celebrity fashion consultant who sold it rather ordinary course of business and without knowledge that than returning it, the court rejected the argument that the fashthe sale is in violation of a security interest. The basic purion consultant was a merchant with voidable title who had the pose of this exception is to protect those who innocently power to transfer all rights of the original owner to a subsebuy from merchants and thereby to promote confidence in quent buyer in the ordinary course of business.

Zaretsky v. William Goldberg Diamond Corp.    89 UCC Rep. 2d 623 (2d Cir. 2016)

The William Goldberg Diamond Corp. (WGDC) was the owner of a 7.44-carat pear-shaped diamond. In February 2003, WGDC consigned the diamond, along with other items, to Derek Khan, a well-known celebrity fashion stylist. The purpose of the consignment— which reflected an ongoing arrangement between Khan and WGBC and between Khan and other established jewelers—was for Khan to adorn his celebrity clients with high-end jewelry in preparation for special events and fashion shoots. The arrangement was governed by a Consignment Agreement, which made clear that Khan had no freestanding authority to “sell, pledge, hypothecate, or otherwise dispose of the diamond,” but that he could sell the diamond “if and when he . . . received from WGDC a separate invoice.” In other words, Khan was authorized to sell the diamond only if WGDC approved the sale and set out specific terms, prior to any sale. Typically, after WGDC consigned a piece of jewelry to Khan, he would return the jewelry to WGDC within a few days of the celebrity event. After the February 2003 consignment, however, Khan failed to return the diamond in a timely manner, prompting WGDC to become suspicious and, eventually, to file a police report.



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On March 17, 2003, the diamond surfaced in the legitimate market, when Louis Newman—a New York diamond merchant—submitted the diamond to the Gemological Institute of America (GIA) for certification, which was issued on March 25, 2003. In late 2003, the diamond was purchased by Stanley & Sons—another New York diamond merchant—on behalf of Frank and Donna Walsh. In August 2012, Donna Walsh gave the diamond to her daughter and son-in-law, Suzanne and Steven Zaretsky. Steven Zaretsky authorized another jeweler to appraise the diamond for insurance purposes. On December 10, 2012, that jeweler submitted the diamond to the GIA for certification. Soon thereafter, the GIA informed the Zaretskys that the diamond appeared to have been stolen from WGDC in 2003. The GIA retained possession pending a final resolution of its rightful owner. When WGDC finally traced the diamond to the Zaretskys, it filed an action seeking a declaratory judgment that it was the rightful owner of the diamond. WGDC contended that because Khan stole the diamond, he could neither hold title in the ­diamond—nor transfer title to it—as a matter of law. On the other hand, the Zaretskys argued that Khan was not a thief, but rather an entrusted merchant who held “voidable title” in the diamond—and therefore was capable of transferring title—under the Uniform Commercial Code. As a result, when the Walshes purchased the diamond in 2003, they acquired good title to the diamond, which was subsequently transferred to the Zaretskys. Accordingly, they contended that WGDC was no longer the owner of the diamond as a matter of law. The trial court held that Khan had the power to transfer WGDC’s rights to the diamond under Section 2–403(2), which provides that “any entrusting of possession of goods to a merchant who deals in goods of that kind gives him power to transfer all rights of the entruster to a buyer in ordinary course of business.” The court concluded that Khan had the power to transfer WGDC’s rights to the diamond under Section 2–403(2) because Kahn fell within the definition of a “merchant” in Section 2–104(1) because, by his occupation, he held “himself out as having knowledge or skill peculiar to the practices or goods involved in the transaction.” The trial court then granted summary judgment in favor of the Zaretskys and entered a final order adjudging the Zaretskys to be the rightful owners of the diamond. WGDC then filed an appeal of the decision and order. Sack, Circuit Judge As the district court noted, two provisions of the NYUCC are relevant to the parties’ competing claims to the diamond. The first is section 2-104(1) which provides three alternative definitions for the stand-alone term “merchant” under the code: (1) a person 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. The second relevant provision is section 2-403(2) which states that “[a]ny entrusting of possession of goods to a merchant who deals in goods of that kind gives him the power to transfer all rights of the entruster to a buyer in the ordinary course of business.” In concluding that the Zaretskys are the rightful owners of the diamond, the district court construed section 2-403(2) as empowering anyone who qualifies as a “merchant” under section 2-104(1) with the ability to pass title to an entrusted good. The court then decided that Khan by holding himself out as having the knowledge or skill peculiar to jewelry, was a “merchant” under the second definition contained in section 2-401(1), and that the entrustment provision under 2-403(2) therefore enabled him to transfer all rights to the diamond to others.

We disagree with the district court’s construction of 2-403(2) of the NYUCC. Section 2-403(2) enables a merchant to transfer rights to an entrusted good only if the person is a “merchant” who “deals in goods of that kind,” in this case diamonds or other high-end jewelry. The entrustment provision, therefore applies to a person who is a merchant under section 2-104(1)’s first definition, which includes the requirement that the person be one who “deals in” the relevant good. But it does not necessarily apply to the person who is a “merchant” under the second or third definition. Even if, as the district court has determined, Khan was a “merchant” under section 2-104(1)’s second definition, the court was also required to find that Khan dealt in goods like the diamond in order for him to have transferred rights to it under section 2-403(2). This appeal turns on whether Khan regularly sold the kind of goods at issue in this case: diamonds or other high-end jewelry. The entrustee must be a person who deals in goods of the kind entrusted to him or her. Because the Zaretsky’s have submitted no evidence that Khan regularly conducted such sale, we conclude that WGDC is entitled to summary judgment. The record supports WGDC’s contention that Khan never sold any of the diamonds WGDC consigned to him. The terms of the Consignment Agreement denied Khan any independent authority to sell the diamond and specified that a sale could only occur if he received a written invoice from WGDC, which WDGC did not provide to him. There is also no record evidence of Khan’s participation in any specific sale of WGDC’s jewelry. The only evidence bearing on Khan’s potential involvement in selling other diamonds or other high-end jewelry is his own declaration, which

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WGDC urges us to ignore because it was “made by a convicted felon and habitual liar who has fled to Dubai (and whom the WGDC has no ability to depose).” We note that our conclusion is consistent with the New York Court of Appeals’ assessment of the underlying purpose of section 2-403(2). It is, the court tells us, “designed to enhance the reliability of commercial sales by merchants (who deal with the kind of goods sold on a regular basis) while shifting the risk of loss through

fraudulent transfer to the owner of the goods, who can select the merchant to whom he entrusts his property.” It would be inappropriate in light of that principle, we think, to shift the risk of loss to WGDC here. Absent evidence that Khan regularly sold diamonds or other high-end jewelry, WGDC had little reason to suspect that he would do so once the company entrusted the diamond to him. Case remanded to district court with instructions to enter summary judgment for WGDC. 

Ethics and Compliance in Action Perils of Entrusting Goods Suppose you are the owner of a small jewelry store that sells new and antique jewelry. A customer leaves a family heirloom—an elaborate diamond ring—with you for cleaning

and resetting. By mistake, a clerk in your store sells it to another customer. What would you do? If you were the buyer of the ring and had given it to your fiancée as a gift and then were informed of the circumstances, what would you do?

CONCEPT REVIEW Title and Third Parties General Rule

A seller cannot pass better title to goods than he has.

Exceptions to ­General Rule

1. A person who has voidable title to goods can pass good title to a bona fide purchaser for value. 2. A buyer in the ordinary course of a retailer’s business usually takes free of any interests in the goods that the retailer has given to others. 3. A person who buys goods in the ordinary course of a dealer’s business takes free of any claims of a person who entrusted those goods to the dealer.

Risk of Loss Apply the UCC rules concerning risk of loss to determine who had the risk of loss in a given transaction where the LO19-5 goods that were the subject of a contract were lost or damaged before the buyer took possession.

The transportation of goods from sellers to buyers can be a risky business. The carrier of the goods may lose, damage, or destroy them; floods, hurricanes, and other natural catastrophes may take their toll; thieves may steal all or part of the goods. If neither party is at fault for the loss, who should bear the risk? If the buyer has the risk when the goods are damaged or lost, the buyer is liable for the contract price. If the seller has the risk, he is liable for damages unless substitute performance can be tendered.

The common law placed the risk on the party who had technical title at the time of the loss. The UCC rejects this approach and provides specific rules governing risk of loss that are designed to provide certainty and to place the risk on the party best able to protect against loss and most likely to be insured against it. Risk of loss under the UCC depends on the terms of the parties’ agreement, on the moment the loss occurs, and on whether one of the parties was in breach of contract when the loss occurred.

Terms of the Agreement The contracting par-

ties, subject to the rule of good faith, may specify who has the risk of loss in their agreement [2–509(4)]. This they may do directly or by using certain commonly accepted shipping terms in their contract. In addition, the UCC has certain general rules on risk of loss that amplify specific



Chapter Nineteen  Formation and Terms of Sales Contracts

shipping terms and control risk of loss in cases where specific terms are not used [2–509].

Shipment Contracts If

the contract requires the seller to ship the goods by carrier but does not require their delivery to a specific destination, the risk passes to the buyer when the seller delivers the goods to the carrier [2–509(1) (a)]. Shipment contracts are considered to be the normal contract where the seller is required to send goods to the buyer but is not required to guarantee delivery at a particular location. The following are commonly used shipping terms that create shipment contracts: 1. FOB (free on board) point of origin. This term calls for the seller to deliver the goods free of expense and at the seller’s risk at the place designated. For example, a contract between a seller located in Chicago and a buyer in New York calls for delivery FOB Chicago. The seller must deliver the goods at his expense and at his risk to a carrier in the place designated in the contract—namely, Chicago—and arrange for their carriage. Because the shipment term in this example is FOB Chicago, the seller bears the risk and expense of delivering the goods to the carrier, but the seller is not responsible for delivering the goods to a specific destination. If the term is “FOB vessel, car, or other vehicle,” the seller must load the goods on board at his own risk and expense [2–319(1)]. 2. FAS (free alongside ship). This term is commonly used in maritime contracts and is normally accompanied by the name of a specific vessel and port—for example, “FAS Calgary [the ship], Chicago Port Authority.” The seller must deliver the goods alongside the vessel Calgary at the Chicago Port Authority at his own risk and expense [2–319(2)]. 3. CIF (cost, insurance, and freight). This term means that the price of the goods includes the cost of shipping and insuring them. The seller bears this expense and the risk of loading the goods [2–320]. 4. C & F. This term is the same as CIF, except that the seller is not obligated to insure the goods [2–320].

Destination Contracts If the contract requires the

seller to deliver the goods to a specific destination, the seller bears the risk and expense of delivery to that destination [2– 509(1)(b)]. The following are commonly used shipping terms that create destination contracts: 1. FOB destination. An FOB term coupled with the place of destination of the goods puts the expense and risk of delivering the goods to that destination on the seller [2– 319(1)(b)]. For example, a contract between a seller in Chicago and a buyer in Phoenix might call for shipment

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FOB Phoenix. The seller must ship the goods to Phoenix at her own expense, and she also retains the risk of delivery of the goods to Phoenix. 2. Ex-ship. This term does not specify a particular ship, but it places the expense and risk on the seller until the goods are unloaded from whatever ship is used [2–322]. 3. No arrival, no sale. This term places the expense and risk during shipment on the seller. If the goods fail to arrive through no fault of the seller, the seller has no further liability to the buyer [2–324]. For example, a Chicago-based seller contracts to sell a quantity of Weber grills to a buyer FOB Phoenix, the buyer’s place of business. The grills are destroyed en route when the truck carrying the grills is involved in an accident. The risk of the loss of the grills is on the seller, and the buyer is not obligated to pay for them. The seller may have the right to recover from the trucking company, but between the seller and the buyer, the seller has the risk of loss. If the contract had called for delivery FOB the seller’s manufacturing plant, then the risk of loss would have been on the buyer. The buyer would have had to pay for the grills and then pursue any claims that he had against the trucking company.

Goods in the Possession of Third Parties

If the goods are in the possession of a third-party bailee (like a carrier or warehouse) and are to be delivered without being moved, the risk of loss passes to the buyer upon delivery to him of a negotiable document of title for the goods; if no negotiable document of title has been used, the risk of loss passes when the bailee indicates to the buyer that the buyer has the right to the possession of the goods [2–509(2)]. For example, if Farmer sells Miller a quantity of grain currently stored at Grain Elevator, the risk of loss of the grain will shift from Farmer to Miller (1) when a negotiable warehouse receipt for the grain is delivered to Miller or (2) when Grain Elevator notifies Miller that it is holding the grain for Miller.

Risk Generally If none of the special rules that have

just been discussed applies, the risk passes to the buyer on receipt of the goods if the seller is a merchant. If the seller is not a merchant, the risk passes to the buyer when the seller tenders (offers) delivery of the goods [2–509(3)]. For example, Frank offers to sell Susan a car, and Susan sends an e-mail accepting Frank’s offer. When he receives the e-mail, Frank calls Susan and tells her she can “pick up the car any time.” That night, the car is destroyed when a tree falls on it during a storm. If Frank is a used-car salesman, he must bear the loss. If Frank is an accountant, Susan must bear the loss. The case that follows, Capshaw v. Hickman, illustrates another critical issue—that is, whether the seller in fact tendered delivery to the buyer.

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Capshaw v. Hickman   64 UCC Rep. 2d 543 (Ohio Ct. App. 2007) Charles Capshaw entered into a written contract with Rachel Hickman to purchase Hickman’s 1996 Honda Civic EX for $5,025. The contract provided, among other things, that “the title will be surrendered upon the new owner’s check clearing.” Capshaw made a down payment of $80 in cash and gave Hickman a personal check for the balance. She provided Capshaw with the keys to the vehicle and also complied with his request to sign the certificate of title over to his father and placed the certificate in the vehicle’s glovebox. They agreed the vehicle was to remain parked in Hickman’s driveway until the check cleared. Unfortunately, before Hickman was notified by her bank that the check had cleared, a hailstorm heavily damaged the vehicle. Due to the damage, Capshaw decided that he no longer wanted the vehicle and asked Hickman to return his money. Hickman refused, believing that the transaction was complete and that the vehicle belonged to Capshaw. She also requested that it be removed from her driveway. Capshaw brought suit against Hickman, alleging, among other things, conversion, breach of contract, and “quasi-contract and unjust enrichment— promissory estoppel.” Capshaw contended that the risk of loss remained with Hickman until the check cleared; because it had not cleared at the time the hail damaged the car, Hickman sustained the loss. Hickman maintained that the risk of loss for a nonmerchant seller like her passes to the buyer after the seller tenders delivery to the buyer. The trial court found that the parties agreed the transfer of title and delivery of the vehicle would occur only after the successful transfer of funds. Because neither had occurred at the time of the hailstorm, the court concluded that the risk of loss remained with the seller. Hickman appealed, arguing that the risk of loss in this instance should depend on whether there had been a tender of delivery and not on whether or not title had passed. Bryant, Judge Where a motor vehicle identified to a purchase contract is damaged, lost, or destroyed prior to the issuance of a certificate of title in the buyer’s name, the risk of such damage, loss or destruction lies with either the seller or buyer as determined under section 1302.53. In relevant part section 1302.53 states “the risk of loss passes to the buyer on his receipt of the goods if the seller is a merchant; otherwise the risk passes to the buyer on tender of delivery.” The parties here agree that defendant is not a merchant. Thus, if Hickman tendered delivery, Capshaw bore the risk of loss; if Hickman did not tender delivery, the risk of loss remained with her. Although the trial court concluded Hickman did not tender delivery, it incorrectly focused on ownership and legal title in reaching its decision. Title is no longer of any importance in determining whether a buyer or seller bears the risk of loss. Rather, tender of delivery “requires that the seller put and hold conforming goods at the buyer’s deposition and give the buyer any notification reasonably necessary to enable him to take delivery.” In this context, disposition means “doing with as one wishes: discretionary control.” When tendering delivery, the seller must not limit the buyer’s disposition of the goods. When, however, limitations upon a buyer’s disposition of personal property do not result from the seller’s activity, then the requirements for tender of delivery are met. Hickman contends she fulfilled the statutory requirements for tendering delivery by turning over the keys to the vehicle and, after signing the certificate of title over to Capshaw’s father per ­Capshaw’s request, by placing the certificate of title in the vehicle’s glove box. She asserts Capshaw chose to leave the vehicle at her residence in order to induce her to take a personal check. Hickman argues that “for all intents and purposes” Capshaw “possessed and

controlled the vehicle when the keys were given to him.” She thus claims not only that she tendered delivery of the vehicle, but that Capshaw was in actual possession of the vehicle at the time it was damaged. Describing the fact that the vehicle remained parked in her driveway as a “red herring,” Hickman asserts she could have done “absolutely nothing else” to complete her performance with respect to the physical delivery of the vehicle. The vehicle’s continued presence in Hickman’s driveway is not a red herring. Under Ohio law, a purchaser’s performance under a contract generally is completed when the purchaser tenders the check. Section 1302.55(B) states “tender of payment is sufficient when made by any means or in any manner current in the ordinary course of business unless the seller demands payment in legal tender and gives any extension of time reasonably necessary to procure it.” Thus upon tendering the check, Capshaw ordinarily would be free to drive away in the vehicle. Understanding why the car remained in the driveway is central to determining whether Hickman tendered delivery. The difficulty in applying the law to this case lies in determining why the car remained on Hickman’s property as the pleadings do not disclose that information. If Capshaw paid by check but Hickman refused to consider payment made until the check cleared, then Capshaw was not free to remove the vehicle from Hickman’s driveway until the check cleared. Under those circumstances Hickman did not tender delivery under section 1302.47, as Capshaw lacked the discretionary control over the vehicle. As a result, the risk of loss would not have passed to Capshaw. By contrast, if to induce Hickman to accept payment by check Capshaw offered to allow the vehicle to remain on Hickman’s driveway until the check cleared, then the risk of loss passed to Capshaw who in his discretion volunteered to leave the car on



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Hickman’s driveway in order to pay in tender most convenient to him. Because the pleadings do not reveal the underlying reasons for leaving the car in the driveway until Capshaw’s check cleared, judgment on the pleadings is inappropriate.

Accordingly . . . we reverse the judgment of the trial court granting judgment on the pleadings to Capshaw, and we remand for further proceedings in accordance with this opinion.

Effect of Breach on Risk of Loss The UCC

Sales on Trial

follows the trend set by earlier law of placing the risk of loss on a party who is in breach of contract. There is no necessary reason why a party in breach should bear the risk, however. In fact, shifting the risk to parties in breach sometimes produces results contrary to some of the basic policies underlying the UCC’s general rules on risk by placing the risk on the party who does not have possession or control of the goods. When the seller tenders goods that the buyer could lawfully reject because they do not conform to the contract description, the risk of loss remains on the seller until the defect is cured or the buyer accepts the goods [2–510(1)]. When a buyer rightfully revokes acceptance of the goods, the risk of loss is on the seller from the beginning to the extent that it is not covered by the buyer’s insurance [2–510(2)]. Buyers who repudiate a contract for identified, conforming goods before risk of loss has passed to them are liable for a commercially reasonable time for any damage to the goods that is not covered by the seller’s insurance [2–510(3)]. For example, Trendy Shoe Stores contracts to buy 1,000 pairs of shoes from Acme Shoe Manufacturing Company. Acme crates the shoes and stores them in its warehouse pending delivery to Trendy. Trendy then tells Acme it will not honor its contract for the shoes, and they are destroyed by a fire in Acme’s warehouse shortly thereafter. If Acme’s insurance covers only part of the loss, Trendy is liable for the balance.

Insurable Interest The UCC rules that govern risk

of loss are supplemented by rules that give the parties an ­insurable interest in the goods, which allows them to insure themselves against most of the risks they must bear. Buyers may protect their interest in goods before they obtain title to them because they have an insurable interest in goods at the moment the goods are identified to the contract [2– 501(1)]. Sellers have an insurable interest in their goods as long as they have title to the goods or a security interest in them [2–501(2)].

There are several common commercial situations in which a seller entrusts goods to another person. This may be done to give a potential buyer the chance to decide whether or not to buy the goods or to give the other party a chance to sell the goods to a third party. These cases present difficult questions about who has the risk of loss of the goods and whose creditors may attach the goods. The UCC provides specific rules to answer these questions depending on the nature of the parties’ agreement. Distinguish between sale or return and sales on approval

LO19-6 and explain the ramifications those distinctions have for

the rights of buyers and sellers.

Sale or Return In

a sale or return contract, the goods are delivered to the buyer primarily for resale with the understanding that the  buyer has the right to return them [2–326(1)(b)]. Unless the parties agreed to the contrary, title and risk of loss rest with the buyer. Return of the goods is at the buyer’s risk and expense [2–327(2)(b)], and the buyer’s creditors can attach the goods while they are in the buyer’s possession [2–326(2)]. Placing the risk on the buyer in these cases recognizes the fact that sale or return contracts are generally commercial transactions.

Sale on Approval In a sale on approval, the goods

are delivered to the buyer primarily for the buyer’s use [2–326(1)(a)]. The buyer is given the opportunity to examine or try the goods so as to decide whether to accept them. Risk of loss and title to the goods do not pass to the buyer until the buyer accepts the goods [2–327(1)(a)]. Any use of the goods that is consistent with a trial of the goods is not an acceptance, but the buyer who fails to give reasonable notice of an intent to return the goods may be held to have accepted them [2–327(1)(b)]. The buyer’s creditors cannot reach goods held on approval [2–326(2)], and return of the goods is at the seller’s risk and expense [2–327(1)(c)]. These provisions recognize the fact that sales on approval are primarily consumer transactions.

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CONCEPT REVIEW Risk of Loss The point at which the risk of loss or damage to goods identified to a contract passes to the buyer is as follows: 1. If there is an agreement between the parties, the risk of loss passes to the buyer at the time they have agreed to. 2. If the contract requires the seller to ship the goods by carrier but does not require that the seller guarantee their delivery to a specific destination (shipment contract), the risk of loss passes to the buyer when the seller has delivered the goods to the carrier and made an appropriate contract for their carriage. 3. If the contract requires the seller to guarantee delivery of the goods to a specific destination (destination contract), the risk of loss passes to the buyer when the seller delivers the goods to the designated destination. 4. If the goods are in the hands of a third person and the contract calls for delivery without moving the goods, the risk of loss passes to the buyer when the buyer has the power to take possession of the goods—for example, when he receives a document of title. 5. In any situation other than those noted above where the seller is a merchant, the risk of loss passes to the buyer on his receipt of the goods. 6. In any situation other than those noted above where the seller is not a merchant, the risk of loss passes to the buyer on the tender of delivery to the buyer by the seller. 7. When a seller tenders goods that the buyer lawfully could reject because they do not conform to the contract description, the risk of loss stays on the seller until the defect is cured or the buyer accepts them. 8. When a buyer rightfully revokes acceptance of goods, the risk of loss is on the seller from the beginning to the extent it is not covered by the buyer’s insurance. 9. If a buyer repudiates a contract for identified, conforming goods before risk of loss has passed to the buyer, the buyer is liable for a commercially reasonable time for any loss or damage to the goods that is not covered by the seller’s insurance.

The Global Business Environment Risk of Loss in International Sales Risk of loss is an important concept in the sale of goods—and takes on additional significance in international sales because of the substantial distances and multiple modes of transportation that may be involved. Between the time a contract is formed and the time the obligations of the parties are completed, the goods that are the subject of the contract may be lost, damaged, or stolen. Both the UCC and the Convention on Contracts for International Sale of Goods (CISG) explicitly address risk of loss in four different situations: (1) where goods are being held by the seller, (2) where goods are being held by a third person or bailee, (3) where goods are in transit, and (4) where goods are in the control of the buyer. Moreover, the CISG deals with risk of loss where goods have been sold or resold

while in transit. Under both the UCC and the CISG, breach by a party may alter the basic rules regarding risk of loss. Before discussing the CISG provisions, it is important to note that the definitions of some terms in the UCC differ from the meaning those terms may have in international trade. The International Chamber of Commerce has compiled a list of widely accepted international shipping terms in a document known as “INCOTERMS.” The most recent version, INCOTERMS 2000, includes 13 different terms that are placed in four different categories, depending on the seller’s responsibilities concerning the goods. Under the first category (known as Group “E”), the seller’s obligation is only to make the goods available to the buyer at the seller’s place of business. This is referred to as an EXW, or EX Works, term. Risk passes from the seller to the buyer when



Chapter Nineteen  Formation and Terms of Sales Contracts

the goods are placed at the buyer’s disposal. Under the second category (known as Group “F”), the seller is required to deliver the goods to a carrier designated by the buyer. This category includes terms like “F.O.B.” (Free on Board) and “F.A.S.” (Free Along Side Ship). Passage of risk varies with the term. Terms in the third category (Group “C”) require the seller to contract for carriage of the goods but not to assume the risk of loss after shipment. Terms in the fourth category (Group “D”) impose on the seller the costs and risks of bringing the goods to the country of destination. Under one such term, “D.A.F.” (Delivered at Frontier), the seller must pay for the carriage of goods

Problems and Problem Cases 1. Star Coach LLC is in the business of converting sport-­ utility vehicles and pickup trucks into custom vehicles. Star Coach performs the labor involved in installing parts supplied by other companies onto vehicles owned by dealers. Heart of Texas Dodge purchased a new Dodge Durango from Chrysler Motors and entered into an agreement with Star Coach, whereby Star Coach would convert the Durango to a Shelby 360 custom performance vehicle and then return the converted vehicle to Heart of Texas Dodge. The manufacturer delivered the dealer’s Durango to Star Coach and, over a period of several months, Star Coach converted the vehicle using parts supplied by another company, Performance West. Several months later, Star Coach delivered the vehicle to Heart of Texas Dodge, and Heart of Texas Dodge paid Star Coach the contract price of $15,768 without inspecting the vehicle. Two days later, Heart of Texas Dodge inspected the vehicle and concluded that the workmanship was faulty. It stopped payment on the check, and Star Coach filed suit against Heart of Texas Dodge. One of the issues in the litigation was whether the UCC applied to the contract in this case. Does the UCC apply to a contract for the conversion of a van that involves both goods and services? 2. Keith Russell, a boat dealer, contracted to sell a 19-foot Kindsvater boat to Robert Clouser for $8,500. The agreement stipulated that Clouser was to make a down payment of $1,700, with the balance due when he took possession of the boat. According to the contract, Russell was to retain possession of the boat in order to install a new engine and drivetrain. While the boat was still in Russell’s possession, it was completely destroyed when it struck a seawall. Transamerica, Russell’s insurance company, refused to honor Russell’s claim for the damages to the boat.

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to some defined point after that where goods have been cleared for export in the country of origin but before the customs boundary of another identified, usually adjoining, country. The CISG, like the UCC, provides a set of default rules governing risk of loss where the parties do not explicitly address risk of loss in their contract. However, it also permits parties to contract out of those rules. Parties to international agreements commonly utilize the INCOTERMS and incorporate them into contracts otherwise governed by the CISG. Thus, the INCOTERMS are used to define when risk of loss passes, and CISG, in turn, provides the legal consequences of the passage of the risk of loss in a particular case.

 The insurance policy between Transamerica and Russell covered only watercraft under 26 feet in length that were not owned by Russell. Transamerica argued that the boat was not covered by the policy because ­Russell still owned it at the time of the accident. Did Russell have title to the boat at the time of the accident? 3. Kenneth West agreed to sell his car, a 1975 Corvette, to a man representing himself as Robert Wilson. In exchange for a cashier’s check, West signed over the Corvette’s title to Wilson. Ten days later, when West learned that the cashier’s check was a forgery, he filed a stolen vehicle report with the police. However, the police did not locate Wilson or the Corvette, and the case grew cold. Nearly two and a half years later, West asked the police to run a check on the Corvette’s vehicle identification number. The check revealed the name and address of Tammy Roberts. ­Roberts, who held the certificate of title, had purchased it from her brother, who in turn had purchased it in response to a newspaper ad. West filed suit against Roberts to establish legal ownership of the Corvette. Is West entitled to regain possession and title to the Corvette from Roberts? 4. Club Pro Golf Products was a distributor of golf products. It employed salespeople who called on customers to take orders for merchandise. The merchandise was sent by Club Pro directly to the purchaser, and payment was made by the purchaser directly to Club Pro. A salesman for Club Pro, Carl Gude, transmitted orders for certain merchandise to Club Pro for delivery to several fictitious purchasers. Club Pro sent the merchandise to the fictitious purchasers at the fictitious addresses, where it was picked up by Gude. Gude then sold the merchandise, worth approximately $19,000, directly to Simpson, a golf pro at a golf club. Gude then retained the proceeds of sale for himself. Club Pro discovered the fraud and brought suit against Simpson to recover the merchandise. Did Simpson

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get good title to the merchandise he purchased from Gude even though Gude had obtained it by fraud? 5. In December, Arlene Bradley entered Alsafi Oriental Rugs and advised the owner that she was an interior decorator and that she was interested in selling some of his rugs to one of her customers. Alsafi did not know Bradley and had never done business with her. However, he allowed her to take three rugs out on consignment with the understanding that she would return them if her customer was not interested. In fact, however, Bradley was not obtaining the rugs for a “customer” but was, instead, working for another individual, Walid Salaam, a rug dealer.  A friend of Bradley’s had introduced her to Salaam earlier. Salaam had advised the two women that he was the owner of a recently closed oriental rug store that he was attempting to reopen. He offered to teach them how to become decorators and told them that when his store reopened, they could operate out of the store. ­Salaam advised them that until he got his store restocked, however, he wanted them to “check out” rugs on approval from other rug dealers in town. As they had no experience with oriental rugs, Salaam instructed them which rugs to look for. He then instructed them to go to rug dealers in Memphis and advise them that they were interior decorators with customers that wanted to purchase oriental rugs.  After Bradley obtained possession of the three rugs from Alsafi, she turned them over to Salaam, who in turn took them to a pawnshop operated by the American Loan Company. There, Salaam pawned the rugs, obtaining approximately $5,000 after filling out the required paperwork. Salaam failed to redeem the rugs. Following the default, the pawnshop gave the appropriate notice that it intended to dispose of them.  In April of the following year, Alsafi learned that his rugs were at the pawnshop. After visiting the pawnshop and identifying the three rugs as his, he brought suit to recover possession of them. Was Alsafi entitled to recover the rugs from the pawnshop? 6. Legendary Homes, a home builder, purchased various appliances from Ron Mead T.V. & Appliance, a retail merchant selling home appliances. They were intended to be installed in one of Legendary Homes’s houses and were to be delivered on February 1. At 5 o’clock on that

day, the appliances had not been delivered. Legendary Homes’s employees closed the home and left. Sometime between 5 and 6:30, Mead delivered the appliances. No one was at the home so the delivery-person put the appliances in the garage. During the night, someone stole the appliances. Legendary Homes denied it was responsible for the loss and refused to pay Mead for the appliances. Mead then brought suit for the purchase price. Did Legendary Homes have the risk of loss of the appliances? 7. In June, Ramos entered into a contract to buy a motorcycle from Big Wheel Sports Center. He paid the purchase price of $893 and was given the papers necessary to register the cycle and get insurance on it. Ramos registered the cycle but had not attached the license plates to it. He left on vacation and told the salesperson for Big Wheel Sports Center that he would pick up the cycle on his return. While Ramos was on vacation, there was an electric power blackout in New York City and the cycle was stolen by looters. Ramos then sued Big Wheel Sports Center to get back his $893. Did Big Wheel Sports Center have the risk of loss of the motorcycle? 8. Richard Burnett agreed to purchase a mobile home with a shed from Betty Jean Putrell, executrix of the estate of Lena Holland. On Saturday, March 3, ­Burnett paid Putrell $6,500 and was given the certificate of title to the mobile home as well as a key to it, but no keys to the shed. At the time the certificate of title was transferred, the following items remained in the mobile home: the washer and dryer, mattress and box springs, two chairs, items in the refrigerator, and the entire contents of the shed. These items were to be retained by Putrell and removed by her. To facilitate removal she retained one key to the mobile home and the only keys to the shed. On Sunday, March 4, the mobile home was destroyed by fire through the fault of neither party. At the time of the fire, Putrell still had a key to the mobile home as well as the keys to the shed and she had not removed the contents of the mobile home or of the shed. The contents of the shed were not destroyed and were subsequently removed by Putrell. Burnett brought suit against Putrell to recover the $6,500 he had paid for the mobile home and shed. Did the seller, Putrell, have the risk of loss of the mobile home?

CHAPTER 20

Product Liability

I

n February 2017, as a high school junior and a minor child, Matthew Divello first tried JUUL e-cigarettes, the pods of which contain high levels of nicotine intentionally designed to taste like candy. Despite measures taken by Matthew’s mother to get him to quit JUULing and his personal desire to quit, Matthew is intensely addicted to nicotine and cannot stop. He experiences intense withdrawal symptoms if he does not JUUL, including headaches. At the time Matthew began using the JUUL products, there were no warnings about the existence of nicotine or the risks of nicotine addiction anywhere on the JUUL products or packaging. He visited JUUL.com, which promoted JUUL use as safe and offered $30.00 gift cards for taking surveys. After prolonged use, he lost 10–12 pounds and was hospitalized on August 4, 2019, for 3 days with high fever, nausea, and vomiting blood. Moreover, his behavior was impacted by the addiction as he became withdrawn, anxious, highly irritable, and prone to angry outbursts. His GPA also dropped during his senior year of high school. Arguing that JUUL was responsible for his nicotine addiction, at-risk status for life-long health problems, and economic losses flowing from his need to sustain his addiction, in August 2019, as an 18-year-old, Matthew filed a lawsuit in New Jersey, his place of residence, against JUUL Labs, a Delaware corporation with its principal place of business in San Francisco. In his complaint, Matthew alleged that JUUL e-cigarettes are different from competing e-cigarettes because of a patented nicotine formulation derived from decades of research and created to foster addiction using a combination of nicotine salts and benzoic acid. Moreover, the lawsuit noted the explosive growth of JUUL among social media platforms aimed at teenagers, and the variety of flavors available, including mango, “cool” cucumber, fruit medley, cool mint, and crème brulee. Noted in the complaint were media reports finding that in one Connecticut high school, “you go to the bathroom . . . there’s a 50-50 chance that there’s five guys JUULing,” and a Kentucky high school student capturing the appeal to children with this comment: “In my opinion it looks like the coolest thing ever. Almost futuristic . . . It’s so small, so easy to hide in the palm of your hand. And they’re rechargeable! I’ve lost track of the number of people I have found charging their JUULs in class through their laptops.” Matthew’s lawsuit also dispelled the fiction that JUUL e-cigarettes were created as a safer alternative to cigarettes or a strategy to wean addicts off of cigarettes. On the contrary, given the increased levels of nicotine distributed into the bloodstream, JUUL use is likely to worsen nicotine addictions. Furthermore, a 2016 report of the U.S. Surgeon General found that the nicotine in JUULs and other e-cigarettes negatively influences brain development in adolescents, specifically impairing cognitive, attention, and memory processes and increasing the risk of anxiety disorders and depression. [Although not a part of Matthew’s original lawsuit filed in August 2019, the U.S. Food and Drug Administration released a report in April 2020 that suggested vaping also increased the risks to lung and heart function and could make one more susceptible to severe complications of COVID-19.] As you read this chapter, consider the following questions: • Will Matthew be successful in his products liability lawsuit if he can prove that his nicotine addiction and adverse health conditions were a result of a defective manufacturing process or the way in which JUUL products are designed?

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• Will Matthew be successful in this litigation if he can prove that JUUL was aware of its product’s potential risks but failed to adequately warn or inform him? • What is the difference between a product liability lawsuit brought on a negligence theory versus a lawsuit based on strict liability? • Is Matthew only eligible for compensatory damages, or is he also eligible for a punitive award? What is the difference? • How would you analyze JUUL’s business practices—as alleged by Matthew in his complaint—according to the various ethical theories discussed in Chapter 4?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 20-1 Explain what is necessary under the UCC for creation of an express warranty regarding goods. 20-2 Identify circumstances in which an implied warranty of merchantability becomes part of a contract for the sale of goods. 20-3 Explain what is meant by the merchantability concept. 20-4 Identify the elements necessary for creation of the implied warranty of fitness for a particular purpose and explain how that warranty differs from the implied warranty of merchantability. 20-5 Identify the major categories into which negligence-based product liability claims fall (negligent manufacture, negligent inspection, negligent failure to provide adequate warnings, and negligent design). 20-6 Explain the factors courts consider and the test they frequently use in determining whether a manufacturer is vulnerable to a negligent design claim. 20-7 Identify the elements of a strict liability claim under Restatement (Second) § 402A and explain how strict liability differs from liability for negligence.

SUPPOSE YOU HOLD AN executive position in a firm that makes products for sale to the public. One of your ­concerns would be the company’s exposure to civil liability for defects in those products. In particular, you might worry about legal developments that make such liability more likely or more expensive. In other situations, however, such developments might appeal to you—especially if you are harmed by defective products you purchase as a consumer. You might also appreciate certain liability-imposing legal theories if your

20-8 Describe the Restatement (Third)’s proposed framework of product liability rules. 20-9 Identify the types of compensatory damages available in product liability cases based on tort theories and in cases based on warranty theories. 20-10 Explain what is normally necessary in order for punitive damages to be awarded in a product liability case. 20-11 Explain the privity doctrine’s lack of role in tort cases and its partial role in warranty-based cases. 20-12 Explain what is necessary for effective disclaimers of the respective implied warranties. 20-13 Describe the role of comparative negligence and comparative fault principles in cases in which fault on the part of the defendant and on the part of the plaintiff led to the harm experienced by the plaintiff. 20-14 Identify the circumstances in which a court may conclude that a federal law preempts a state law– based product liability claim and thus furnishes the defendant a defense against liability.

firm wants to sue a supplier that has sold it defective products. Each of these situations involves the law of product liability, the body of legal rules governing civil lawsuits for losses and harms resulting from a defendant’s furnishing of defective goods. After sketching product liability law’s historical evolution, this chapter discusses the most important theories of product liability on which plaintiffs rely. The second part of the chapter considers certain legal problems that may be resolved differently under different theories of recovery.



Chapter Twenty Product Liability

The Evolution of Product Liability Law The 19th Century A century or so ago, the rules

governing suits for defective goods were very much to manufacturers’ and other sellers’ advantage. This was the era of caveat emptor (let the buyer beware). In contract cases involving defective goods, there usually was no liability unless the seller had made an express promise to the buyer and the goods did not conform to that promise. In negligence cases, the “no liability without fault” principle was widely accepted, and plaintiffs often had difficulty proving negligence because the necessary evidence was under the defendant’s control. In both contract and negligence cases, finally, the doctrine of “no liability outside privity of contract”—that is, no liability without a direct contractual relationship between plaintiff and defendant—often prevented plaintiffs from recovering against parties with whom they had not directly dealt. The laissez-faire approach that influenced public policy and the law helped lead to such prodefendant rules. A key factor limiting manufacturers’ liability for defective products was the perceived importance of promoting industrialization by preventing potentially crippling damage recoveries against infant industries. Even though the 19th century’s approach to product liability was pro­defendant, some commentators maintain that most plaintiffs were not especially disadvantaged by the applicable legal rules. Goods tended to be simple, so buyers often could inspect them for defects. Before the emergence of large corporations late in the 19th century, moreover, sellers and buyers often were of relatively equal size, sophistication, and bargaining power. Thus, they could deal on relatively equal footing.

The 20th and 21st Centuries Today, laissez-

faire values, while still influential, do not pack the weight they once did. With the development of a viable industrial economy, there is less perceived need to protect manufacturers from liability for defective goods. The emergence of long chains of distribution has meant that consumers often do not deal directly with the parties responsible for defects in the products they buy. Because large corporations tend to dominate the economy, consumers are less able to bargain freely with the corporate sellers with which they deal. Finally, the growing complexity of goods has made buyers’ inspections of the goods more difficult. In response to these changes, product liability law has moved from its earlier caveat emptor emphasis to a stance that sometimes resembles caveat venditor (let the seller beware). To protect consumers, modern courts and legislatures effectively

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intervene in private contracts for the sale of goods and, in certain instances, impose liability regardless of fault. As a result, sellers and manufacturers face potentially greater liability for defects in their products than they once did. Underlying the shift toward caveat venditor is the belief that sellers, manufacturers, and their insurers are better able to bear the economic costs associated with product defects, and that they usually can pass on these costs through higher prices. Thus, the economic risk associated with defective products can be spread throughout society, or “socialized.”

The Current Debate over Product Liability Law Modern product liability law and its

socialization-of-risk rationale have come under increasing attack over the past three decades. Such attacks often focus on the increased costs sellers and manufacturers sometimes encounter in obtaining product liability insurance. Some observers blame insurance industry practices for these developments, whereas others trace them to the increased liability prospect noted earlier. Whatever their origin, these problems have, at times, put sellers and manufacturers in a difficult spot. Businesses unwilling or unable to buy expensive product liability insurance run the risk of being crippled by large damage awards unless they self-insure, which can be an expensive option. Firms that purchase insurance, on the other hand, often must pay higher prices for it. In either case, the resulting costs may be difficult to pass on to consumers. Those costs may also deter the development and marketing of innovative new products. For reasons including those identified earlier, calls have been made in some quarters for a reining-in of the pro-­ plaintiff aspects of product liability law. This is one aspect of the tort reform movement discussed in Chapter 7. Opponents of reform point out, however, that plaintiffs tend to win product liability cases no more often—or even less frequently—than defendants do and that average amounts of damage awards when plaintiffs do win have not been on the rise in recent years. Proponents of reform have periodically urged Congress to federalize certain aspects of product liability law (which historically has been state law) by enacting such measures as caps on damages, but such federal measures neither had been enacted nor had appeared on the horizon as this book went to press in 2020. However, as we note later in this chapter, tort reform measures have been enacted in some states.

Theories of Product Liability Recovery Some theories of product liability recovery are contractual and some are tort-based. The contract theories involve a

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product warranty—an express or implied promise about the nature of the product sold. In warranty cases, plaintiffs claim that the product failed to live up to the seller’s promise. In tort cases, on the other hand, plaintiffs contend that the defendant was negligent or that strict liability should apply. LO20-1

Explain what is necessary under the UCC for creation of an express warranty regarding goods.

Express Warranty Creation of an Express Warranty UCC § 2-313(1) states that an express warranty may be created in any of three ways. 1. If an affirmation of fact or promise regarding the goods becomes part of the basis of the bargain (a requirement to be discussed shortly), there is an express warranty that the goods will conform to the affirmation or promise. For instance, if a computer manufacturer’s website says that a computer has a certain amount of memory, this statement may create an express warranty to that effect. 2. Any description of the goods that becomes part of the basis of the bargain creates an express warranty that the goods will conform to the description. Descriptions include (a) statements that goods are of a certain brand, type, or model (e.g., a Hewlett-Packard laser printer); (b) adjectives that characterize the product (e.g., shatterproof glass); and (c) drawings, blueprints, and technical specifications. A description that gives rise to an express warranty under which the goods must be as described does not, without more, amount to an express warranty regarding quality or duration of the goods’ future performance. 3. Assuming it becomes part of the basis of the bargain, a sample or model of goods to be sold creates an express warranty that the goods will conform to the sample or model. A sample is an object drawn from an actual collection of goods to be sold, whereas a model is a replica offered for the buyer’s inspection when the goods themselves are unavailable. Moreover, any seller—professional or not—may make an express warranty. When an express warranty has been breached (because the goods were not as warranted), the plaintiff who demonstrates resulting losses is entitled to compensatory damages. Damages issues receive further attention later in this chapter. The first two types of express warranties may often overlap; also, each may be either written or oral. “Magic” words such as warrant or guarantee are not necessary for creation of an express warranty. Value, Opinion, and Sales Talk Statements of value (“This chair would bring you $2,000 at an auction”) or

opinion (“I think this chair might be an antique”) do not create an express warranty. The same is true of statements that amount to sales talk or puffery (“This chair is a good buy”). No sharp line separates such statements from express warranties. In close cases, a statement is more likely to be an express warranty if it is specific rather than indefinite, if it is stated in the sales contract rather than elsewhere,1 or if it is unequivocal rather than hedged or qualified. The relative knowledge possessed by the seller and the buyer also matters. For instance, a car salesperson’s statement about a used car may be more likely to be an express warranty where the buyer knows little about cars than where the buyer is another car dealer. The Basis-of-the-Bargain Requirement Under preUCC law, there was no recovery for breach of an express warranty unless the buyer significantly relied on that warranty in making the purchase. The UCC, however, requires—though ambiguously—that the affirmation, promise, description, or sample or model has become part of the basis of the bargain in order for an express warranty to be created. Although some courts read the UCC’s basisof-the-bargain test as saying that significant reliance still is necessary, most courts require only that the seller’s warranty has been a contributing factor in the buyer’s decision to purchase. Advertisements Statements made in advertisements, catalogs, or brochures may be express warranties. However, such sources often are filled with sales talk. Basis-ofthe-bargain problems may arise if it is unclear whether or to what degree the statement induced the buyer to make the purchase. For example, suppose that the buyer read an advertisement containing a supposed express warranty one month before actually purchasing the product. In such an instance, there may be a dispute over whether the advertisement’s content contributed to the buyer’s decision to buy. Multiple Express Warranties What happens when a seller gives two or more express warranties and those warranties arguably conflict? UCC § 2-317 says that such warranties should be read as consistent with each other and as cumulative if this is reasonable. If not, the parties’ intention controls. In determining that intention, (1) exact or technical specifications defeat a sample, a model, or general descriptive language and (2) a sample defeats general descriptive language. Parol evidence rule problems may arise in express warranty cases. For example, a seller who used a written contract may argue that the rule excludes an alleged oral warranty. On the parol evidence rule, see Chapter 16. 1



Chapter Twenty Product Liability

Implied Warranty of Merchantability Identify circumstances in which an implied warranty of

LO20-2 merchantability becomes part of a contract for the sale

of goods.

LO20-3 Explain what is meant by the merchantability concept.

An implied warranty is a warranty created by operation of law rather than the seller’s express statements. UCC § 2-314(1) creates the UCC’s implied warranty of merchantability with this language: “[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.” This is a clear example of the modern tendency of legislatures to intervene in private contracts to protect consumers. In an implied warranty of merchantability case, the plaintiff argues that the seller breached the warranty by selling unmerchantable goods and that the plaintiff should therefore recover compensatory damages. Under § 2-314, such claims can succeed only where the seller is a merchant with respect to goods of the kind sold.2 An accounting professor’s sale of homemade preserves and a grocery store owner’s sale of a used car, for example, would not trigger the implied warranty of merchantability. UCC § 2-314(2) states that, to be merchantable, goods must at least (1) pass without objection in the trade; (2) be fit for the ordinary purposes for which such goods are used; (3) be of even kind, quality, and quantity within each unit (case, package, or carton); (4) be adequately contained, packaged, and labeled; (5) conform to any promises or statements of fact made on the container or label; and (6) in the case of fungible goods, be of fair average quality. The most important of these requirements is that the goods must be fit for the ordinary purposes for which such goods are used. (In the Moss case, which appears later in the chapter, the implied warranty of merchantability was made but was not breached because the relevant goods were suitable for ordinary purposes.) The goods need not be perfect to be fit for their ordinary purposes. Rather, they need only meet the reasonable expectations of the average consumer. This broad, flexible test of merchantability is almost inevitable given the wide range of products sold in the United States today and the varied defects they may pre- The term merchant is defined in Chapter 9.

2

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sent. Still, a few generalizations about merchantability determinations are possible. Goods that fail to function properly or that have harmful side effects normally are not merchantable. A computer that fails to work properly or that destroys the owner’s programs, for example, is not fit for the ordinary purposes for which computers are used. In cases involving allergic reactions to drugs or other products, courts may find the defendant liable if it was reasonably foreseeable that an appreciable number of consumers would suffer the reaction. When food products have been alleged to be unmerchantable because they contained harmful objects or substances, courts have developed two tests for determining whether the implied warranty of merchantability was violated. The traditional test, still employed by some courts, asks whether the object or substance in the food product is “foreign” or, instead, “natural” to the product. Under this test, the food product is unmerchantable if the harm-causing object or substance is “foreign” to the food product but not if it is “natural” to it. The trend among courts, however, has been to replace the foreign–natural test with the reasonable expectations test. Under the latter test, a food product containing a harmful object or substance is deemed unmerchantable if consumers would not reasonably have expected to encounter such an object or substance in the food product. Although the cases are highly fact-specific, the reasonable expectations test holds the potential for being more pro-plaintiff in nature than the foreign–natural test. Sometimes, however, either test might lead to the same outcome in a given case. Bissinger v. New Country Buffet, which follows, serves as an example.

Implied Warranty of Fitness Identify the elements necessary for creation of the implied warranty of fitness for a particular purpose LO20-4 and explain how that warranty differs from the implied warranty of merchantability.

UCC § 2-315’s implied warranty of fitness for a particular purpose arises where (1) the seller has reason to know a particular purpose for which the buyer requires the goods, (2) the seller has reason to know that the buyer is relying on the seller’s skill or judgment for the selection of suitable goods, and (3) the buyer actually relies on the seller’s skill or judgment in purchasing the goods. If these tests are met, there is an implied warranty that the goods will be fit for the buyer’s particular purpose. Any seller—­merchant or nonmerchant—may make this implied warranty, the

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Bissinger v. New Country Buffet   2014 Tenn. App. LEXIS 331 (June 6, 2014) At a New Country Buffet Restaurant in Nashville, Tennessee, customer Randall Bissinger ordered an “All You Can Eat” buffet meal. He selected three raw oysters from the buffet table. Soon after consuming the oysters, Bissinger began to experience severe symptoms and illness. His brother took him to a hospital, where he was diagnosed with Vibrio vulnificus septicemia, a serious blood infection. Vibrio vulnificus is a naturally occurring bacterium found in shellfish that absorb it from their environment. Approximately three months later, Bissinger filed a lawsuit in a Tennessee court against New Country Buffet and its owner (hereinafter “New Country Buffet” or “the restaurant”). Bissinger alleged that the oysters he consumed were contaminated and that they caused his injuries. Several weeks after Bissinger filed the case, he died. His nephew, the executor of his estate, was substituted as the plaintiff. In an amended complaint, the nephew named as defendants not only New Country Buffet, but also three companies that supplied oysters (hereinafter “the Suppliers”) to the restaurant. He pleaded causes of action for negligence and breach of the implied warranty of merchantability. The plaintiff asserted that his uncle’s illness and death resulted from his ingestion of Vibrio vulnificus. He also alleged that his uncle suffered from hepatitis C and cirrhosis of the liver, was unaware of the dangers of severe injury or death associated with consuming raw oysters, and was unaware that people with liver disease or weakened immune systems were at increased risk of those dangers. In addition, the plaintiff alleged that not long before Bissinger’s visit to New Country Buffet, the restaurant had been cited by the Nashville Public Health Department for health and safety violations, including storing seafood (though not necessarily raw oysters) and other food at improper temperatures. There was no dispute that the oysters Bissinger ate contained Vibrio vulnificus, although there was no proof regarding the level of the bacteria in the oysters. New Country Buffet and the Suppliers moved for summary judgment. A Tennessee trial court granted the Suppliers’ motion and dismissed the negligence and breach of implied warranty of merchantability claims against them. The court denied New Country Buffet’s motion, however. The plaintiff and the restaurant appealed to the Tennessee Court of Appeals, which affirmed the trial court’s grant of summary judgment to the Suppliers on the plaintiff’s negligence claim. The following edited version of the Court of Appeals opinion focuses on that court’s treatment of the breach of implied warranty of merchantability claims against the restaurant and the Suppliers. Cottrell, Judge The standards for decision on a motion for summary judgment are well-known. The trial court may only grant such a motion if the filings supporting the motion show that there is no genuine issue of material fact and that the moving party is entitled to judgment as a matter of law. The undisputed expert testimony was that Vibrio vulnificus is a naturally occurring, salt-loving bacteria [sic] found mainly in warmer marine environments all over the world. Some level of Vibrio is present in almost all oysters. The bacteria has no taste and no odor, and it cannot be detected by any method that does not also require killing the oyster. There was also undisputed testimony that Vibrio vulnificus can be lethal when large enough quantities are ingested. There was no evidence regarding the concentration of the bacteria in the oysters consumed by Bissinger or those on the buffet. [However, the] absolute numbers [of deaths] are relatively small. [T]he vast majority of those who become infected with Vibrio also suffer from predisposing conditions such as liver disease and diabetes. In fact, the presence of Vibrio vulnificus in oysters is not seriously harmful to the general public. While otherwise healthy individuals may suffer temporary gastrointestinal illness, they do not contract the serious blood infection involved in this case. The only danger of serious illness from the bacteria is to those

individuals with immune disorders, liver conditions, or stomach disorders. A certified food safety professional testified that Vibrio vulnificus proliferates in warm water, which is the reason for the widespread recognition that it can be dangerous to eat raw oysters in the summer. Because Vibrio can continue to multiply in raw oysters after they are harvested, federal and state regulations govern the manner in which such oysters are handled, in order to prevent such proliferation by always keeping them at a temperature below 45 degrees Fahrenheit and preferably between 37 degrees and 40 degrees. [Authors’ note: In a portion of the opinion not excerpted here, the Court of Appeals held that the trial court had properly rejected the plaintiffs’ negligence claim against the Suppliers. The court then turned to the implied warranty of merchantability claim against the Suppliers.] The plaintiff alleged that Suppliers breached an implied warranty that the oysters were merchantable. Tennessee Code Annotated § 47-2-314, part of the Sales Chapter of the Uniform Commercial Code, states that a contract of sale between a merchant and a customer implies a warranty that the goods sold are “merchantable.” To be merchantable, goods must, among other things, be “fit for the ordinary purposes for which such goods are used.” § 47-2-314(2)(c). That statute specifically includes the sale



Chapter Twenty Product Liability

of food and drink for consumption either on the premises or elsewhere as subject to the implied warranty. To be “fit for ordinary purposes” and thus merchantable, food must be safe to eat. [W]arranty claims sound in contract rather than in tort. [T]o prevail on a warranty theory, it is not necessary to show negligence, but only breach of the implied warranty that the product is wholesome and fit for human consumption. There are no Tennessee cases that specify the standards a court should apply to determine whether food is merchantable under § 47-2-314. However, one undisputed principle is that regardless of the type of product involved, to recover for breach of an implied warranty, the plaintiff must establish that the alleged defect or unfitness was present when the product left the defendant’s control. Suppliers argue that, as a matter of law, the presence of Vibrio vulnificus could not be deemed a breach of the warranty that their oysters were wholesome and fit for human consumption, because the microorganism is natural to shellfish and is found in almost all oysters. The plaintiff offered no proof of the concentration of Vibrio in the oysters consumed by his uncle or the concentration when the oysters left the control of Suppliers. Thus, the plaintiff would have us hold that any amount of the bacteria would make an oyster unmerchantable. As Suppliers have explained, although Tennessee has not established a standard for analyzing the merchantability of food, other states have adopted the “foreign natural test” or the “reasonable expectation test.” Under the foreign natural test, food is unfit for the purpose for which it is sold if an object found in the food does not naturally occur in that food. Under the reasonable expectation test, “liability will lie for injuries caused by a substance where the consumer of the product would not reasonably have expected to find the substance in the product.” [Citation omitted.] Factors relevant to the reasonable expectation analysis, i.e., what a consumer might reasonably expect, include the “naturalness” of the substance causing the injury and the amount of processing the food may have gone through since its harvesting and its sale. As one court explained, “A consumer, by seeking to eat clams raw, wishes the clams to be such. Thus a consumer should expect substances that are indigenous to the organism in its natural state to be present when he or she receives it.” [Citation omitted.] Because Vibrio vulnificus is naturally occurring, appears in most shellfish and almost all oysters to some degree, and can reasonably be expected to be found in live raw oysters, the oysters supplied herein were merchantable under both tests. We find the tests used in other states to be a reasonable way to analyze the issue of merchantability of food products. Since the consumption of raw summer oysters can be dangerous to consumers who suffer from certain medical conditions, it follows that the sale of such oysters without adequate warning of the dangers of ingesting them could indeed render them

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unmerchantable and make their sale a breach of the implied warranty. Suppliers acknowledge that they have a duty to warn such individuals of the danger of consuming raw oysters. Suppliers contend, however, that, even if there were a question of merchantability as to certain individuals, they have rendered their product merchantable by furnishing specific warnings directed toward people whose medical condition places them at risk. They also insist that they had no reason to believe that such individuals would be so foolish as to ignore those warnings. The proof in this case showed that in accordance with federal regulations, [Suppliers] fastened harvesting tags to each bag of oysters they sold. The information on the tags included the harvest date, the state where the oysters were harvested, and the instruction that the product should not be consumed raw after 14 days from the date of harvest, but should be thoroughly cooked. The tags contained the following warning: Consumer Information: There is a risk associated with consuming raw oysters or any raw animal protein. If you have chronic illness of the liver, stomach, or blood or have immune disorders, you are at greater risk of serious illness from raw oysters. You may, however, eat your oysters fully cooked. If unsure of your risk you should consult your physician. Please share this information with your customers. These warnings were adequate to put a susceptible individual on notice and to put a restaurant on notice that it should pass the warning on to customers. The plaintiff argued that the notice was not sufficient because it did not mention death as a potential risk. It is not entirely clear if the plaintiff’s failure-to-warn claim was brought as a separate, negligence-based claim or whether it was part of its lack of merchantability argument. Despite the plaintiff’s insistence, we hold that the warnings provided by Suppliers were sufficient to meet the reasonable care standard and to satisfy the implied warranty of merchantability. Additionally, because Suppliers had no ability to directly warn customers of restaurants that bought oysters from them, they cannot be held to have breached a duty to warn the eventual consumer of its products. Accordingly, we [affirm the grant of] summary judgment to Suppliers on the claim of breach of implied warranty of merchantability. [Authors’ note: The Court then addressed the plaintiff’s claims against the restaurant. Because it identified factual disputes in regard to New Country Buffet’s handling and storage of foods and in regard to whether the restaurant passed along the Suppliers’ warnings to its customers, the court concluded that the restaurant was not entitled to summary judgment on the plaintiff’s negligence claim against it. Next, the court addressed the breach of implied warranty of merchantability claim against the restaurant.] The plaintiff also claimed that New Country Buffet violated the implied warranty of merchantability “by serving oysters that

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were contaminated with Vibrio vulnificus and were therefore unmerchantable and unfit for human consumption” [quoting the plaintiff’s brief]. New Country Buffet asserts on appeal “that it should have been granted summary judgment on this claim as the raw oysters in question were merchantable, wholesome and fit for human consumption” [quoting the restaurant’s brief]. Based upon the same authorities and standards that we discussed with regard to Suppliers, the restaurant argues that because Vibrio vulnificus is natural to shellfish, their oysters should be deemed to have passed the two tests that are normally applied to determine whether food is suitable for sale and consumption. Under the foreign-natural test, food is considered unfit for ordinary purposes if an object is found in the food that does not occur naturally. There are no allegations in the record that such an object made the oysters unfit. Under the reasonable expectations test, food is considered unfit for ordinary purposes if it contains substances which cause injury and which the consumer would not reasonably expect to find in the product, even if those substances are natural. Such substances might include a chicken bone found in a chicken enchilada or a walnut shell in walnut ice cream. New Country Buffet argues that because Vibrio vulnificus occurs naturally, the restaurant cannot be found liable under the foreign-natural test, and that since the proof shows that Vibrio is found in virtually all oysters, a consumer cannot reasonably expect to receive an oyster free from the bacteria. For these or

similar reasons, we hold that Suppliers could not be held liable under [the] implied warranty of merchantability. The same basic legal principles apply to New Country Buffet.  However, if New Country was, in fact, negligent in its handling of the oysters, its conduct may have allowed the bacteria to proliferate. Thus, actions of the restaurant may have rendered the oysters unfit for consumption. [Tennessee law] defines adulterated food as including shellfish capable of supporting rapid and progressive growth of infectious or toxigenic micro-organisms, unless the shellfish is stored or offered for sale at a temperature greater than forty-five degrees Fahrenheit (45°F). Because of testimony on the temperature findings of inspectors [from the Health Department], it may be possible for the plaintiff to establish that the oysters consumed by his uncle were adulterated and, thus, unfit for consumption. At present, there is no proof of the concentration of Vibrio when the oysters were delivered to the restaurant or the concentration when the oysters were served. However, while it may be difficult for the plaintiff to establish an increase, that question is not before us at this time. The trial court did not err in declining to grant New Country Buffet summary judgment [on the] breach of implied warranty of merchantability [claim].

breach of which will give rise to liability for compensatory damages. In many fitness warranty cases, buyers effectively put themselves in the seller’s hands by making their needs known and by saying that they are relying on the seller to select goods that will satisfy those needs. This may happen, for example, when a seller sells a computer system specially manufactured or customized for a buyer’s particular needs. Sellers also may be liable when the circumstances reasonably indicate that the buyer has a particular purpose and is relying on the seller to satisfy that purpose, even though the buyer fails to make either explicit. However, buyers may have trouble recovering if they are more expert than the seller, submit specifications for the goods they wish to buy, inspect the goods, actually select them, or insist on a particular brand.

As indicated in Moss v. Batesville Casket Co., which follows, the implied warranty of fitness differs from the implied warranty of merchantability. The tests for the creation of each warranty plainly are different. Under § 2-315, moreover, sellers warrant only that the goods are fit for the buyer’s particular purposes, not the ordinary purposes for which such goods are used. If a 400-pound man asks a department store for a hammock that will support his weight but is sold a hammock that can support only average-sized people, there is a breach of the implied warranty of fitness but no breach of the implied warranty of merchantability. Depending on the facts of the case, therefore, one of the implied warranties may be breached but the other is satisfied, both implied warranties may be breached, or, as in Moss, neither ends up being breached.

Trial court’s grant of summary judgment in favor of Suppliers affirmed; trial court’s denial of summary judgment to restaurant affirmed.



Chapter Twenty Product Liability

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Moss v. Batesville Casket Co.   935 So. 2d 393 (Miss. 2006) Nancy Moss Minton, a Mississippi resident, died on March 7, 1999. Her four adult children became the plaintiffs in the lawsuit described below and will be referred to as “the plaintiffs” during this summary of the facts. The plaintiffs engaged Ott & Lee Funeral Home, a Mississippi firm, to handle the arrangements for their mother’s burial. From the models on Ott & Lee’s showroom floor, the plaintiffs selected a cherry wood casket manufactured by Batesville Casket Co. According to the deposition testimony later provided by each of the plaintiffs, aesthetic reasons played a key role in the choice of the cherry wood casket. The casket “looked like” their mother and “suited her” because all the furniture in her home was cherry wood. The plaintiffs contended that Ott & Lee told them the casket was “top of the line.” At the time the wooden casket was selected, Ott & Lee informed the plaintiffs that unlike a metal casket, a wooden casket could not be sealed. The plaintiffs testified in their depositions that Ott & Lee so informed them and that at Ott & Lee’s suggestion, they chose to use a concrete vault with the wooden casket. According to the plaintiffs, Ott & Lee said the vault would keep the pressure of the dirt off the casket and would prevent water from reaching the casket. Ott & Lee made no representations to the plaintiffs about the ability of a wooden casket to preserve the remains contained inside it. The plaintiffs made no inquiry about whether the casket could or would preserve the remains. The wooden casket chosen by the plaintiffs carried Batesville’s written limited warranty, which specified that Batesville would replace the casket if, “at any time prior to the interment of this casket,” defects in materials or workmanship were discovered. Thus, Batesville expressly warranted the casket until the time of Ms. Minton’s burial, which took place on March 9, 1999. Later, believing that a medical malpractice claim may have existed against Ms. Minton’s medical care providers, the plaintiffs had their mother’s body exhumed for an autopsy on August 10, 2001. When the casket was exhumed, the plaintiffs observed visible cracks and separation in the casket. As the casket was removed, it began to break apart. The body remained in the casket, and none of the plaintiffs saw the body. After the exhumation, the plaintiffs filed suit against Ott & Lee and Batesville in a Mississippi court. The plaintiffs claimed that given the casket’s cracked, separated, and partially dismantled condition, as revealed during the exhumation, the defendants had breached the implied warranties of merchantability and fitness for particular purpose. Ott & Lee and Batesville each moved for summary judgment. The plaintiffs presented affidavits from expert witnesses whose specialties were wood rot and adhesives, as opposed to caskets per se. These experts opined that the casket appeared as it did during the exhumation because of a probable failure of the adhesives used when it was manufactured. There was no evidence that Ms. Minton’s body had not been properly preserved or that there was any damage to the body because of the cracks and separation in the casket. After the Mississippi circuit court granted the defendants’ motions for summary judgment, the plaintiffs appealed to the Supreme Court of Mississippi.

Easley, Justice Miss. Code Ann. § 75-2-315 establishes the foundation for the concept of an implied warranty for fitness for a particular purpose. The statute provides in pertinent part [that] “where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller’s skill or judgment to select or furnish suitable goods, there is an implied warranty that the goods shall be fit for such purpose.” The warranty of fitness for a particular purpose does not arise unless there is reliance on the seller by the buyer, and the seller selects goods which are unfit for the particular purpose. During discovery, depositions were taken from the plaintiffs. These depositions, which were provided to the trial court [in connection with] the motion for summary judgment, demonstrate that the plaintiffs purchased the wooden casket for its aesthetic value. [One plaintiff] testified: We spotted the cherry wood casket. [An Ott & Lee employee] walked us over there to it and we all decided, standing there— us four—that it looked like our mother. That’s—I mean—she

had everything in her house was cherry wood. I mean, it just looked like her. We asked . . . about the casket. I mean, I’m not stupid. I know a casket won’t seal—a wood casket. [Another plaintiff] testified: “We were looking at the different caskets, and when we saw the wood casket, we knew that we wanted this one for Mother because it looked just like her—a wood cherry casket. And we were just all [in] agreement with it.” [A third plaintiff] testified that the reason he chose this casket was because his mother “just liked cherry wood furniture.” He further stated [that] “[i]t just suited her.” In [its] conclusions of law, the trial court stated: “The court is convinced from the deposition testimony that the plaintiffs were well aware of the characteristic differences between a wooden casket as compared to a metal one, but that the former was selected because of their mother’s love of cherry wood.” The trial court found that “the fitness-purpose aspect was served during the time the decedent’s body was placed in the casket and viewed by family members, loved ones, and friends at the funeral home.”

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Part Four Sales

Here, the evidence did not justify the submission of this case to a jury on the [implied] warranty of fitness for a particular purpose [claim]. Nothing in the record provides that the plaintiffs identified any particular purpose to the defendants when the casket was selected. Furthermore, assuming arguendo that the plaintiffs sought to preserve their mother’s remains for some unspecified, indefinite period of time in the wooden casket, the record is completely devoid of any proof that the body had been damaged in any way by the alleged problems with the casket. As such, the burial had preserved the remains until the plaintiffs had their mother’s remains unearthed and the autopsy performed. [T]he trial court did not err in granting summary judgment [in favor of the defendants on this implied warranty claim]. Miss. Code Ann. § 75-2-314 establishes the statutory foundation for the concept of an implied warranty of merchantability. [The statute] provides in pertinent part: “[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.” [The statute also states that in order for goods to be merchantable, they must be] “fit for the ordinary purposes for which such goods are used.” The plaintiffs argue that, as reasonable consumers, they expected the casket to preserve the remains for an indefinite period of time. The defendants contend that even if the plaintiffs’ theory that the ordinary purpose of the casket was to preserve the remains for an indefinite or some unknown period of time is accepted as true, there is no evidence in the record which indicates the remains were not in fact properly preserved for an indefinite or unknown period of time. When the remains were exhumed by the plaintiffs approximately two and one-half years after burial, the record reflects the remains were preserved. The plaintiffs present no claim that the remains had been damaged in any way by the cracks and separations. As such, the defendants assert the plaintiffs’ alleged ordinary purpose of the casket was satisfied.

In Craigmiles v. Giles, 110 F. Supp. 2d 658, 662 (E.D. Tenn. 2000), the district court stated:

Negligence

manufacturer breached a duty to the plaintiff by failing to eliminate a reasonably foreseeable risk of harm associated with the product. Such cases typically involve one or more of the following claims: (1) negligent manufacture of the goods (including improper materials and packaging), (2) negligent inspection, (3) negligent failure to provide adequate warnings, and (4) negligent design.

Identify the major categories into which negligencebased product liability claims fall (negligent manufacture, LO20-5 negligent inspection, negligent failure to provide adequate warnings, and negligent design).

Product liability lawsuits brought on the negligence theory discussed in Chapter 7 usually allege that the seller or

A casket is nothing more than a container for human remains. Caskets are normally constructed of metal or wood, but can be made of other materials. Some have “protective seals,” but those seals do not prevent air and bacteria from exiting. All caskets leak sooner or later, and all caskets, like their contents, eventually decompose. Likewise, Batesville contends that the ordinary purpose of a wooden casket is to house the remains of the departed until interment. Batesville argues that the ordinary purpose includes uses which the manufacturer intended and those which are reasonably foreseeable. Accordingly, Batesville asserts that it would not be reasonably foreseeable that any customer would expect a wooden casket to preserve the remains for an indefinite period of time, as claimed by the plaintiffs. [T]he record does not indicate that the plaintiffs ever stated a specified period of time that they, as reasonable customers, would have reasonably expected the wooden casket to last. The plaintiffs contend that they reasonably expected the casket to protect the remains for an indefinite period of time. Indefinite is defined as “without fixed boundaries or distinguishing characteristics; not definite, determinate, or precise.” Black’s Law Dictionary 393 (5th ed. 1983). [Under the circumstances, the] trial court [appropriately] found that the ordinary purpose for which the casket was designed ceased once the pallbearers bore the casket from the hearse to the grave site for burial. [In any event,] [a]s previously stated, the record also fails to demonstrate that the remains were damaged in any way from the alleged cracks and separation when the casket and body were exhumed. Accordingly, [we reject] the plaintiffs’ assignment of error [concerning the lower court’s grant of summary judgment in favor of the defendants on the breach of implied warranty of merchantability claim].

Summary judgment in favor of defendants affirmed.

Negligent Manufacture Negligence claims alleging the manufacturer’s improper assembly, materials, or packaging



Chapter Twenty Product Liability

often encounter obstacles because the evidence needed to prove a breach of duty is under the defendant’s control. However, modern discovery rules and the doctrine of res ipsa loquitur may help plaintiffs establish a breach in such situations.3 Negligent Inspection Manufacturers have a duty to inspect their products for defects that create a reasonably foreseeable risk of harm, if such an inspection would be practicable and effective. As noted above, res ipsa loquitur and modern discovery rules may help plaintiffs prove their case against the manufacturer. Most courts have held that intermediaries such as retailers and wholesalers have a duty to inspect the goods they sell only when they have actual knowledge or reason to know of a defect. In addition, such parties generally have no duty to inspect if inspection would be unduly difficult, burdensome, or time-consuming. Unless the product defect is obvious, for example, middlemen usually are not liable for failing to inspect goods sold in the manufacturer’s original packages or containers. On the other hand, sellers that prepare, install, or repair the goods they sell ordinarily have a duty to inspect those goods. Examples include restaurants, automobile dealers, and installers of household products. In general, the scope of the inspection need only be consistent with the preparation, installation, or repair work performed. It is unlikely, therefore, that such sellers must unearth hidden or latent defects. If there is a duty to inspect and the inspection reveals a defect, further duties may arise. For example, a manufacturer or other seller may be required not to sell the product in its defective state, or at least to give a suitable warning. The Wilke case, which appears in this chapter’s later section on implied warranty disclaimers, also deals with a seller’s presale duty to inspect goods (in that case, a used car) and potential negligence liability for a breach of that duty. Negligent Failure to Warn Sellers and manufacturers often have a duty to give an appropriate warning when their products pose a reasonably foreseeable risk of harm. In determining whether there was a duty to warn and whether the defendant’s warning was adequate, however, courts often consider other factors besides the reasonable foreseeability of the risk. These include the magnitude or severity of the likely harm, the ease or difficulty of providing an appropriate warning, and the likely effectiveness of a

Chapter 2 discusses discovery. Chapter 7 discusses res ipsa loquitur.

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warning. Many courts, moreover, hold there is no duty to warn if the risk is open and obvious. Negligent Design Explain the factors courts consider and the test they

LO20-6 frequently use in determining whether a manufacturer

is vulnerable to a negligent design claim.

Manufacturers have a duty to design their products so as to avoid reasonably foreseeable risks of harm. As in failure-towarn cases, however, design defect cases frequently involve other factors such as the magnitude or severity of the foreseeable harm. Three other factors are industry practices at the time the product was manufactured, the state of the art (the state of existing scientific and technical knowledge) at that time, and the product’s compliance or noncompliance with government safety regulations. When determining whether a manufacturer was negligent in adopting a particular design, courts frequently supplement the above factors with an analysis known as the risk-utility test. In that analysis, three other factors— the design’s social utility, the availability and effectiveness of alternative designs, and the cost of safer designs—assume considerable importance. Special considerations may attend the negligent design determination regarding certain products. Consider, for instance, a motor vehicle. Because vehicle accidents occur on a very frequent basis and are thus to be expected, is the manufacturer obligated to use due care to design a “crashworthy” vehicle? Courts have fairly often, but not always, furnished a “yes” answer. Given the foreseeability of traffic accidents—even ones resulting from driver error—some courts have concluded that vehicle manufacturers must adopt designs that furnish reasonable protection to vehicle occupants in the event of typical crashes. Of course, this crashworthiness doctrine does not make vehicle manufacturers liable every time a vehicle occupant is injured in a traffic accident. Instead, as a specialized application of the due care standard, the crashworthiness doctrine recognizes that foreseeable harm-causing scenarios require relevant and reasonable steps on the part of the manufacturer. The Green case, which appears in the chapter’s later section on comparative fault issues, contains a useful discussion of the crashworthiness doctrine. As indicated earlier, however, not all courts recognize the crashworthiness doctrine. Holiday Motor Corp. v. Walters, which follows, serves as an example. The decision also explores various issues that arise in cases brought on a negligent design theory.

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Part Four Sales

Holiday Motor Corp. v. Walters   790 S.E.2d 447 (Va. 2016) In June 2006, Shannon Walters was driving her 1995 Mazda Miata convertible along a two-lane highway in Virginia. The Miata was equipped with a soft top that could be folded and stowed for open-air driving. The soft top also could be unfolded and closed by engaging latches located on each side of the vehicle in order to connect the top to the windshield header (the curved steel bar running across the top of the windshield). Walters was operating the Miata in the closed-top configuration with the latches engaged. As she later testified at the trial of the case described below, she saw a large object—one that “basically covered [her] whole lane of travel”—coming toward her from the back of a pickup truck she was following. (The object that fell from the truck was later determined to be a swimming pool. The driver of the truck did not return to the scene and was not apprehended.) Seeing no traffic in the oncoming lane, Walters veered left across the road, off the highway, and up a slight grassy incline. The vehicle overturned and landed on its top, with the driver’s side pushed up against a tree. Michael Evans, who was also driving on the same highway, came upon the same object in the road, hit his brakes, steered left, and pulled his vehicle onto the grass. As he later testified, he saw Walters’s vehicle and noted that it was “inverted, on its top, up against the tree,” which “was against the driver’s side.” Because the vehicle was “resting on a slope,” the driver’s side “was closer to the ground than the passenger side.” Evans testified that the “back of the convertible bows,” or the beams across the top, “appeared to be holding the vehicle up, but the front of the hood and windshield . . . were flat on the ground.” Because Evans could not enter the vehicle through the driver’s side, he broke the glass out of the passenger’s side window, reached through the window, and opened the passenger’s side door. He then crawled into the vehicle and turned off the ignition. At that time, he noticed that the windshield header was separated from the soft top in such a way that the top “was actually underneath of the windshield.” Evans cut Walters’s seat belt and lowered her to a reclining position. He observed that Walters had a head injury and was bleeding. Because Walters told Evans she could not feel her legs, he was reluctant to move her. Evans remained with Walters until emergency medical personnel arrived on the scene. Walters, who sustained a serious cervical spine injury in the accident, later sued three defendants: Mazda Motor Corp., which designed and manufactured her Miata; Mazda Motor of America Inc., which distributed the vehicle; and Holiday Motor Corp., which sold her the vehicle. (Hereinafter, the three defendants will be referred to collectively as “Mazda.”) She contended that her injuries in the rollover accident stemmed from the fact that the windshield header disconnected from the Miata’s top and collapsed into the occupant compartment. In particular, she claimed that Mazda was negligent in failing to design the latches connecting the windshield header to the top in a way that would keep the latches engaged during a foreseeable rollover crash. An automotive engineer testified as an expert witness for Walters at the trial. He offered an opinion that supported the negligent design argument referred to above. A physician who specialized in sports medicine offered the opinion that the plaintiff’s spine injury resulted from her being hit on the top of the head—probably by the collapsing windshield header—during the rollover accident. Mazda argued that it had no duty to design or supply a soft top that provided occupant protection in a rollover crash. After the jury returned a $20 million verdict in favor of Walters, Mazda appealed to the Supreme Court of Virginia. McClanahan, Justice Mazda argues that it owed no legal duty to design the soft top or the latches to provide occupant rollover protection because it is not the intended or foreseeable purpose of a convertible soft top, including the latching system, to provide such protection. Mazda points out that there was no evidence that Mazda or any car manufacturer designs soft tops or latches to provide occupant rollover protection, that consumers expect a soft top to provide occupant rollover protection, or that there exists any industry standard or custom to design soft tops or their latches to provide such protection. Walters contends that Mazda sold a dual-purpose product. According to Walters, when the top was in use, it was a foreseeable purpose of the top and latching mechanism to provide the same occupant rollover protection as a sedan with a permanent roof structure. Walters specifically asserts [in her brief] that it was “a fundamental and intended purpose” of the latches to

“keep any part of the structure from intruding into the occupant compartment and creating a hazardous environment.” Thus, she argues, “the latches failed their intended safety purpose of keeping the structures connected and thus away from the occupant.” The issue of whether a manufacturer of a soft top convertible owes a legally recognized duty to design or supply a soft top or its latching system to provide occupant rollover protection is a threshold question that we determine as a matter of law. Walters does not claim that a defect in the Miata caused the rollover crash; rather, Walters seeks to hold Mazda liable for failing to design the soft top latching system to provide occupant protection during the rollover crash. In Virginia, [unlike in some states,] there is no duty on the part of vehicle manufacturers to design or supply a crashworthy vehicle. See Slone v. General Motors Corp., 457 S.E.2d 51, 53–54 (Va. 1995) (expressly rejecting the “crashworthiness” doctrine). Therefore, if a duty to design convertible



Chapter Twenty Product Liability

soft tops to provide occupant rollover protection exists, it must be found within the scope of a vehicle manufacturer’s duty to exercise reasonable care to design a product that is reasonably safe for the purpose for which it is intended. See id. (stating that instead of injecting the doctrine of “crashworthiness” into our well-settled jurisprudence, we will apply the product liability principles articulated in our precedent). Our well-settled jurisprudence establishes that the manufacturer of a product is only under a duty “to exercise ordinary care to design a product that is reasonably safe for the purpose for which it is intended.” [Citation omitted.] The determination of whether a vehicle manufacturer owes a duty to design a convertible soft top to provide occupant rollover protection, therefore, requires that we consider whether such protection is the intended or reasonably foreseeable use, given the inherent characteristics, market purposes, and utility of a convertible soft top. “After all, it is a commonplace that utility of design and attractiveness of the style of the car are elements which car manufacturers seek after and by which buyers are influenced in their selections.” Dreisonstok v. Volkswagenwerk, A.G., 489 F.2d 1066, 1072 (4th Cir. 1974). “Foreseeability [of harm], it has been many times repeated, is not to be equated with duty.” Id. at 1070. Accordingly, while the possibility that a convertible may be involved in a rollover accident is undoubtedly foreseeable, “[c]ommon knowledge of a danger from the foreseeable misuse of a product does not alone give rise to a duty to safeguard against the danger of that misuse.” [Citation omitted.] “To the contrary, the purpose of making the finding of a legal duty as a prerequisite to a finding of negligence . . . is to avoid the extension of liability for every conceivably foreseeable accident, without regard to common sense or good policy.” [Citation omitted.] Existence of duty is an issue that is separate and distinct from its breach. To sustain a claim for negligent design, a plaintiff must show that the manufacturer failed to meet objective safety standards prevailing at the time the product was made. “When deciding whether a product’s design meets those standards, a court should consider whether the product fails to satisfy applicable industry standards, applicable government standards, or reasonable consumer expectations.” [Citation omitted.] In contrast to vehicles with a permanent roof structure, soft top convertibles provide the owner with a roof that can, with relative ease, be retracted and stowed for an open-air driving experience or closed to protect the occupants from the outside elements such as wind and rain. The absence of a permanent roof structure necessarily diminishes the level of occupant rollover protection. Not only is this characteristic of a convertible “readily discernible to anyone using the vehicle,” it is “the unique feature of the vehicle.” Dreisonstok, 489 F.2d at 1074 (noting that the unique design of the Volkswagen microbus reduced the space between the front of the vehicle and driver’s compartment so as

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to provide the maximum amount of cargo or passenger space). “If a person purchases a convertible . . . he cannot expect—and the Court may not impose on the manufacturer the duty to provide him with—the exact kind of protection in a roll-over accident as in the standard American passenger car.” Id. at 1075. In connection with examining the duty of a vehicle manufacturer to design a convertible soft top to provide rollover protection, we note that when the Mazda Miata was manufactured in 1995, there were no government or automotive industry safety standards in existence requiring that convertible soft tops provide protection from intrusion of the roof system into the occupant compartment during a rollover crash. While the National Highway Transportation Safety Administration (NHTSA) established strength requirements for the passenger compartment roof of specified vehicles, it expressly excluded convertibles from such requirements. See Federal Motor Vehicle Safety Standard (FMVSS) No. 216, 49 C.F.R. § 571.216(S3)(c). The stated purpose of FMVSS No. 216 “is to reduce deaths and injuries due to the crushing of the roof into the occupant compartment in rollover crashes.” The roof over the front seat area specifically includes the windshield header. In 2009, NHTSA upgraded its safety standard on roof crush resistance “[a]s part of a comprehensive plan for reducing the risk of rollover crashes and the risk of death and serious injury in those crashes.” 74 Fed. Reg. 22,348. NHTSA continued to exclude convertibles, including retractable hard top convertibles, from the FMVSS No. 216 requirements. Explaining its reason for excluding convertibles from the roof crush resistance standard, NHTSA stated: We believe that to establish a roof crush requirement on vehicles that do not have a permanent roof structure would not be practical from a countermeasure perspective. A convertible roof would have to be strong enough to pass the quasi-static test, yet flexible enough to fold into the vehicle. Since we are not aware of any such designs, we do not agree with Advocates [who objected to excluding convertibles from FMVSS No. 216] on this point. We also note that new rollover and ejection requirements for convertibles are outside the scope of this rulemaking. 74 Fed. Reg. at 22,375. Even as to folding hardtops and removable hardtops, NHTSA noted that “[t]hese roof systems are not intended as significant structural elements but are designed primarily to provide protection from inclement weather, improve theft protection and are generally offered as a luxury item.” Id. Furthermore, NHTSA expressed its belief that “consumers readily recognize that [these roof systems] will afford occupants limited protection in a rollover.”  Id. Accordingly, there continues to be no government or automotive industry safety standards requiring convertible soft tops to provide occupant rollover protection.

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Part Four Sales

Walters argues that consideration of FMVSS No. 216, and in particular the exclusion of convertibles from its roof crush requirements, is inappropriate because this case is about defective latches, not a defective roof. Walters’ argument is a non sequitur. It is the absence of a permanent roof structure that requires use of latches to connect the top to the windshield. And it is this inherent feature of a convertible—the absence of a fixed, rigid structural member to connect the . . . frame [for] the vehicle’s windshield to the . . . frame [for] the vehicle’s rear window—that makes roof crush requirements impractical for convertibles. Furthermore, Walters’ effort to make a distinction between the roof and the latches is unavailing since the basis of her claims for negligence . . . is that the Miata “would not provide reasonable occupant protection in a foreseeable rollover while being used in its closed top configuration” [quoting her brief]. Occupant protection in a rollover crash is the precise issue addressed by FMVSS No. 216. In short, we believe that imposing a duty upon manufacturers of convertible soft tops to provide occupant rollover protection  defies both “common sense” and “good policy.” [Citation omitted.] There are no safety standards in existence, promulgated either by the government or the automotive industry, that require convertible soft tops, including their latching mechanisms, to provide occupant rollover protection. Indeed, NHTSA has expressly

excepted convertibles from the roof crush standard because it is unaware of any convertible top that could meet such a standard. There is certainly no evidence that Mazda or any other manufacturer of convertibles in fact designs or markets soft tops to provide occupant rollover protection or that consumers reasonably expect such protection. To the contrary, the marketable feature of the soft top convertible is the absence of a permanent roof structure. The absence of this structural component is not only obvious but chosen by consumers who desire the flexibility of a soft top that can be easily detached, folded, and stowed for an open-air driving experience, or closed and latched to the windshield header for a quieter ride without exposure to the outside elements. The use of a convertible soft top, including its latches, for occupant rollover protection is neither its purpose nor an intended or reasonably foreseeable use. For these reasons, we hold that no duty extended to Mazda to design the soft top, including its latches, so that it would provide occupant rollover protection. Therefore, we reverse the judgment of the circuit court and enter final judgment in favor of Mazda.

Strict Liability

Section 402A’s Requirements Because it is the most common version of strict liability in the products context, we limit our discussion of the subject to § 402A. It provides that a “seller . . . engaged in the business of selling” a product is liable for physical harm or property damage suffered by the ultimate user or consumer of that product, if the product was “in a defective condition unreasonably dangerous to the user or consumer or to his property.” This rule applies even though “the seller has exercised all possible care in the preparation and sale of his product.” Thus, § 402A states a strict liability rule, which does not require plaintiffs to prove a breach of duty. Each element required by § 402A must be present in order for strict liability to be imposed.

Identify the elements of a strict liability claim under

LO20-7 Restatement (Second) § 402A and explain how strict

liability differs from liability for negligence.

Strict liability for certain defective products has been a feature of the legal landscape since the mid-20th century. The movement toward imposing strict liability received a critical boost when the American Law Institute promulgated § 402A of the Restatement (Second) of Torts in 1965. By now, the vast majority of the states have adopted some form of strict liability, either by statute or under the common law. The most important reason is the socializationof-risk strategy discussed earlier. By not requiring plaintiffs to prove a breach of duty, strict liability makes it easier for them to recover; sellers then may pass on the costs of this liability through higher prices. Another justification for strict liability is that it stimulates manufacturers to design and build safer products.

Jury verdict in favor of Walters vacated; lower court decision reversed; judgment entered in favor of Mazda.

1. The seller must be engaged in the business of selling the product that harmed the plaintiff. Thus, § 402A binds only parties who resemble UCC merchants because they regularly sell the product at issue. For example, the section does not apply to a plumber’s sale of a used car.



Chapter Twenty Product Liability

2. The product must be in a defective condition when sold and must also be unreasonably dangerous because of that condition. The reasonable-expectations-of-the-consumer test normally governs the determination of whether a product is in a defective condition. Determining whether a product is unreasonably dangerous can vary depending upon what supposedly makes the product possess that level of dangerousness. Where the apparent problem was manufacturing-oriented, the test tends to be whether the product is dangerous to an extent beyond the reasonable contemplation of the average consumer. For instance, good whiskey is not unreasonably dangerous even though it can cause harm, but whiskey contaminated with a poisonous substance would be considered unreasonably dangerous. Where the question is whether the design adopted for a product made it unreasonably dangerous, courts today often employ a version of the risk-utility test noted earlier in the discussion of negligence-based cases. The Branham case, which appears shortly, discusses the role of the risk-utility test in strict liability cases involving allegedly defective designs. Section 402A’s requirement of unreasonable dangerousness means that strict liability applies to a smaller range of product defects than does the implied warranty of merchantability. For example, a power mower that fails to operate shortly after a merchant’s sale of it would be unmerchantable and evidently defective (satisfying one element of a § 402A claim) but would not be unreasonably

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dangerous (failing the remaining § 402A element). Therefore, the merchant seller could be liable for a breach of the implied warranty of merchantability but would not be held strictly liable under § 402A. 3. Finally, defendants may avoid § 402A liability where the product was substantially modified by the plaintiff or another party after the sale, and the modification contributed to the plaintiff’s injury or other loss. Applications of § 402A As the preceding discussion suggests, manufacturing-defect and design-defect cases can be brought under § 402A. The same is true of failure-to-warn cases. Even though § 402A sets forth a strict liability rule, the factors considered and tests employed in § 402A cases resemble those applied in the negligence cases discussed in the chapter’s previous section. The conceptual difference between negligence-based cases and strict liability cases is that the former consider the defendant’s conduct as it contributed to the product’s condition, whereas in strict liability cases the focus is solely on the product’s condition (not on whether the defendant’s conduct was blameworthy). Nevertheless, given that similar factors and tests apply in each type of case and the further fact that plaintiffs often argue in the alternative by bringing negligence and strict liability claims in the same case, courts sometimes encounter difficulty in keeping the two claims analytically distinct.

The Global Business Environment By virtue of a 1985 European Union (EU) Council Directive premised on consumer protection grounds, producers of defective products face strict liability for the personal injuries and property damage those products cause. The 1985 Directive defined product as all movables, with the exception of primary agricultural products and game, even though incorporated into another movable or into an immovable. “Primary agricultural products” means the products of the soil, of stock-farming and of fisheries, excluding products which have undergone initial processing. “Product” includes electricity. A 1999 amendment, however, broadened the Directive’s definition of product and coverage of the strict liability regime by eliminating the original version’s exclusion of agricultural products. After the 1999 amendment, product includes “all movables even if incorporated into another movable or into an immovable.” The 1999 amendment also retained the original version’s inclusion of “electricity” within the definition of product.

The Directive states that a product is considered defective when it does not provide the safety which a person is entitled to expect, taking all circumstances into account, including: (a) the presentation of the product; (b) the use to which it could reasonably be expected that the product would be put; [and] (c) the time when the product was put into circulation. Because the Directive contemplates strict liability, the harmed consumer need not show a failure to use reasonable care on the part of the producer. The typical tendency among the states of the United States is to require, in a strict liability case, proof that the product was both defective and unreasonably dangerous. The Directive, however, takes a different approach to strict liability. Although the consumer must demonstrate personal injury or property damage resulting from use of the product, the Directive’s definition of defective does not contemplate a separate showing that the harm-causing product was defective to the point of being unreasonably dangerous. Only limited possible defenses against liability are provided for producers in the Directive.

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Part Four Sales

[As will be seen, the Restatement (Third) of Torts borrows features of negligence and strict liability without using either of those labels and then combines those features in a proposed set of rules that emphasizes differences among types of product defects.] Because it applies to professional sellers, § 402A covers retailers and other middlemen who market goods containing defects that they did not create and may not have been able to discover. Even though such parties often escape negligence liability, courts have held them liable under § 402A’s strict liability rule. Some states, however, have given middlemen protection against § 402A liability or have required the manufacturer or other responsible party to indemnify them. What about products, such as some medications, that have great social utility but pose serious and unavoidable risks? Imposing strict liability regarding such “unavoidably unsafe” products might deter manufacturers from developing and marketing them. When products of this kind cause harm and a lawsuit follows, many courts follow Comment k to § 402A. Comment k says that unavoidably unsafe products are neither defective nor unreasonably dangerous if they are properly prepared and accompanied by proper directions and a proper warning. For this rule to apply, the product must be genuinely incapable of being made safer.

The Restatement (Third) LO20-8

Describe the Restatement (Third)’s proposed framework of product liability rules.

In 1998, the American Law Institute published its Restatement (Third) of Torts: Product Liability. The Restatement (Third)’s proposed approach to the tort aspects of product liability calls for different analyses for different types of defects. It borrows to some extent from both negligence and strict liability in doing so (though without using those terms). Although its approach has not yet been adopted by enough states to make it a majority rule, the Restatement (Third) may signal the likely evolution of product liability law in coming years. As evidenced by the Branham case, which appears shortly, the Restatement (Third) can be influential even when courts continue to adhere to the traditional theories of negligence and strict liability. Basic Provisions The Restatement (Third)’s basic product liability rule states: “One engaged in the business of selling or otherwise distributing products who sells or distributes a defective product is subject to liability for harm to persons or property caused by the defect.” As does § 402A, this rule covers only those who are engaged in the

business of selling the kind of product that injured the plaintiff. The rule also resembles § 402A in covering not only manufacturers but also other sellers down the product’s chain of distribution. Unlike § 402A, however, the Restatement (Third) does not require that the product be unreasonably dangerous. Specific Rules The Restatement (Third) states special rules governing the sale of product components, prescription drugs, medical devices, food products, and used goods. More importantly, it adds substance to the basic rule set forth above by describing three kinds of product defects. 1. Manufacturing defects. A manufacturing defect occurs when the product does not conform to its intended design at the time it leaves the manufacturer’s hands. This includes products that are incorrectly assembled, physically flawed, or damaged. 2. Inadequate instructions or warnings. Although the Restatement (Third) applies strict liability to manufacturing defects, liability for inadequate instructions or warnings resembles negligence more than strict liability. [The Restatement (Third) rules regarding failures to warn do not use the term negligence, however.] This liability exists when reasonable instructions or warnings could have reduced the product’s foreseeable risk of harm, but the seller did not provide such instructions or warnings and the product thus was not reasonably safe. Manufacturers and sellers are liable only for failing to instruct or warn about reasonably foreseeable harms, and not about every conceivable risk their products might present. As with negligence and § 402A, moreover, they need not warn about obvious and generally known risks. The other failure-to-warn factors discussed earlier probably apply under the new Restatement as well. 3. Design defects. The Restatement (Third) calls for liability for design defects to be determined under principles resembling those of negligence [though the Restatement (Third) rule for such cases avoids using the term negligence]. According to the Restatement (Third), courts should employ a riskutility test of the sort discussed earlier and plaintiffs must prove that the use of a reasonable alternative design would have reduced or avoided foreseeable risks of harm. The Branham case, which follows, presents a plaintiff’s attempt to have strict liability imposed for a design defect. Although the court regards § 402A as controlling, it points to the Restatement (Third) in support of its conclusions that the risk-utility test should guide the unreasonable dangerousness inquiry and that the plaintiff had to demonstrate the existence of a reasonable alternative design. The court also addresses the question whether evidence of a manufacturer’s decisions and actions after the harm-causing product’s distribution should be permitted in a design defect case.



Chapter Twenty Product Liability

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Branham v. Ford Motor Co.   701 S.E.2d 5 (S.C. 2010) Cheryl Hale purchased a 1987 Ford Bronco II (Bronco) in 1999. The Bronco had been manufactured by Ford Motor Co. in 1986. In 2001, Hale was driving the Bronco on a South Carolina road. She was transporting several children to her home. Among them was Jesse Branham. Hale momentarily took her eyes off the road and turned to the backseat to ask the children to quiet down. When she did so, the Bronco veered to the right. Its right rear wheel then went off the roadway. Realizing what was happening, Hale responded by overcorrecting to the left. The vehicle began to shake and then rolled over. Branham was thrown from the vehicle and was seriously injured. Branham (through his parents, acting on his behalf) sued Ford and Hale in a South Carolina court. The case against Ford presented a “handling and stability” design defect claim related to the Bronco’s supposed tendency to roll over. Branham pursued this claim on the alternative grounds of negligence and strict liability. Ford denied liability and asserted that Hale’s negligence caused the accident. The jury found both Ford and Hale liable. It awarded Branham $16,000,000 in compensatory damages and $15,000,000 in punitive damages. Ford appealed to the Supreme Court of South Carolina. (Further relevant facts appear below, in the edited version of the state supreme court’s opinion.) Kittredge, Justice The “handling and stability” design defect claim (strict liability and negligence) is the gravamen of Branham’s case [against Ford]. Ford appeals from the denial of its motions to dismiss the strict liability and negligence causes of action. For a plaintiff to successfully advance a [strict liability-based] design defect claim, he must show that the design of the product caused it to be unreasonably dangerous. In South Carolina, we have traditionally employed two tests to determine whether a product was unreasonably dangerous as a result of a design defect: (1) the consumer expectations test; and (2) the risk-utility test. In [an earlier decision], this Court phrased the consumer expectations test as follows: “The test . . . is whether the product is unreasonably dangerous to the consumer or user given the conditions and circumstances that foreseeably attend use of the product.” [In the same decision, we] articulated the risk-utility test in the following manner: “[N]umerous factors must be considered [when determining whether a product is unreasonably dangerous], including the usefulness and desirability of the product, the cost involved for added safety, the likelihood and potential seriousness of injury, and the obviousness of danger.” Later, . . . our court of appeals phrased the risk-utility test as follows: “[A] product is unreasonably dangerous and defective if the danger associated with the use of the product outweighs the utility of the product.” [Citation omitted.] Ford contends Branham failed to present evidence of a feasible alternative design. Implicit in Ford’s argument is the contention that a product may only be shown to be defective and unreasonably dangerous by way of a risk-utility test, for by its very nature, the risk-utility test requires a showing of a reasonable alternative design. Branham counters, arguing that under [our prior decisions] he may prove a design defect by resort to the consumer expectations test or the risk-utility test. Branham also argues that regardless of which test is required, he has met both, including evidence of a feasible alternative design. We agree

with Branham’s contention that he produced evidence of a feasible alternative design. As discussed above, Branham challenged the design of the Ford Bronco II by pointing to the MacPherson suspension as a reasonable alternative design. A former Ford vice-president (Feaheny) testified that the MacPherson suspension system would have significantly increased the handling and stability of the Bronco II, making it less prone to rollovers. Dr. Richardson also noted that the MacPherson suspension system would have enhanced vehicle stability by lowering the vehicle center of gravity. There was further evidence that the desired sport utility features of the Bronco II would not have been compromised by using the MacPherson suspension. Moreover, there is evidence that use of the MacPherson suspension would not have increased costs. Whether this evidence satisfies the risk-utility test is ultimately a jury question. But it is evidence of a feasible alternative design, sufficient to survive [Ford’s] directed verdict motion. While the consumer expectations test fits well in manufacturing defect cases, we agree with Ford that the test is ill-suited in design defect cases. We hold today that the exclusive test in a product liability design defect case is the risk-utility test with its requirement of showing a feasible alternative design. In doing so, we recognize our legislature’s presence in the area of strict liability for products liability. In 1974, our legislature adopted the Restatement (Second) of Torts § 402A (1965), and identified its comments as legislative intent. The comments [regarding] § 402A are pointed to as the basis for the consumer expectations test. Since the adoption of § 402A, the American Law Institute published the Restatement (Third) of Torts: Products Liability (1998). The third edition effectively moved away from the consumer expectations test for design defects, and toward a risk-utility test. We believe the legislature’s foresight in looking to the American Law Institute for guidance in this area is instructive. The legislature has expressed no intention to foreclose court consideration of developments in product liability law. For

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Part Four Sales

example, this Court’s approval of the risk-utility test in [a previous case] yielded no legislative response. We thus believe the adoption of the risk-utility test in design defect cases in no manner infringes on the legislature’s presence in this area. Some form of a risk-utility test is employed by an overwhelming majority of the jurisdictions in this country. Some of these jurisdictions exclusively employ a risk-utility test, while others do so with a hybrid of the risk-utility and the consumer expectations test, or an explicit either-or option. States that exclusively employ the consumer expectations test are a decided minority. We believe that in design defect cases the risk-utility test provides the best means for analyzing whether a product is designed defectively. Unlike the consumer expectations test, the focus of a risk-utility test centers upon the alleged defectively designed product. The risk-utility test provides objective factors for a trier of fact to analyze when presented with a challenge to a manufacturer’s design. Conversely, we find the consumer expectations test and its focus on the consumer ill-suited to determine whether a product’s design is unreasonably dangerous. The consumer expectations test is best suited for a manufacturing defect claim. [Our adoption of the risk-utility test as the exclusive test in design defect cases is also] in accord with the current edition of the Restatement (Third) of Torts: A product . . . is defective in design when the foreseeable risks of harm posed by the product could have been reduced or avoided by the adoption of a reasonable alternative design by the seller or other distributor, or a predecessor in the commercial chain of distribution, and the omission of the alternative design renders the product not reasonably safe. In sum, in a product liability design defect action, the plaintiff must present evidence of a reasonable alternative design. The plaintiff will be required to point to a design flaw in the product and show how his alternative design would have prevented the product from being unreasonably dangerous. This presentation of an alternative design must include consideration of the costs, safety, and functionality associated with the alternative design. The analysis asks the trier of fact to determine whether the potential increased price of the product (if any), the potential decrease in the functioning (or utility) of the product (if any), and the potential increase in other safety concerns (if any) associated with the proffered alternative design are worth the benefits that will inhere in the proposed alternative design. On retrial, [which is necessary for the reasons set forth below], Branham’s design defect claim will proceed pursuant to the risk-utility test and not the consumer expectations test. Post-Distribution Evidence Notwithstanding the existence of ample evidence to withstand a directed verdict motion on the handling and stability design defect claim, we reverse and remand for a new trial. [T]his case implicates [an important] evidentiary rule related to product liability

cases. The rule provides that whether a product is defective must be measured against information known at the time the product was placed into the stream of commerce. When a claim is asserted against a manufacturer, post-manufacture evidence is generally not admissible. Evidence was introduced that violated [this] rule. [T]o prove his case in a product liability action, [the plaintiff] must show that the “product was in a defective condition at the time that it left the hands of the particular seller . . . and unless evidence can be produced which will support the conclusion that it was then defective, the burden is not sustained.” [Citation omitted.] Because the claim here is against the manufacturer, the “time of distribution” is the time of manufacture. While we find Branham presented sufficient evidence to create a jury question on his design defect claim, we further find Ford was prejudiced by Branham’s unrelenting pursuit of postdistribution evidence on the issue of liability. Given the extent of the improper post-distribution evidence introduced, the error cannot be considered harmless. Simply defined, post-distribution evidence is evidence of facts neither known nor available at the time of distribution. When assessing liability in a design defect claim against a manufacturer, the judgment and ultimate decision of the manufacturer must be evaluated based on what was known or reasonably attainable at the time of manufacture. The use of post-distribution evidence to evaluate a product’s design through the lens of hindsight is improper. Hale’s Ford Bronco II 4x2 was manufactured in 1986. The following is a sampling of the post-manufacture (or post-distribution) evidence. Branham introduced a memorandum dated April 14, 1989, dealing with a meeting that three Ford engineers had with “six people from Consumers Report.” The memorandum stated that: Our objective was to “give it our best shot” at diffusing a very negative story on the Bronco II in the June issue. . . . The magazine has done a comparative test of the Chevy S-10 Blazer, Geo Tracker, Dodge Raider and Bronco II. As the result of several calls from a Consumer Report writer, we were led to believe that the story could be nearly as negative as last summer’s Suzuki Samurai story. Plus, NHTSA is currently conducting an engineering analysis of the Bronco II which creates a negative cloud. And, FARS [Fatal Analysis Reporting System] data shows Bronco II to have a higher fatal rollover rate relative to certain competitors. The memorandum went on to note the following: “Our data are not terribly favorable. Our rollover rate is three times higher than the Chevy S-10 Blazer.” This evidence of the Bronco II’s rollover rate is post-manufacture evidence. Through Branham’s expert, Dr. Richardson, a 1989 film was introduced. [T]his film, taped in 1989, compared the S-10 Blazer and the Bronco II. [It] revealed that the 1989 Bronco II did not handle as well as the S-10 Blazer. Dr. Richardson also testified regarding a document . . . referencing post-manufacture evidence



Chapter Twenty Product Liability

that compared a 1989 Bronco II to the [supposedly safer] UN46 prototype, now known as the Ford Explorer. This document shows the additional evidence of the rollover tendency of the Bronco II that came to light after 1986. Yet another example of post-distribution evidence is found in a memorandum addressing [a 1989 Bronco II rollover] accident caused while Ford was testing a prototype anti-lock braking system. There are other examples of post-manufacture evidence, but the few examples cited illustrate the inherent prejudice that flows from post-distribution evidence. It is good when a manufacturer continues to test and evaluate its product after initial manufacture. As additional information is learned, changes may be made that improve product safety and function. As a matter of policy, the law should encourage the design and manufacture of safe, functional products. In holding manufacturers accountable

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for unreasonably dangerous products pursuant to a fair system, product liability law serves that goal. Moreover, the law should encourage manufacturers to continue to improve their products in terms of utility and safety free from prior design decisions judged through the lens of hindsight. Whether the 1987 Ford Bronco II was defectively designed and in a defective condition unreasonably dangerous must be determined as of the 1986 manufacture date of the vehicle. Ford’s 1986 design and manufacture decision should be assessed on the evidence available at that time, not the increased evidence of additional rollover data that came to light after 1986. Trial court’s judgment in favor of Branham affirmed in part and reversed in part; case remanded for new trial.

CYBERLAW IN ACTION When Amazon sells defective products via third-party sellers on Amazon’s Marketplace, can Amazon be held liable? As this text goes to press in 2020, the answer is not clear, but a variety of cases in recent years are worth noting, especially because third-party vendors accounted for half of all sales on Amazon, or approximately $160 billion, in 2018. As for official Amazon policy, the company claims to have no responsibility for flawed or defective items sold by third-party merchants, and many courts have agreed. For examples, see the 2018 decisions in Allstate New Jersey Insurance Co. v. Amazon.com and Eberhart v. Amazon.com. However, in Oberdorf v. Amazon.com, Inc., decided in July 2019, the U.S. Court of Appeals for the Third Circuit became the first court to reject Amazon’s claim that it cannot be considered a “seller” of products offered by third parties. In this case, Heather Oberdorf bought a retractable leash dog collar on Amazon.com. While out for a walk with her dog Sadie, the animal lunged forward, causing the collar to break and the retractable leash to recoil and hit Ms. Oberdorf in the face and eyeglasses. As a result, she was rendered permanently blind in her left eye. Unable to locate the third-party seller of the leash, Ms. Oberdorf sued Amazon.com on claims of strict products liability and negligence. At trial, the district court found that under Pennsylvania law, Amazon was not liable for Oberdorf’s injuries. The district court emphasized that a third-party vendor—not Amazon—had listed the collar on Amazon’s online marketplace and shipped the collar directly to Oberdorf. Based on these facts, the court first found Amazon was not a “seller” under Pennsylvania law, and then concluded that the Communications Decency Act (CDA) barred Oberdorf’s claims that Amazon was liable for its role as the online publisher of third-party content.

On appeal, the Third Circuit Court of Appeals disagreed with the trial court and found that Amazon.com was indeed a “seller” and not merely an online marketplace for other sellers. The appellate court’s analysis focused on Amazon’s practice of neither ensuring that its third-party vendors are in good legal standing in their country of registration nor vetting that these vendors are amenable to the legal process. Moreover, the appellate court concluded that by virtue of its strong position as a gatekeeper to permitting third-party vendors access to the Amazon online marketplace, Amazon was fully capable of removing unsafe products from its website and incentivized to do so. Judge Jane Richards Roth, writing for the court, noted summarized majority opinion: “We do not believe that Pennsylvania law shields a company from strict liability simply because it adheres to a business model that fails to prioritize consumer safety.” While Amazon is currently appealing the appellate court’s decision, some commentators noted that consumers would be left with little recourse against sellers of defective products if the decision was overturned by future proceedings. Still, e-commerce advocates warned that this decision could hurt the expansion of online commerce and harm the U.S. economy. Even while the fate of the Oberdorf decision is not settled, its impact has already been felt in other jurisdictions. A district court in New Jersey, following the logic in Oberdorf, concluded in Papataros v. Amazon.com, a case involving a defective scooter, that Amazon is a “seller” for purposes of New Jersey strict products liability law. In Wisconsin, a district court similarly found that Amazon bears responsibility for putting a defective bathtub faucet adapter (which caused a house to be flooded) into the stream of commerce in that state, and Amazon was best positioned to allocate among itself and its third-party sellers the risks that products sold on Amazon.com would be defective.

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Other Theories of Recovery The Magnuson-Moss Act The relevant civil-recovery provisions of the federal Magnuson-Moss Warranty Act apply to sales of consumer products costing more than $10 per item. A consumer product is tangible personal property normally used for personal, family, or household purposes. If a seller gives a written warranty for such a product to a consumer, the warranty must be designated as full or limited. A seller who gives a full warranty promises to (1) remedy any defects in the product and (2) replace the product or refund its purchase price if, after a reasonable number of attempts, it cannot be repaired.4 A seller who gives a limited warranty is bound to whatever promises it actually makes. However, neither warranty applies if the seller simply declines to give a written warranty. Misrepresentation Product liability law has long allowed recoveries for misrepresentations made by sellers of goods. The Restatement (Third) does likewise. Its rule applies to merchantlike sellers engaged in the business of selling the product in question. The rule includes fraudulent, negligent, or innocent misrepresentations made by such sellers. The misrepresentation must involve a material fact about the product—a fact that would matter to a reasonable buyer. This means that sellers are not liable for inconsequential misstatements, sales talk, and statements of opinion. However, the product need not be defective. Unlike past law, moreover, the misrepresentation need not be made to the public, and the plaintiff need not have justifiably relied upon it. However, it must have made the plaintiff suffer personal injury or property damage. Industrywide Liability The legal theory we call industrywide liability is a way for plaintiffs to bypass problems of causation that exist where several firms within an industry have manufactured a harmful standardized product, and it is impossible for the plaintiff to prove which firm produced the product that injured her. The main reasons for these proof problems are the number of firms producing the product and the time lag between exposure to the product Also, many states have enacted so-called lemon laws that may apply only to motor vehicles or to various other consumer products as well. The versions applying to motor vehicles generally require the manufacturer to replace the vehicle or refund its purchase price once certain conditions are met. These conditions may include the following: a serious defect covered by warranty, a certain number of unsuccessful attempts at repair or a certain amount of downtime because of attempted repairs, and the manufacturer’s failure to show that the defect is curable. 4

and the appearance of the injury. Most of the cases presenting such problems have involved DES (an antimiscarriage drug that produced various ailments in daughters of the women to whom it was administered) or diseases resulting from long-term exposure to asbestos. In such cases, each manufacturer of the product can argue that the plaintiff should lose because she cannot show that its product harmed her. How do courts handle these cases? Most of the time, they continue to deny recovery under traditional causation rules because the special circumstances necessary to trigger application of industrywide liability are found not to be present. However, using various approaches whose many details are beyond the scope of this text, other courts have made it easier for plaintiffs to recover in appropriate cases. Where recovery is allowed, some of these courts have apportioned damages among the firms that might have produced the harm-causing product. Such an apportionment is typically based on market share at some chosen time.

Time Limitations We now turn to several problems that are common to each major product liability theory but that may be resolved differently from theory to theory. One such problem is the time within which the plaintiff must sue or else lose the case. Traditionally, the main time limits on product liability suits have been the applicable contract and tort statutes of limitations. The usual UCC statute of limitations for express and implied warranty claims is four years after the seller offers the defective goods to the buyer (usually, four years after the sale). In tort cases, the applicable statute of limitations may be shorter, depending upon applicable state law. It begins to run, however, only when the defect was or should have been discovered—often, the time of the injury. In part because of tort reform, some states now impose various other limitations on the time within which product liability suits must be brought. Among these additional time limitations are (1) special statutes of limitations for product liability cases involving death, personal injury, or property damage (e.g., from one to three years after the time the death or injury occurred or should have been discovered); (2) special time limits for “delayed manifestation” injuries such as those resulting from exposure to asbestos; (3) useful safe life defenses (which prevent plaintiffs from suing once the product’s “useful safe life” has passed); and (4) statutes of repose (whose aim is similar). Statutes of repose usually run for a 10- to 12-year period



Chapter Twenty Product Liability

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Ethics and Compliance in Action Litigation against tobacco companies has proliferated in recent years. Many cases have been brought by cigarette smokers or the estates of deceased smokers in an effort to obtain damages for the adverse health effects resulting from their years of smoking cigarettes. Sometimes, class action suits brought by groups of smokers or persons exposed to secondhand smoke have been instituted. The federal government and many state governments have also sued tobacco companies in an effort to recoup health care costs incurred by those governments in regard to citizens whose health problems allegedly resulted from smoking. The cases against tobacco firms—particularly those brought by private parties—have been pursued on a wide variety of legal theories that initially included breach of express or implied warranty, negligent design, negligent failure to warn, and strict liability. Results have been mixed, with tobacco companies frequently prevailing but plaintiffs occasionally receiving jury verdicts for very large amounts of damages (some of which have been subject to reduction or outright elimination by the trial judge or an appellate court). During the past several years, plaintiffs had greater success in cases against tobacco companies than they once did, in large part because plaintiffs acquired access to old tobacco industry documents they previously did not have. Some of these documents helped plaintiffs augment the traditional product liability claims referred to above with claims for fraudulent concealment of, and conspiracy to conceal, the full extent of the health risks of smoking during a time when tobacco firms’ public pronouncements allegedly minimized or soft-pedaled those risks. Although plaintiffs’ cases against tobacco companies remain far from surefire winners, there is no doubt that plaintiffs’ chances of winning such cases are somewhat better today than they were roughly 20 years ago. In addition to the many legal issues spawned by cases against tobacco companies, various ethical issues come to mind. Consider, for instance, the questions set forth below. Some of them pertain to tobacco litigation, whereas others pertain to related issues for business and society. In considering these questions, you may wish to employ the ethical theories outlined in Chapter 4, as well as that chapter’s suggested process for making decisions that carry potential ethical implications.

• Given what is now known about the dangers of tobacco use, are the production and sale of tobacco products ethically

justifiable business activities? What are the arguments each way? Does it make a difference whether the health hazards of smoking have, or have not, been fully disclosed by the tobacco companies? • Would the federal government be acting ethically if it took the step of outlawing the production and sale of tobacco products? Why or why not?

• If a company that produces a product—whether tobacco or another product—acquires information indicating that its product may be or is harmful to users of it, does the company owe an ethical duty to disclose this actual or potential danger? If so, at what point? What considerations should be taken into account?

• If a manufacturer’s product—whether tobacco or another product—is well received by users but poses a significant risk of harm when used as intended by the manufacturer, does the manufacturer owe an ethical duty to take steps to redesign the product so as to lessen the risk or severity of the harm? Justify your conclusion, noting the considerations you have taken into account.

• When tobacco companies comply with federal law by placing the mandated health warnings on packages of their cigarettes and in their cigarette advertisements, have they simultaneously taken care of any ethical obligations they may have regarding disclosure of health risks? Why or why not?

• Are smokers’ (or smokers’ estates’) lawsuits against tobacco companies ethically justifiable? If so, is this true of all of them or only some of them, and why? If only some are ethically justifiable, which ones, and why? If you believe that such lawsuits are not ethically justifiable, why do you hold that view?

• Some critics have taken the position that health care cost– recouping litigation brought by the federal government and state governments against tobacco companies reflects hypocrisy because our governments extend support to tobacco farmers and collect considerable tax revenue from parties involved in tobacco growing, tobacco product manufacturing, and tobacco product sales. How do you weigh in on this issue? Are there ethical dimensions here? If our federal and state governments are “in bed” with the tobacco industry, did our governments act unethically in pursuing this litigation, or would our governments have been acting unethically if they had not pursued this litigation? Be prepared to justify your conclusions.

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that begins when the product is sold to the first buyer not purchasing for resale—usually an ordinary consumer. In a state with a 10-year statute of repose, for example, such parties cannot recover for injuries that occur more than 10 years after they purchased the product causing the harm. This is true even when the suit is begun quickly enough to satisfy the applicable statute of limitations.

Damages in Product Liability Cases Identify the types of compensatory damages available in

LO20-9 product liability cases based on tort theories and in cases

based on warranty theories.

The damages obtainable under each theory of product liability recovery strongly influence a plaintiff’s strategy. Here, we describe the major kinds of damages awarded in product liability cases, along with the theories under which each can be recovered. One lawsuit may involve claims for all these sorts of damages. LO20-10

E xplain what is normally necessary in order for punitive damages to be awarded in a product liability case.

1. Basis-of-the-bargain damages. Buyers of defective goods have not received full value for the goods’ purchase price. The resulting loss, usually called basis-of-the-bargain damages or direct economic loss, is the value of the goods as promised under the contract, minus the value of the goods as received. (For an example, see the Lincoln Composites case, which appears later in the chapter.) Basis-of-the-bargain damages are almost never awarded in tort cases. In express and implied warranty cases, however, basis-of-the-bargain damages are recoverable where there was privity of contract (a direct contractual relation) between the plaintiff and the defendant. As discussed in the next section, however, only occasionally will a warranty plaintiff who lacks privity with the defendant obtain basisof-the-bargain damages. Such recoveries most often occur where an express warranty was made to a remote plaintiff through advertising, brochures, or labels. 2. Consequential damages. Consequential damages include personal injury, property damage (harm to the plaintiff’s property other than the product at issue), and indirect economic loss (e.g., lost profits or diminished business reputation) resulting from a product defect. Consequential damages also include noneconomic loss—for

example, pain and suffering, physical impairment, mental distress, loss of enjoyment of life, loss of companionship or consortium, inconvenience, and disfigurement (as opposed to more readily quantifiable damages such as the dollar amounts of medical bills). As the just-noted examples suggest, noneconomic loss usually is part of a plaintiff’s personal injury claim. In recent years, some states have limited noneconomic loss recoveries by placing a dollar cap on them. The tort theories of recovery—negligence and strict liability—permit claims for personal injury and property damage. The type of harm experienced by the plaintiff can be a factor in the determination of whether the case can proceed on a tort theory. Plaintiffs in tort cases normally can recover for personal injury and property damage. Recoveries for foreseeable indirect economic loss sometimes are allowed. In express and implied warranty cases where privity exists between the plaintiff and the defendant, the plaintiff can recover for (1) personal injury and property damage, if either proximately resulted from the breach of warranty, and (2) indirect economic loss, if the defendant had reason to know that this was likely. As discussed in the next section, a UCC plaintiff who lacks privity with the defendant has a reasonably good chance of recovering for personal injury or property damage. Recovery for indirect economic loss is rare because remote sellers usually cannot foresee such losses. 3. Punitive damages. Unlike the compensatory damages discussed above, punitive damages are not designed to compensate the plaintiff for harms suffered (even though the plaintiff typically becomes entitled to collect any punitive damages assessed against the defendant). Punitive damages are intended to punish defendants who have acted in an especially outrageous fashion, and to deter them and others from so acting in the future. Of the various standards for awarding punitive damages, probably the most common is the defendant’s conscious or reckless disregard for the safety of those likely to be affected by the goods. Examples include concealment of known product hazards, knowing violation of government or industry product safety standards, failure to correct known dangerous defects, and grossly inadequate product testing or quality control procedures. In view of their perceived frequency, size, and effect on business and the economy, punitive damages were targeted for some states’ tort reform efforts during the 1980s and 1990s. The approaches taken by the resulting statutes vary. Some set the standards for punitive damage assessment and the plaintiff’s burden of proof; some articulate factors



Chapter Twenty Product Liability

courts should consider when ruling on punitive damage awards; and some create special procedures for punitive damage determinations. A number of states have also limited the size of punitive damage recoveries, usually by restricting them to some multiple of the plaintiff’s compensatory damages or by putting a flat dollar cap on them. Moreover, decisions of the U.S. Supreme Court have revealed that constitutional concerns may be implicated by a punitive damages award that does not bear a reasonable relation to the amount of compensatory damages awarded. Assuming that the standards just described have been met, punitive damages are recoverable in tort cases. Because of the traditional rule that punitive damages are not available in contract cases, they seldom are awarded in express and implied warranty cases. However, in recent years enormous punitive damages have been awarded by some juries. A Philadelphia jury ordered Johnson & Johnson to pay $8 billion in punitive damages when it found that the company failed to warn males that taking the drug Risperdal could result in the development of female breast tissue. This award was later reduced by the judge to $6.8 million. In another blockbuster punitive damages award, a jury in Oakland, ­California, ordered Monsanto to pay a couple more than $2 billion in damages after concluding that its Roundup week killer had caused the couple to develop non-Hodgkin’s lymphoma.

The No-Privity Defense LO20-11

E xplain the privity doctrine’s lack of role in tort cases and its partial role in warranty-based cases.

Today, defective products often move through long chains of distribution before reaching the person they harm. This means that a product liability plaintiff often has not dealt directly with the party ultimately responsible for her losses. For example, in a chain of distribution involving defective component parts, the parts may move vertically from their manufacturer to the manufacturer of a product in which those parts are used, and then to a wholesaler and a retailer before reaching the eventual buyer. The defect’s consequences may move horizontally as well, affecting members of the buyer’s family, guests in her home, and even bystanders. If the buyer or one of these parties suffers loss because of the defect in the component parts, may she successfully sue the component parts manufacturer or any other party in the vertical chain of distribution with whom she did not directly deal?

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Such cases were unlikely to succeed under 19th-century law. At that time, there was no recovery for defective goods without privity of contract between the plaintiff and the defendant. In many such cases, a buyer would have been required to sue his dealer. If the buyer was successful, the retailer might have sued the wholesaler, and so on up the chain. For various reasons, the party ultimately responsible for the defect often escaped liability.

Tort Cases By now, the old no-liability-outside-privity rule effectively has been eliminated in tort cases. It has no effect in strict liability cases, where even bystanders can recover against remote manufacturers. In negligence cases, a plaintiff generally recovers against a remote defendant if the plaintiff’s loss was a reasonably foreseeable consequence of the defect. Depending on the circumstances, therefore, bystanders and other distant parties may recover in a negligence case against a manufacturer. The Restatement (Third) suggests that tort principles should govern the privity determination. This should mean a test of reasonable foreseeability in most instances.

Warranty Cases The

no-privity defense retains some vitality in UCC cases. Unfortunately, the law on this subject is complex and confusing. Under the UCC, the privity question is formally governed by § 2-318, which comes in three alternative versions. Section 2-318’s language, however, is a less-than-reliable guide to the courts’ actual behavior in UCC privity cases. UCC § 2-318 Alternative A to § 2-318 states that a seller’s express or implied warranty runs to natural persons in the family or household of his (the seller’s) buyer and to guests in his buyer’s home, if they suffer personal injury and if it was reasonable to expect that they might use, consume, or be affected by the goods sold. On its face, Alternative A does little to undermine the traditional no-privity defense. Alternatives B and C go much further. Alternative B extends the seller’s express or implied warranty to any natural person who has suffered personal injury, if it was reasonable to expect that this person would use, consume, or be affected by the goods. Alternative C is much the same, but it extends the warranty to any person (not just natural persons) and to those suffering injury in general (not just personal injury). If the reasonable-to-expect test is met, these two provisions should extend the warranty to many remote parties, including bystanders. Departures from § 2-318 For various reasons, § 2-318’s literal language sometimes has little relevance in UCC privity cases. Some states have adopted privity statutes that

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Part Four Sales

differ from any version of § 2-318. One of the comments to § 2-318, moreover, allows courts to extend liability beyond what the section expressly permits. Finally, versions B and C are fairly open-ended as written. The plaintiff’s ability to recover outside privity in warranty cases thus varies from state to state and situation to situation. The most important factors affecting resolution of this question are: 1. Whether it is reasonably foreseeable that a party such as the plaintiff would be harmed by the product defect in question. 2. The status of the plaintiff. On average, consumers and other natural persons fare better outside privity than do corporations and other business concerns. 3. The type of damages the plaintiff has suffered. In general, remote plaintiffs are (a) most likely to recover for personal injury, (b) somewhat less likely to recover for property damage, (c) occasionally able to obtain basis-ofthe-bargain damages, and (d) seldom able to recover for indirect economic loss. Recall from the previous section that a remote plaintiff is most likely to receive basis-of-thebargain damages where an express warranty was made to her through advertising, brochures, or labels.

Disclaimers and Remedy Limitations LO20-12

E xplain what is necessary for effective disclaimers of the respective implied warranties.

A product liability disclaimer is a clause in the sales contract whereby the seller attempts to eliminate liability it might otherwise have under the theories of recovery described earlier in the chapter. A remedy limitation is a clause attempting to block recovery of certain damages. If a disclaimer is effective, no damages of any sort are recoverable under the legal theory attacked by the disclaimer. A successful remedy limitation prevents the plaintiff from recovering certain types of damages but does not attack the plaintiff’s theory of recovery. Damages not excluded still may be recovered because the theory is left intact. The main justification for enforcing disclaimers and remedy limitations is freedom of contract. Why, however, would any rational contracting party freely accept a disclaimer or remedy limitation? Because sellers need not insure against lawsuits for defective goods accompanied by an effective disclaimer or remedy limitation, they should be able to sell those goods more cheaply. Thus, enforcing such clauses allows buyers to obtain a lower price by accepting the economic risk of

a product defect. For purchases by ordinary consumers and other unsophisticated buyers, however, this argument often is illusory. Sellers normally present the disclaimer or remedy limitation in a standardized, take-it-or-leave-it fashion. It is also doubtful whether many consumers read disclaimers and remedy limitations at the time of purchase, or would comprehend them if they did read them. As a result, there is little or no genuine bargaining over disclaimers or remedy limitations in consumer situations. Instead, they are effectively dictated by a seller with superior size and organization. These observations, however, are less valid when the buyer is a business entity with the capability to engage in genuine bargaining with sellers. Because the realities surrounding the sale differ from situation to situation, and because some theories of recovery are more hospitable to contractual limitation than others, the law on product liability disclaimers and remedy limitations is complicated. We begin by discussing implied warranty disclaimers. Then we examine disclaimers of express warranty liability, negligence liability, strict liability, and liability under the Restatement (Third), before considering remedy limitations separately.

Implied Warranty Disclaimers The Basic Tests of UCC § 2-316(2) UCC § 2-316(2) makes it relatively easy for sellers to disclaim the implied warranties of merchantability and fitness for a particular purpose. The section states that to exclude or modify the implied warranty of merchantability, a seller must (1) use the word merchantability and (2) make the disclaimer conspicuous if it is written. To exclude or modify the implied warranty of fitness, a seller must (1) use a writing and (2) make the disclaimer conspicuous. A disclaimer is conspicuous if it is written so that a reasonable person ought to have noticed it. Capital letters, larger type, contrasting type, and contrasting colors usually suffice. Unlike the fitness warranty disclaimer, a disclaimer of the implied warranty of merchantability can be oral. Although disclaimers of the latter warranty must use the word merchantability, no special language is needed to disclaim the implied warranty of fitness. For example, a conspicuous written statement that “THERE ARE NO WARRANTIES THAT EXTEND BEYOND THE DESCRIPTION ON THE FACE HEREOF” disclaims the implied warranty of fitness but not the implied warranty of merchantability. Other Ways to Disclaim Implied Warranties: § 2-316(3)  According to UCC § 2-316(3)(a), sellers may also disclaim either implied warranty by using such terms as “with all



Chapter Twenty Product Liability

faults,” “as is,” and “as they stand.” Some courts have held that these terms must be conspicuous to be effective as disclaimers. Other courts have allowed such terms to be effective disclaimers only in sales of used goods. The Wilke case, which follows, illustrates the application of an “as is” disclaimer. UCC § 2-316(3)(b) describes two situations in which the buyer’s inspection of the goods or her refusal to inspect may operate as a disclaimer. If a buyer examines the goods before the sale and fails to discover a defect that should have been reasonably apparent to her, there can be no implied warranty claim based on that defect. Also, if a seller requests that the buyer examine the goods and the buyer refuses, the buyer cannot base an implied warranty claim on a defect that would have been reasonably apparent had she made the inspection. The definition of a reasonably apparent defect varies with the buyer’s expertise. Unless the defect is blatantly obvious, ordinary consumers have little to fear from § 2-316(3)(b). Finally, UCC § 2-316(3)(c) says that an implied warranty may be excluded or modified by course of dealing (the parties’ previous conduct), course of performance (the parties’ previous conduct under the same contract), or usage of trade (any practice regularly observed in the trade). For example, if it is accepted in the local cattle trade that buyers who inspect the seller’s cattle and reject certain animals must accept all

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defects in the cattle actually purchased, such buyers cannot mount an implied warranty claim regarding those defects. Unconscionable Disclaimers From the previous discussion, it seems that any seller who retains a competent attorney can escape implied warranty liability at will. A seller’s ability to disclaim implied warranties sometimes is restricted, however, by the doctrine of unconscionability established by UCC § 2-302 and discussed in Chapter 15. In appropriate instances, courts may apply § 2-302’s unconscionability standards to implied warranty disclaimers even though those disclaimers satisfy UCC § 2-316(2). Despite a growing willingness to protect smaller firms that deal with corporate giants, however, courts still tend to reject unconscionability claims where business parties have contracted in a commercial context. Implied warranty disclaimers are more likely to be declared unconscionable in personal injury cases brought by ordinary consumers. In the Wilke case, the court upholds an implied warranty disclaimer and declines to hold that the disclaimer violated public policy even though one of the plaintiffs suffered personal injury. The court emphasizes, however, that the implied warranty disclaimer would not protect the defendant against possible liability for negligent failure to inspect the product (there, a van) before selling it to the plaintiffs.

Wilke v. Woodhouse Ford, Inc.   774 N.W.2d 370 (Neb. 2009) Elizabeth and Mark Wilke purchased a used 2002 Ford Econoline cargo van from Woodhouse Ford, Inc. in 2004. Besides stating that the van was used, the parties’ purchase agreement stated in bold type that the van was being sold “AS IS” and “WITHOUT ANY WARRANTY.” The agreement further provided, in a smaller font, that “DEALER HEREBY EXPRESSLY DISCLAIMS ALL WARRANTIES, EXPRESS OR IMPLIED, INCLUDING ANY IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE.” Woodhouse made no affirmative representations to the Wilkes regarding the condition or quality of the van. Immediately after purchasing the van, the Wilkes drove to the home of a friend. Mark parked the van in the friend’s driveway, which was slightly sloped. Mark did not apply the emergency brake after he parked the van. [In a deposition provided in connection with the litigation described below,] he testified that after parking the van, he took the key out of the ignition and put the key in his pocket. Elizabeth testified in her deposition that she did not hear any chimes or buzzers indicating that the key had been left in the ignition. After Mark parked the van, the Wilkes began showing it to their friend. Mark opened the driver’s-side door and the two doors in the back of the van. Elizabeth testified in her deposition that as they were talking to their friend, she saw their daughter climbing into the driver’s seat. Elizabeth immediately screamed for her daughter to get down and ran to the driver’s side of the van. Elizabeth testified that as she approached the side of the van, she saw her daughter with her left hand on the steering wheel and her right hand on the gearshift. Elizabeth heard a “clunk,” and then the van started rolling backward. As the van rolled backward, Elizabeth was hit by the open door. The force caused her to fall backward. Her head struck the pavement and the van’s left front tire rolled over her right foot and thigh. Mark managed to stop the van from rolling by entering the van through the open back doors, diving for the brake pedal, and depressing it with his hand. Elizabeth was taken by ambulance to a hospital. Mark testified in his deposition that he did not know which gear the van was in as it rolled over Elizabeth, but that he knew the gearshift was not “aligned with the P” [for “park”].

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A deputy sheriff who responded to a call regarding the accident filed a report stating that “Vehicle was discovered to have a defective shift lever that was able to be shifted out of park mode without depressing brake pedal.” Donald Jeffers, an automotive engineering consultant and the Wilkes’s expert witness, conducted an investigation of the accident and prepared a report on his findings. According to the Federal Motor Vehicle Safety Standards relied upon by Jeffers, vehicles that have an automatic transmission with a “park” position must “‘prevent removal of the key unless the transmission or transmission shift lever is locked in “park” as the direct result of removing the key.’” The purpose of this feature is “‘to reduce the incidence of crashes resulting from the rollaway of parked vehicles with automatic transmissions as a result of children moving the shift mechanism out of the “park” position.’” After the accident, Elizabeth’s father took the van to Woodhouse for the first of two repairs. Woodhouse adjusted the linkage on the gearshift in case it was not going into “park” completely. A Woodhouse employee involved in the repair testified in his deposition that there was excessive play in the gearshift. He stated that “[y]ou could move the lever up and down excessively but not actually physically get it out of gear.” He further testified that although there was free play in the gearshift, the transmission would not shift from park to reverse without the key in the ignition. According to Mark, the transmission continued to shift out of park without the key in the ignition after the first Woodhouse repair. He therefore returned the van to Woodhouse for further repair. Even though Woodhouse employees reportedly could not duplicate the complained-about problem of being able to shift the van out of park without the key in the ignition and the brake depressed, they replaced the bushings and adjusted the shifter cable. Mark testified that after the second repair, he could not get the gearshift to come out of park without the key in the ignition and the brake pedal depressed. The gearshift on the van thus seemed to work properly after the second repair. Based on his review and investigation, Jeffers concluded that “[t]hree separate failure modes caused and contributed” to the accident. According to his report, the brake shift interlock system failed, the transmission shift cable was misadjusted, and the key shift interlock failed or malfunctioned. It was undisputed that the van was not inspected by Woodhouse employees prior to the Wilkes’s purchase. Woodhouse employees explained in deposition testimony that because of the high volume of vehicles traded in, there are times when the service department does not inspect used vehicles before they are resold. The Wilkes sued Woodhouse in a Nebraska district court in an effort to obtain suitable compensatory damages, including damages for Elizabeth’s injuries. They pleaded two theories: that the van was unmerchantable and that Woodhouse therefore breached the UCC’s implied warranty of merchantability; and that Woodhouse negligently failed to inspect the van prior to selling it. Woodhouse sought summary judgment, maintaining that it had effectively disclaimed the implied warranty of merchantability and that the plaintiff’s negligence claim was without merit. The district court granted Woodhouse summary judgment, and the Wilkes appealed. The Supreme Court of Nebraska moved the case to its docket from that of the state’s intermediate court of appeals pursuant to statutory authority permitting the Supreme Court to do so in order to regulate the caseload of the intermediate appellate court.

McCormack, Judge This case presents two issues: (1) whether a car dealer can exclude through the use of an “as is” clause the implied warranty of merchantability, and (2) whether a car dealer has a duty to inspect used vehicles for safety defects prior to selling the vehicle. Implied Warranty of Merchantability Claim The Wilkes’ breach of warranty claim arises from the law of sales as codified in the Uniform Commercial Code (UCC). Under the UCC, warranties relating to goods sold can be either express or implied. Under UCC § 2-314: (1) Unless excluded or modified (section 2-316), 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. . . .

(2) Goods to be merchantable must be at least such as. . . . (c) are fit for the ordinary purposes for which such goods are used[.] The Wilkes contend that Woodhouse breached [the implied] warranty of merchantability with respect to the van it sold to them. As noted in the statutory language defining an implied warranty of merchantability, it exists “unless excluded or modified.” Section 2-316(3)(a) provides: “[U]nless the circumstances indicate otherwise, all implied warranties are excluded by expressions like ‘as is,’ ‘with all faults’ or other language which in common understanding calls the buyer’s attention to the exclusion of warranties and makes plain that there is no implied warranty.” The purchase agreement evidencing the sale of the van from Woodhouse to the Wilkes included a conspicuous statement that it was sold “as is,” “without any warranty either expressed or implied,”



Chapter Twenty Product Liability

and further stated that Woodhouse was disclaiming any implied warranty of merchantability. This language met the requirements of § 2-316(2) and (3)(a) for excluding an implied warranty of merchantability. The Wilkes argue, however, that exclusion of an implied warranty of merchantability with respect to a safety defect would violate public policy and therefore should not be enforced by a court. In support of their argument, the Wilkes cite to general propositions defining public policy as restrictions on the freedom to contract in order to prevent acts injurious to the public. But we have also explained that it is the function of the legislature, through the enactment of statutes, to declare what is the law and public policy of this state. And our legislature has provided, in § 2-316, that the implied warranty of merchantability may be disclaimed or excluded. The provisions of the UCC which permit a seller to exclude warranties make no exception for warranties relating to the safety of the product. We conclude that the use of an “as is” clause to exclude the implied warranty of merchantability cannot be against the public policy of this state when it mirrors the statutory requirements specifically allowing for such exclusion. Section 2-316 is the legislature’s clear expression of the public policy of this state. Therefore, the purchase agreement effectively disclaimed and excluded any implied warranties for the vehicle. As such, the district court properly entered summary judgment in favor of Woodhouse on the Wilkes’ cause of action for breach of the implied warranty of merchantability. Negligence Claim The Wilkes also alleged a theory of recovery based on negligence. A negligence claim focuses on the seller’s conduct. A common law duty exists to use due care so as not to negligently injure another person. The absence of implied warranties [from the parties’ transaction] does not absolve Woodhouse from any potential liability resulting from its failure to exercise reasonable care. In other words, nothing in the statutes dealing with exclusion of implied warranties allows for the exclusion of tort liability. The Wilkes alleged that Woodhouse was negligent because it failed to reasonably inspect the van for safety defects prior to its sale and that but for such negligence, Elizabeth would not have sustained her injuries by being run over by the van. Ordinary negligence is defined as the doing of something that a reasonably careful person would not do under similar circumstances, or the failing to do something that a reasonably careful person would do under similar circumstances. In order to prevail in a negligence action, there must be a legal duty on the part of the defendant to protect the plaintiff from injury, a failure to discharge that duty, and damage proximately caused by the failure to discharge that duty. Woodhouse first maintains that it had no duty to inspect the van prior to its sale. When determining whether a legal duty

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exists, a court employs a risk-utility test concerning (1) the magnitude of the risk, (2) the relationship of the parties, (3) the nature of the attendant risk, (4) the opportunity and ability to exercise care, (5) the foreseeability of the harm, and (6) the policy interest in the proposed solution. The existence of a duty and the identification of the applicable standard of care are questions of law, but the ultimate determination of whether a party deviated from the standard of care and was therefore negligent is a question of fact. To resolve the issue, a finder of fact must determine what conduct the standard of care would require under the particular circumstances presented by the evidence and whether the conduct of the alleged tortfeasor conformed with the standard. We have never before addressed whether a used-car dealer has a duty to its customers to inspect vehicles for safety defects before they are sold. Most courts which have considered the issue have recognized a limited duty on the part of the dealer to inspect for patent safety defects existing at the time of sale. For example, Minnesota courts have held that the seller of a used vehicle intended for use upon the public highways has a duty to the public using such highways to exercise reasonable care in supplying the purchaser with a vehicle which will not constitute a menace or source of danger, so that liability attaches to the seller for injuries which are the result of patent defects in the vehicle, or defects which could have been discovered in the exercise of reasonable care. Ohio courts have held that even when a dealer sells a used vehicle “as is,” the dealer has a duty to exercise reasonable care in examining the vehicle to discover defects which would make the vehicle dangerous to users or those who might come in contact with them, and upon discovery, to correct those defects or at least give warning to the purchaser. The Montana Supreme Court has held that a used-car dealer had a duty to inspect a vehicle for safety defects prior to sale, notwithstanding the fact that the vehicle was sold “as is.” The court reasoned: When the ordinary person purchases a car “as is,” he expects to have to perform certain repairs to keep the car in good condition. He does not expect to purchase a death trap. Public policy requires a used car dealer to inspect the cars he sells and to make sure they are in safe, working condition. This duty cannot be waived by the use of a magic talisman in the form of an “as is” provision. But courts which have recognized a duty on the part of used car dealers to inspect for safety defects prior to sale have also emphasized that the duty is limited. Courts have stated that used-car dealers are not insurers and therefore are not liable for latent defects in the vehicle. Courts have limited the duty to inspect for patent defects affecting the minimum essentials for safe operation of the vehicle. Dealers are not required to disassemble the vehicle to inspect for latent defects, and they are not responsible for the continuing safety of the vehicles they sell.

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Applying our risk-utility test for the existence of a legal duty to use reasonable care, we conclude that there is a relatively great magnitude of risk of injury in the circumstance where an unknowing buyer drives off the dealer’s lot in a used vehicle which has a patent safety defect, such as defective brakes or steering. The dealer is better equipped than the purchaser to perceive such a defect before it causes harm. The nature of the risk is such that personal injury or death could result not only with respect to the purchaser of the defective vehicle, but to other members of the motoring public. The dealer has the earliest opportunity to discover and repair a patent safety defect in a used vehicle. An unknown safety defect existing at the time of sale poses foreseeable harm to the purchaser and the general public, and there exists a policy interest in requiring reasonable conduct on the part of the dealer to prevent such harm. We, therefore, hold that a commercial dealer of used vehicles intended for use on public streets and highways has a duty to conduct a reasonable inspection of the vehicle prior to sale in order to determine whether there are any patent defects existing at the time of sale which would make the vehicle unsafe for ordinary operation and, upon discovery of such a defect, to either repair it or warn a prospective purchaser of its existence. The dealer has no duty to disassemble the vehicle to discover latent defects or to anticipate the future development of safety defects which do not exist at the time of sale. The tort duty we recognize today is not affected by a valid disclaimer or exclusion of UCC warranties, because such contractual provisions do not absolve a seller from exercising reasonable care to prevent foreseeable harm. Tort liability is not based upon representations or warranties. Rather, it is based upon a duty imposed by the law upon one who may foresee that his or her actions or failure to act may result in injury to others. That being the case, whether or not the court properly entered summary judgment in favor of Woodhouse depends upon whether Woodhouse breached this duty. It is undisputed that Woodhouse did not inspect the van prior to selling it. However, that alone does not rise to the level of a breach of the applicable standard of care, because its duty extends only to patent, not to latent, defects. Thus, a breach of duty occurred if a reasonable inspection would have revealed the alleged defect in the gearshift. This is a question of fact that must be decided by the fact finder. The record presents conflicting testimony as to whether the gearshift malfunctioned occasionally or regularly. As such, there is a genuine issue of material fact (and thus a jury question as to) whether a reasonable inspection of the van would have revealed any alleged defect. Woodhouse argues that even if there is a duty that was breached, there is no material issue of fact that Woodhouse was not the proximate cause of the accident. Determination of causation is, ordinarily, a matter for the trier of fact. To establish proximate cause, the plaintiff must meet three basic requirements:

(1) Without the negligent action, the injury would not have occurred, commonly known as the “but for” rule; (2) the injury was a natural and probable result of the negligence; and (3) there was no efficient intervening cause. Assuming that Woodhouse breached its duty to reasonably inspect, Woodhouse proximately caused the vehicle to be placed into the hands of the Wilkes with a defect that could have been discovered by a reasonable inspection. This defect undoubtedly existed at the time of sale. And it is undisputed that the van was not altered in any way prior to the incident. But Woodhouse first argues that Mark’s failure to set the parking brake was the proximate cause of the accident. In doing so, however, Woodhouse confuses the concepts of proximate causation and contributory negligence. Woodhouse is really arguing that Mark was contributorily negligent by not using the parking brake. Whether or not the Wilkes were contributorily negligent to the point where recovery is precluded is a question for the trier of fact, and Woodhouse’s allegations regarding Mark’s failure to implement the parking brake are insufficient to warrant summary judgment in Woodhouse’s favor. Second, Woodhouse argues that the Wilkes’ daughter was the proximate cause of the accident because she manipulated the gearshift, causing the accident. Essentially, Woodhouse is arguing that viewing the facts in the light most favorable to the Wilkes, the daughter’s actions constituted an efficient intervening cause, warranting judgment as a matter of law in its favor. An efficient intervening cause is new and independent conduct of a third person, which itself is a proximate cause of the injury in question and breaks the causal connection between the original conduct and the injury. But if a third party’s negligence is reasonably foreseeable, then the third party’s negligence is not an efficient intervening cause as a matter of law. A jury could find that it is foreseeable that an accident could occur if a young child was able to take the vehicle out of park without the key in the ignition and the brake pedal depressed. We conclude that Woodhouse effectively disclaimed all implied warranties, including the warranty of merchantability. But we also conclude that commercial dealers of used vehicles have a duty to exercise reasonable care to discover any existing safety defects that are patent or discoverable in the exercise of reasonable care or through reasonable inspection. Because there are genuine issues of material fact as to whether Woodhouse breached its duty of care and, if so, whether Woodhouse’s breach was the proximate cause of Elizabeth’s injuries, we conclude that the district court incorrectly granted summary judgment in favor of Woodhouse on the Wilkes’ negligence claim. District court’s grant of summary judgment in favor of Woodhouse affirmed as to breach of implied warranty of merchantability claim but reversed as to negligence claim; case remanded for further proceedings.



Chapter Twenty Product Liability

The Impact of Magnuson-Moss The Magnuson-Moss Act also limits a seller’s ability to disclaim implied warranties. If a seller gives a consumer a full warranty on consumer goods whose price exceeds $10, the seller may not disclaim, modify, or limit the duration of any implied warranty. If a limited warranty is given, the seller may not disclaim or modify any implied warranty but may limit its duration to the duration of the limited warranty if this is done conspicuously and if the limitation is not unconscionable. These are significant limitations on a seller’s power to disclaim implied warranties. Presumably, however, a seller still can disclaim by refusing to give a written warranty while placing the disclaimer on some other writing.

Express Warranty Disclaimers UCC § 2-316(1) says that an express warranty and a disclaimer should be read consistently if possible, but that the disclaimer must yield if such a reading is unreasonable. Because it normally is unreasonable for a seller to exclude with one hand what he has freely and openly promised with the other, it is quite difficult to disclaim an express warranty.

Disclaimers of Tort Liability Disclaimers

of negligence liability and strict liability are usually ineffective in cases involving ordinary consumers. However, some courts enforce such disclaimers where both parties are business entities that (1) dealt in a commercial setting, (2) had relatively equal bargaining power, (3) bargained over the product’s specifications, and (4) negotiated the risk of loss from product defects (e.g., the disclaimer itself). Even though it has a provision that seems to bar all disclaimers, the same should be true under the Restatement (Third).

Limitation of Remedies In view of the expense

they can create for sellers, consequential damages are the usual target of remedy limitations. When a limitation of consequential damages succeeds, buyers of the product may suffer. For example, suppose that Dillman buys a computer system for $20,000 under a contract that excludes consequential damages and limits the buyer’s remedies to the repair or replacement of defective parts. Suppose also that the system never works properly, causing Dillman to suffer $10,000 in lost profits. If the remedy limitation is enforceable, Dillman could only have the system replaced or repaired by the seller and could not recover his $10,000 in consequential damages. In tort cases, the tests for the enforceability of remedy limitations resemble the previous tests for tort liability disclaimers. Under the UCC, however, the standards for remedy limitations differ from those for disclaimers. UCC

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§ 2-719 allows the limitation of consequential damages in express and implied warranty cases unless the limitation of remedy “fails of its essential purpose” or is unconscionable. The section adds that a limitation of consequential damages is very likely to be unconscionable where the sale is for consumer goods and the plaintiff has suffered personal injury. Where the loss is “commercial,” however, the limitation may or may not be unconscionable. Whether a limitation of remedy “fails of its essential purpose” depends on all of the relevant facts and circumstances. For instance, a court concluded that a limitation of remedy in a contract for the sale of a motor home failed of its essential purpose when a collection of problems caused the motor home to be out of service for 162 days during the first year after the buyer purchased it.5 In the Lincoln Composites case, which follows, the court considers whether a limited remedy provision calling for repair or replacement of fire-detection tubing failed of its essential purpose and therefore entitled the plaintiff to pursue damages remedies.

Defenses Various matters—for example, the absence of privity or a valid disclaimer—can be considered defenses to a product liability suit. Here, however, our initial concern is with product liability defenses that involve the plaintiff’s behavior. Although the Restatement (Third) has a “comparative responsibility” provision that apportions liability among the plaintiff, the seller, and distributors, and various states have similar rules, the following discussion is limited to two-party situations.

The Traditional Defenses Traditionally,

the three main defenses in a product liability suit have been the overlapping trio of product misuse, assumption of risk, and contributory negligence. Product misuse (or abnormal use) occurs when the plaintiff uses the product in some unusual, unforeseeable way, and this causes the loss for which he sues. Examples include ignoring the manufacturer’s instructions, mishandling the product, and using the product for purposes for which it was not intended. If, however, the defendant had reason to foresee the misuse and failed to take reasonable precautions against it, there is no defense. Product misuse traditionally has been a defense in warranty, negligence, and strict liability cases.

Pack v. Damon Corp., 2006 U.S. App. LEXIS 2303 (6th Cir. Jan.5, 2006).

5

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CYBERLAW IN ACTION In earlier chapters, you learned about shrinkwrap and clickwrap contracts, which are often used in sales of computer hardware and licenses of software and in establishing terms of use for access to networks and websites. It is extremely common for these shrinkwrap or clickwrap contracts to contain warranty disclaimers and limitation of remedy clauses. For some examples of how these disclaimers and limitations of remedy look, see Warranty and Liability Disclaimer Clauses in Current Shrinkwrap and Clickwrap Contracts, www.cptech.org/ecom/ucita/licenses/ liability.html. The courts that have considered the enforceability of clickwrap or shrinkwrap warranty disclaimers or limitations of remedy have upheld them. For example, in M. A. Mortenson Company, Inc. v. Timberline Software Corp., 998 P.2d 305 (Wash. 2000), Mortenson, a general contractor, purchased Timberline’s licensed software and

used it to prepare a construction bid. Mortenson later discovered that its bid was $1.95 million too low because of a malfunction of the software. When Mortenson sued Timberline and others for breach of warranty, Timberline asserted that the limitation of remedies clause contained in the software license, which limited Mortenson’s remedies to the purchase price of the software, prevented Mortenson from recovering any consequential damages caused by a defect in the software. Although Mortenson contended that it never saw or agreed to the terms of the license agreement, the Washington Supreme Court held that the terms of the license became part of the parties’ contract. The terms were set forth or referenced in various places, such as the shrinkwrap packaging for the program disks, the software manuals, and the protection devices for the software. Applying the principle that limitations of remedy are generally enforceable unless they are unconscionable, the court found the limitation of remedies clause to be enforceable.

Lincoln Composites, Inc. v. Firetrace USA, LLC   825 F.3d 453 (8th Cir. 2016) Lincoln Composites, Inc. manufactures composite tanks for the storage and transport of natural gas in places where pipelines are unavailable. Firetrace USA, LLC makes custom-designed fire suppression systems that detect and suppress fires. In a series of transactions, Lincoln purchased fire-detection tubing from Firetrace. Lincoln then installed this tubing in its Titan Module tanks. There was no dispute that through these transactions, the parties entered into a contract for the purchase and delivery of Firetrace’s tubing. Some of the tubing later proved to be defective. Despite Firetrace’s repeated attempts to fix the defect, the tubing failed, resulting in natural gas being vented into the air when there was not a fire. After 18 months, Lincoln decided that it could no longer use the Firetrace tubing and demanded that Firetrace refund the purchase price. Firetrace refused, contending that the contract was governed by Firetrace’s written terms and conditions, which limited remedies to repair or replacement of the tubing. Lincoln then sued Firetrace in Nebraska state court on various grounds, including breach of express warranty. Firetrace removed the case to federal court. At the conclusion of the trial in the U.S. District Court for the District of Nebraska, the jury returned a verdict in favor of Lincoln. Having concluded that Firetrace breached an express warranty to Lincoln, the jury awarded damages in the amount of $920,227.76. Firetrace moved for a new trial on the merits and either a new trial on damages or a remittitur on damages (i.e., a reduction in the damages amount). When the federal district court denied Firetrace’s post-trial motions, Firetrace appealed to the U.S. Court of Appeals for the Eighth Circuit.

Kelly, Circuit Judge Firetrace first asserts it is entitled to a new trial because the jury’s finding that it breached an express warranty to Lincoln is against the weight of the evidence. “When the basis of the motion for a new trial is that the jury’s verdict is against the weight of the evidence, the district court’s denial of the motion is virtually unassailable on appeal.” [Citation omitted.] Because this is a diversity action, we apply the substantive law of the forum state, in this case, Nebraska. Under Nebraska law, the existence and scope of an express warranty is one of fact. [The

jury resolved this question by determining that an express warranty was both made and breached. Moreover, the district court’s denial of the new trial motion suggests that the court regarded the jury’s conclusions as supported by the evidentiary record. On appeal, the Eighth Circuit will not second-guess that conclusion.] [Although Firetrace does not agree that it breached an express warranty, Firetrace agrees that its written contract terms] provided an express warranty. [Firetrace stresses, however, that] upon a breach of the express warranty, Firetrace’s terms limited



Chapter Twenty Product Liability

Lincoln’s remedies to repair or replacement of any defective tubing. [Therefore, Firetrace contends, Lincoln should not have been awarded damages.] [Despite their disagreements over the outcome in the district court], the parties agree that by finding that Firetrace breached an express warranty to Lincoln and awarding damages to Lincoln, the jury must have decided . . . that the exclusive repair or replace remedy failed of its essential purpose, making a remedy of damages available. Firetrace argues that [the jury] erroneously concluded that Firetrace’s limited remedy of repair or replace failed of its essential purpose. Nebraska law allows a seller to establish exclusive limited warranties, as well as to limit the availability of damages. See Neb. UCC § 2-719. But, “[w]here circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this act.” Id. As explained in the comments to §  2-719, “where an apparently fair and reasonable clause because of circumstances fails in its purpose or operates to deprive either party of the substantial value of the bargain, it must give way to the general remedy provisions of this article.” Id. cmt. 1. “Where a seller is given a reasonable chance to correct defects and the equipment still fails to function properly, the limited remedy of repair or replacement of defective products fails of its essential purpose.” Id. If this happens, the buyer may invoke any remedies available under the UCC, including damages. Id. The district court concluded that a reasonable jury could find that Firetrace’s limited remedy of repair or replacement failed of its essential purpose when Firetrace was not able to repair the tubing properly within a reasonable time. Don Baldwin, Lincoln’s engineering director, testified that he worked on the Titan Modules beginning in 2008. Baldwin described the repeated failures of the tubing and Firetrace’s multiple unsuccessful attempts, over the course of a year and a half, to provide tubing that did not fail. An expert in engineering and plastics testified about how and why the tubing failed. He testified that the failures were the result of manufacturing defects [and] that the Firetrace tubing still in Titan Modules out in the field also would fail at some point. Whether Lincoln was deprived of the substantial value of its contract by Firetrace’s limited remedy of repairing and replacing the tubing was a question for the jury. The district court did not abuse its discretion when it denied Firetrace’s motion for a new trial because there was sufficient evidence for a reasonable jury to find that Firetrace’s limited repair or replace remedy failed of its essential purpose. Firetrace argues that it is entitled to a new trial because the district court erred in . . . its instructions to the jury. We generally review a district court’s jury instructions for an abuse of discretion. Our review is limited to determining “whether the

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instructions, taken as a whole and viewed in the light of the evidence and applicable law, fairly and accurately submitted the issues to the jury.” [Citation omitted.] At the final instruction conference, the district court informed the parties it would instruct the jury as follows: To show that the limited remedy of repair and replacement has failed of its essential purpose, Lincoln Composites must prove all of the following elements by the greater weight of the evidence: 1. That Lincoln Composites provided Firetrace with a reasonable opportunity to fix the defects in the tubing; 2. That despite Firetrace’s attempts to fix the defects or provide replacement tubing, the tubing still failed to function properly; and 3. That this deprived Lincoln Composites of the substantial value of its contract with Firetrace. It is for you to decide how many attempts were needed, and what was a reasonable time frame in which to remedy the defect, before the remedy would fail of its essential purpose, if it did. [In deciding to give the above instruction, the court rejected Firetrace’s proposed jury instruction. Firetrace’s proposed instruction matched the above instruction in its introductory language and in itemized points 1, 2, and 3, but offered this different concluding sentence:] The mere fact that a defect is not properly remedied after the first attempt, or even multiple attempts to repair or replace it does not mean the warranty failed its essential purpose. Additionally, if Defendant stands ready to perform, there is no failure of essential purpose, even though the buyer remains highly unsatisfied with the results obtained by the limited remedy. Finally, a repair or replace remedy does not fail of its essential purpose so long as repairs are made each time a defect arises. Firetrace asserts that its proposed instruction more closely follows the law of Nebraska. We disagree. Although Nebraska law allows a seller to limit a buyer’s remedies to repair and replacement, the Nebraska Supreme Court has stated that “[t]he purpose of an exclusive remedy of ‘repair or replacement’ from a buyer’s viewpoint is to give him goods which conform to the contract within a reasonable time after a defect is discovered.” John Deere Co. v. Hand, 319 N.W.2d 434, 437 (Neb. 1982). “Where the seller is given a reasonable chance to correct defects and the equipment still fails to function properly, the limited remedy of repair or replacement of defective parts fails of its essential purpose.” Id. The court’s jury instruction was a correct statement of Nebraska law and recognized that the key issue for the jury to

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decide was whether Firetrace was given a reasonable amount of time in which to correct defects in the tubing. Accordingly, we conclude that the district court did not plainly err in not giving Firetrace’s proposed instruction. Firetrace argues that the district court erred by not granting its motion for a remittitur or new trial on damages, alleging ­Lincoln did not present sufficient evidence to support the amount of damages awarded by the jury. Under the Nebraska UCC, the measure of direct damages for the breach of an express warranty “is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted. . . .” Neb. UCC § 2-714(2). “The measure set forth in § 2-714 is the equivalent of what is known as the diminished value rule.” T.O. Haas Tire Co., Inc. v. Futura Coatings, Inc., 507 N.W.2d 297, 304 (Neb. Ct. App. 1993). A buyer asserting a breach of warranty under the UCC has the burden to prove damages. “[The buyer does not have to] prove damages with mathematical certainty, but the evidence must be sufficient to allow the trier of fact to estimate the actual damages with reasonable certainty.” [Citation omitted.] The jury found that the value of the tubing as warranted was $857,334.48 and that the value of the tubing as received was zero. Firetrace does not dispute the jury’s conclusion of the value of the tubing as warranted, but argues Lincoln failed to prove that the tubing as received had no value. Firetrace claims the only evidence Lincoln offered to support its claim was the testimony of its President and CEO, John Schimenti. Schimenti testified that the tubing had no value to Lincoln. Firetrace argues that this evidence, by itself, was insufficient to support the jury’s award. But Schimenti also testified that the [already installed tubing] had to be removed and that Lincoln would not charge customers for the removal. Don Baldwin, an engineering director at Lincoln, also testified the tubing had no value to Lincoln because of “inadvertent releases”—that is, random releases of large amounts of natural gas into the atmosphere due to the tubing falsely “detecting” a fire that . . . would require evacuations of neighborhoods. Baldwin testified that Lincoln felt obligated to replace all the previously installed Firetrace tubing before it failed because of this risk. In addition, Lincoln’s expert [witness] testified that he believed all of the remaining tubing would fail at some point. Firetrace concedes that this testimony might demonstrate there was a latent defect in the tubing but asserts that it did not address the value of the tubing. Firetrace contends that it presented evidence from which a reasonable jury could find that most of the tubing had not failed, giving the tubing at least some

salvage value, and points out that Lincoln passed on the cost of the Firetrace tubing to its buyers. As the district court noted, however, the determination of whether even a low risk of failure rendered the tubing worthless to Lincoln was a question for the jury. “In determining whether to grant a new trial, a district judge is not free to reweigh the evidence and set aside the jury verdict merely because the jury could have drawn different inferences or conclusions or because judges feel that other results are more reasonable.” [Citation omitted.] Firetrace’s arguments to the jury may have been compelling, but the jury’s verdict is not so against the great weight of the evidence as to rise to the level of a miscarriage of justice or so excessive as to shock the judicial conscience. Under the circumstances, the district court did not abuse its discretion in denying Firetrace’s motion for remittitur or new trial. Firetrace also challenges the jury’s award of $62,893.29 in consequential damages because at least some of the award was for future replacement of tubing that Firetrace asserts was no longer under warranty, calling into question whether Lincoln would continue to replace that  tubing. Lincoln presented evidence through two of its engineers . . . about travel and labor expenses Lincoln had already incurred in replacing tubing previously installed in Titan Modules. [One engineer] estimated that Lincoln would incur an additional $57,140.00 in future costs to replace the remaining tubing, based on Lincoln’s estimate that it would take four trips of 7–10 days each to replace the tubing in all the modules located in Vietnam and a separate trip of 7–10 days to replace the tubing in 5 modules in Peru. Lincoln presented sufficient evidence as to the cost of travel and labor expenses it has incurred and will incur in the future to replace the Firetrace tubing to support the consequential damages awarded by the jury. Under Nebraska law, damages need not be proved with mathematical certainty. It was the jury’s responsibility to weigh the evidence and determine whether Lincoln would ultimately replace the tubing in all these modules and at what cost. Firetrace’s challenge to the estimate of Lincoln’s future consequential damages is in essence an attack on the jury’s credibility determinations. Firetrace asks us to make a factual finding that, despite its witnesses’ testimony to the contrary, Lincoln did not intend to replace the Firetrace tubing still remaining in Titan Modules. We decline to second-guess the jury’s credibility determinations, and the district court did not abuse its discretion in denying Firetrace’s motion for remittitur or a new trial on the award of consequential damages. Jury verdict and district court judgment in favor of Lincoln affirmed. 



Chapter Twenty Product Liability

Assumption of risk, discussed in Chapter 7, is the plaintiff’s voluntary consent to a known danger. It can occur anytime the plaintiff willingly exposes herself to a known product hazard—for example, by consuming obviously adulterated food. As with product misuse, assumption of risk ordinarily has been a defense in warranty, negligence, and strict liability cases. Contributory negligence, also discussed in Chapter 7, is the plaintiff’s failure to act reasonably and prudently. In the product liability context, perhaps the most common example is the simple failure to notice a hazardous product defect. Contributory negligence is a defense in a negligence case (if state law has not replaced the contributory negligence defense with the comparative rules discussed below), but courts have disagreed about whether or when it should be a defense in warranty and strict liability cases.

Comparative Principles  escribe the role of comparative negligence and D comparative fault principles in cases in which fault LO20-13 on the part of the defendant and on the part of the plaintiff led to the harm experienced by the plaintiff.

Where they are allowed and proven, the three traditional product liability defenses completely absolve the defendant from liability. Dissatisfaction with this allor-nothing situation has spurred the increasing use of comparative principles in product liability cases.6 Rather than letting the traditional defenses completely absolve the defendant, nearly all states now require apportionment of damages on the basis of relative fault. They do so by requiring that the fact-finder establish the plaintiff’s and the defendant’s percentage shares of the total fault for the injury and then award the plaintiff his total provable damages times the defendant’s percentage share of the fault.

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Unsettled questions persist among the states that have adopted comparative principles. First, it is not always clear what kinds of fault will reduce the plaintiff’s recovery. Some state comparative negligence statutes, however, have been read as embracing assumption of risk and product misuse, and state comparative fault statutes usually define fault broadly. Second, comparative principles may assume either the pure or the mixed forms described in Chapter 7. In “mixed” states, for example, the defendant has a complete defense when the plaintiff was more at fault than the defendant. There is also some uncertainty about the theories of recovery and the types of damage claims to which comparative principles apply. In Green v. Ford Motor Co., which follows, the plaintiff claimed that the vehicle manufactured by the defendant was not “crashworthy.” (The crashworthiness doctrine receives discussion earlier in the chapter.) The plaintiff further contended that the defendant’s alleged breach of the crashworthiness obligation caused the plaintiff to experience enhanced injuries when an accident occurred—in other words, more extensive injuries than he would have suffered in the accident if the vehicle had been crashworthy. The defendant asserted, however, that the plaintiff’s own fault caused, or played a key role in causing, the accident in which the plaintiff was injured. The court therefore had to decide whether, under the state’s comparative fault system, evidence of the plaintiff’s role in causing the accident should be taken into account even though the plaintiff’s claim was for enhanced injury damages.

Comparative negligence and comparative fault are discussed in ­ Chapter 7. Although courts and commentators often use the terms comparative fault and comparative negligence interchangeably, comparative fault usually includes forms of blameworthiness other than negligence. 6

Green v. Ford Motor Co.   942 N.E.2d 791 (Ind. 2011) Nicholas Green sued Ford Motor Co. in the U.S. District Court for the Southern District of Indiana. Relying on the Indiana Product Liability Act, Green claimed that his Ford Explorer vehicle was defective and unreasonably dangerous and that Ford was negligent in its design of the vehicle’s restraint system. In particular, Green alleged that Ford failed to fulfill its obligation to produce a “crashworthy” vehicle. The case arose from a 2006 accident in which the Explorer left the road, struck a guardrail, rolled down an embankment, and came to rest upside down in a ditch. Green, who was driving the Explorer at the time of the accident, sustained severe injuries and was rendered a quadriplegic. He claimed that his injuries were substantially enhanced because of the alleged defects in the vehicle’s restraint system.

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Green filed a motion in limine in which he asked the court to exclude any evidence of his alleged negligence in operating the vehicle because, in his view, any conduct by him in causing the vehicle to leave the road and strike the guardrail was not relevant to whether Ford’s negligent design of the restraint system caused him to suffer more extensive injuries than he otherwise would have suffered. Ford responded by asserting that Green’s product liability lawsuit was subject to Indiana’s statutory comparative fault principles, which require the jury to consider the fault of Green in causing or contributing to the physical harm he suffered. The federal district court concluded that the question presented by Green’s motion and Ford’s response was not clearly answered by Indiana legislation and case law. At Green’s request, the district court utilized a procedure in which it certified the issue to the Supreme Court of Indiana for its analysis and resolution. The following is an edited version of the opinion issued by the Supreme Court of Indiana.

Dickson, Justice The U.S. District Court for the Southern District of Indiana has certified for our resolution the following issue of Indiana state law: “Whether, in a crashworthiness case alleging enhanced injuries under the Indiana Product Liability Act, the finder of fact shall apportion fault to the person suffering physical harm when that alleged fault relates to the cause of the underlying accident.” As explained more fully below, subject to certain qualifications that require modification of the question, our answer is in the affirmative. The “crashworthiness” doctrine[, on which Green relies in this case,] was enunciated by the Eighth Circuit Court of Appeals in Larsen v. General Motors Corp., 391 F.2d 495, 502 (8th Cir. 1968). Larsen recognized that, in light of the statistical inevitability of collisions, a vehicle manufacturer must use reasonable care in designing a vehicle to avoid subjecting the user to an unreasonable risk of injury in the event of a collision. The court explained that “the manufacturer should be liable for that portion of the damage or injury caused by the defective design over and above the damage or injury that probably would have occurred as a result of the impact or collision absent the defective design.” [The court added that] “[t]he normal risk of driving must be accepted by the user but there is no need to further penalize the user by subjecting him to an unreasonable risk of injury due to negligence in design.” In Miller v. Todd, 551 N.E.2d 1139 (Ind. 1990), this Court expressly recognized the theory of crashworthiness presented in Larsen, noting that “the doctrine of crashworthiness merely expands the proximate cause requirement to include enhanced injuries.” We reasoned that, because it is foreseeable that a vehicle may be involved in collisions, for purposes of product liability law, such occurrences are included in the concept of expected use of a vehicle. [In Indiana cases decided since Miller], claims for enhanced injuries based on alleged uncrashworthiness have been viewed as separate and distinct from the circumstances relating to the initial collision or event. [The focus has been on] the “second collision” involving a manufacturer’s failure to exercise reasonable care in the design of a product to protect its users in light of the likelihood that the product could be involved in an accident. Thus, a claimant could recover only for the enhanced injuries caused

by the lack of reasonable care in designing a crashworthy product. And the fact that the initial collision was not caused by the product’s uncrashworthy design did not preclude such a claim for enhanced injuries. We acknowledge the logical appeal to extend this analysis so as to view any negligence of a claimant in causing the initial collision as therefore irrelevant to determining liability for the “second collision.” But two considerations lead to a contrary conclusion. First, most of the early crashworthiness decisions arose under common law or statutory product liability law that imposed strict liability for which a plaintiff’s contributory negligence was not available as a defense, making it irrelevant in those cases to consider a plaintiff’s contributory negligence. Second, and more important, product liability claims in Indiana are governed by the Indiana Product Liability Act, which, since 1995, has expressly required liability to be determined in accordance with the principles of comparative fault. We find the statutory language to be significant in resolving the question. The appropriate considerations in determining comparative fault are primarily established by statute. The statutory definition of “fault” provides: (a) “Fault,” for purposes of [the Indiana Product Liability Act], means an act or omission that is negligent, willful, wanton, reckless, or intentional toward the person or property of others. The term includes the following:  (1) Unreasonable failure to avoid an injury or to mitigate damages.  (2) A finding under IC 34-20-2 . . . that a person is subject to liability for physical harm caused by a product, notwithstanding the lack of negligence or willful, wanton, or reckless conduct by the manufacturer or seller. (b) “Fault,” for purposes of [the Indiana Comparative Fault Act,] includes any act or omission that is negligent, willful, wanton, reckless, or intentional toward the person or property of others. The term also includes unreasonable assumption of risk not constituting an enforceable express consent, incurred risk, and unreasonable failure to avoid an injury or to mitigate damages. Ind. Code § 34-6-2-45. In evaluating and allocating comparative fault, a jury may also consider “the relative degree of causation



Chapter Twenty Product Liability

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attributable among the responsible actors.” [Citation omitted.] Our statutory scheme thus allows a diverse array of factors to be considered in the allocation of comparative fault. In both the Product Liability Act and the Comparative Fault Act, the [Indiana] legislature employed expansive language to describe the breadth of causative conduct that may be considered in determining and allocating fault. Both enactments require consideration of the fault of all persons “who caused or contributed to cause” the harm. Ind. Code §§ 34-20-8-1(a), 34-51-2-7(b)(1), 34-51-2-8(b) (1). We note that in prescribing the scope of such initial consideration, the legislature employed the phrase “caused or contributed to cause” instead of “proximately caused.” The Comparative Fault Act, however, further specifies that, in comparative fault actions, the “legal requirements of causal relation apply.” Ind. Code § 34-51-2-3. This requirement of proximate cause to establish liability was preserved in the Indiana comparative fault scheme. The legislature has thus directed that a broad range of potentially causative conduct initially may be considered by the fact-finder but that the jury may allocate comparative fault only to those actors whose fault was a proximate cause of the claimed injury. We conclude that, in a crashworthiness case alleging enhanced injuries under the Indiana Product Liability Act, it is the function of the fact-finder to consider and evaluate the conduct of all relevant actors who are alleged to have caused or contributed to cause the harm for which the plaintiff seeks damages. An assertion that a plaintiff is limiting his claim to “enhanced injuries” caused by only the “second collision” does not preclude the fact-finder from considering evidence of all relevant conduct of the plaintiff reasonably alleged to have contributed to cause the injuries. From that evidence, the jury must then, following argument of counsel and proper instructions from the court, determine whether such conduct satisfies the requirement of proximate cause. The

fact-finder may allocate as comparative fault only such fault that it finds to have been a proximate cause of the claimed injuries. And if the fault of more than one actor is found to have been a proximate cause of the claimed injuries, the fact-finder, in its allocation of comparative fault, may consider the relative degree of proximate causation attributable to each of the responsible actors. Thus, while a jury in a crashworthiness case may receive evidence of the plaintiff’s conduct alleged to have contributed to cause the claimed injuries, the issue of whether such conduct constitutes proximate cause of the injuries for which damages are sought is a matter for the jury to determine in its evaluation of comparative fault. As presented, the certified question asks whether the factfinder shall apportion fault to the person suffering physical harm when the alleged fault of the injured person “relates to” the “underlying accident.” As explained above, the fact-finder shall apportion fault to the injured person only if the fact-finder concludes that the fault of the injured person is a proximate cause of (not merely “relates to”) the injuries for which damages are sought (not merely the “underlying accident”). Otherwise, any alleged fault of the injured person is not fault for the purposes of the Product Liability or Comparative Fault Acts and shall not be apportioned. With these qualifications, we revise and restate the certified question as follows: “Whether, in a crashworthiness case alleging enhanced injuries under the Indiana Product Liability Act, the finder of fact shall apportion fault to the person suffering physical harm when that alleged fault is a proximate cause of the harm for which damages are being sought.” We answer this question in the affirmative.

Preemption and Regulatory Compliance 

product’s manufacturer has met those standards? Does the manufacturer’s compliance with the federal standards serve as a defense when a plaintiff brings state law claims such as negligence, strict liability, or breach of implied warranty in an effort to hold the manufacturer liable for supposed defects in product? The answer: Sometimes. The questions just posed, and the indefinite answer just offered, pertain to two potential defenses: the preemption defense and the regulatory compliance defense. The preemption defense rests on a federal supremacy premise—the notion that federal law overrides state law

Identify the circumstances in which a court may conclude that a federal law preempts a state law– LO20-14 based product liability claim and thus furnishes the defendant a defense against liability.

What if Congress—or an administrative agency acting within the scope of power delegated to it by Congress— enacts legislation or promulgates regulations dealing with safety standards for a certain type of product, and the

Certified question, as revised and restated, answered affirmatively.

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when the two conflict or when state law stands in the way of the objectives underlying federal law. Sometimes a federal statute dealing with a certain type of product may contain a provision that calls for preemption of state law–based claims under circumstances specified in the federal law’s preemption provision. In that event, courts must determine whether the plaintiff’s state law–based claim (e.g., negligence, strict liability, or breach of implied warranty) is preempted. Such a determination depends heavily upon the language used in the statute and the specific nature of the plaintiff’s claim. When preemption occurs, the federal law controls and the state law–based claim cannot serve as a basis for relief— meaning that the plaintiff loses. For instance, in Riegel v. Medtronic, Inc., a 2008 decision that follows shortly, the Supreme Court interpreted a preemption provision in the federal statute dealing with medical devices as barring the plaintiffs’ state law–based claims against the manufacturer of an allegedly defective medical device. Even when a federal law dealing with product safety does not contain a preemption section, it is conceivable that courts could interpret the statute as having a pre-emptive effect if the federal law sets up a highly specific regulatory regime that the court believes would be undermined by allowance of liability claims brought under state law. The absence of a specific preemption section from the relevant federal statute, however, makes it less likely that a court would consider a plaintiff’s state law–based claims to be preempted. For example, there is no preemption provision in the federal statute requiring Food and Drug Administration (FDA) approval of new drugs and of their labels before they go into the marketplace (in contrast with the medical device approval statute interpreted in Riegel). In Wyeth v. Levine, 555 U.S. 555 (2009), the Supreme Court relied on the absence of a preemption provision in concluding that the federal law requiring FDA approval of drugs and their labels did not preempt a state law–based product liability claim in which the plaintiff asserted that a stronger warning than what appeared on a medication’s FDA-approved label would have prevented the harm she suffered. The Court also concluded that allowing such a product liability claim would not undermine the federal regulatory regime regarding drug and drug label approval, given that the federal statute also contained a provision permitting drug manufacturers to employ labels containing stronger warnings than those on the FDA-approved labels if information indicating the probable need for such stronger warnings came to the manufacturers’ attention. In such a situation, the manufacturer could begin using the enhanced label and then request FDA approval of that label. Allowance of the state law–based product liability claim of the sort at issue in Levine thus seemed generally

consistent with the purpose of the enhanced-label provision in the federal law. Two years after Levine, the Supreme Court decided Pliva, Inc. v. Mensing, 131 S. Ct. 2567 (2011). There, a five-justice majority held that federal law preempted a state law–based product liability claim that was premised on the need for a stronger warning than what was on the federally approved label for the drug at issue. The Court explained that Levine’s reasoning did not control the decision in Mensing because the drug at issue in Mensing was a generic version of a brand-name drug. The court concluded that federal law required generics to have exactly the same label as the corresponding brand-name drugs—meaning that the maker of the generic in Mensing could not have adopted a label with a stronger warning on its own and that permitting the plaintiff’s state law–based claim would undermine the purposes of the federal regulatory regime. For the dissenters in Mensing, the Court’s resolution of the case amounted to little more than an attempt to cut back on the effect of Levine. The close vote in Mensing and the divergent views expressed there by the justices illustrate the difficulty of predicting the outcome in a case in which the preemption defense is raised. Regulatory compliance is the other potential defense connected with the questions asked earlier. Even if outright preemption of the plaintiff’s negligence, strict liability, or breach-of-warranty claim is not appropriate, defendants in product liability cases have become increasingly likely in recent years to argue that their products complied with applicable federal safety standards and that this compliance should shield them from liability. This defense becomes highly fact-specific, with its potential for success depending upon the particular product and product defect at issue and the specific content of the federal standards. In some cases, courts may not treat regulatory compliance as a full-fledged defense, but may still allow it to be considered as a factor in determining whether the defendant should be held liable. For instance, in a negligence case, the court may regard the defendant’s compliance with federal standards as being among the relevant factors in a determination of whether the defendant failed to use reasonable care in the design or manufacturing of the product or in not issuing a warning about a supposed danger presented by the product. Holiday Motor Corp. v. Walters, which appears earlier in the chapter, serves as an example. Similarly, in a strict liability case, the court may decide to take the defendant’s compliance with federal standards into account in determining whether the product was both defective and unreasonably dangerous.



Chapter Twenty Product Liability

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Riegel v. Medtronic, Inc.   552 U.S. 312 (2008) The case referred to below centered around an allegedly defective medical device—a balloon catheter—that was produced by Medtronic, Inc. and was inserted into Charles Riegel’s right coronary artery during an angioplasty procedure. Before further discussion of the case’s facts and identification of the key issues presented, explanation of the federal regulatory process regarding medical devices is necessary. A federal statute, the Food, Drug, and Cosmetic Act, has long required Food and Drug Administration (FDA) approval prior to the introduction of new drugs into the marketplace. Until the Medical Device Amendments of 1976 (MDA), however, the introduction of new medical devices was left largely for the states to supervise as they saw fit. The regulatory landscape changed in the 1960s and 1970s, as complex devices proliferated and some failed. In the absence of federal regulation, several states adopted regulatory measures requiring premarket approval of medical devices. In 1976, Congress federalized the medical device approval requirement by enacting the MDA, 21 U.S.C. § 360(c) et seq., which imposed a regime of detailed federal oversight of medical devices. The new regulatory regime established by the MDA set differing levels of oversight for medical devices, depending on the risks they present. Class I, which includes such devices as elastic bandages and examination gloves, is subject to the lowest level of oversight: “general controls” such as labeling requirements. Class II, which includes such devices as powered wheelchairs and surgical drapes, is subject in addition to “special controls” such as performance standards and postmarket surveillance measures. Class III devices receive the most federal oversight. That class includes such devices as replacement heart valves, implanted cerebella stimulators, and pacemaker pulse generators. In general, a device is assigned to Class III if it cannot be established that a less stringent classification would provide reasonable assurance of safety and effectiveness, and the device is “purported or represented to be for a use in supporting or sustaining human life or for a use which is of substantial importance in preventing impairment of human health,” or the device “presents a potential unreasonable risk of illness or injury.” 21 U.S.C. § 360c(a)(1)(C)(ii). Although the MDA established a rigorous regime of premarket approval for new Class III devices, it grandfathered many that were already on the market. Devices sold before the MDA’s effective date may remain on the market until the FDA promulgates a regulation requiring premarket approval. A related provision seeks to limit the competitive advantage grandfathered devices thus would appear to receive. According to that provision, a new device need not undergo premarket approval if the FDA finds it is “substantially equivalent” to another device exempt from premarket approval. The FDA’s review of devices for substantial equivalence is known as the § 510(k) process, named after the section of the MDA describing the review. Most new Class III devices enter the market through § 510(k). In 2005, for example, the FDA authorized the marketing of 3,148 devices under § 510(k) and granted premarket approval to just 32 devices. Premarket approval is a rigorous process involving the device manufacturer’s submission of a multivolume application; detailed explanations of the device’s components, ingredients, and properties; and detailed reports regarding studies and investigations into the device’s safety and effectiveness. Before deciding whether to approve the application, the FDA may refer it to a panel of outside experts and may request additional data from the manufacturer. The FDA spends an average of 1,200 hours reviewing each application for premarket approval (as opposed to roughly 20 hours for the typical § 510(k) substantial equivalence application). The premarket approval process also includes review of the device’s proposed labeling. The FDA evaluates safety and effectiveness under the conditions of use set forth on the label, and must determine that the proposed labeling is neither false nor misleading. After completing its review, the FDA may grant or deny premarket approval, or may also condition approval on adherence to performance standards or other specific conditions or requirements. Premarket approval is to be granted only if the FDA concludes there is a “reasonable assurance” of the device’s “safety and effectiveness.” § 360e(d). The agency must “weig[h] any probable benefit to health from the use of the device against any probable risk of injury or illness from such use.” § 360c(a)(2)(C). The MDA includes an express preemption provision, § 360k(a), which states, in pertinent part: [N]o State or political subdivision of a State may establish or continue in effect with respect to a device intended for human use any requirement— (1) which is different from, or in addition to, any requirement applicable under this chapter to the device, and (2) which relates to the safety or effectiveness of the device or to any other matter included in a requirement applicable to the device under this chapter. Inclusion of the preemption provision causes the MDA to differ from the Food, Drug, and Cosmetic Act’s sections requiring FDA approval prior to the introduction of new drugs into the marketplace. No such preemption provision appears in the drug approval sections of the Food, Drug, and Cosmetic Act. Medtronic’s Evergreen Balloon Catheter Company Profile is a Class III device that received premarket approval from the FDA in 1994. Changes to its label received supplemental approvals in 1995 and 1996. Charles Riegel underwent coronary angioplasty in

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Part Four Sales

1996, shortly after suffering a myocardial infarction. His right coronary artery was diffusely diseased and heavily calcified. Riegel’s doctor inserted the Evergreen Balloon Catheter into his patient’s coronary artery in an attempt to dilate the artery, even though the device’s labeling stated that use was contraindicated for patients with diffuse or calcified stenoses. The label also warned that the catheter should not be inflated beyond its rated burst pressure of eight atmospheres. Riegel’s doctor inflated the catheter five times, to a pressure of 10 atmospheres. On its fifth inflation, the catheter ruptured. Riegel developed a heart block, was placed on life support, and underwent emergency coronary bypass surgery. In 1999, Riegel and his wife, Donna, sued Medtronic in the U.S. District Court for the Northern District of New York. Their complaint raised various claims centering around the allegations that Medtronic’s catheter was designed, labeled, and manufactured in a manner that violated New York common law, and that these defects caused Riegel to suffer severe and permanent injuries. The district court held that the MDA preempted the Riegels’ claims of strict liability, breach of implied warranty, and negligence in the design, testing, manufacturing, inspection, distribution, labeling, marketing, and sale of the catheter. After the U.S. Court of Appeals for the Second Circuit affirmed, the U.S. Supreme Court granted the Riegels’ petition for a writ of certiorari.

Scalia, Justice We consider whether the pre-emption clause enacted in the MDA, 21 U.S.C. § 360k, bars common-law claims challenging the safety and effectiveness of a medical device given premarket approval by the Food and Drug Administration (FDA). Since the MDA expressly pre-empts only state requirements “different from, or in addition to, any requirement applicable . . . to the device” under federal law, § 360k(a)(1), we must determine whether the federal government has established requirements applicable to Medtronic’s catheter. If so, we must then determine whether the Riegels’ common-law claims are based upon New York requirements with respect to the device that are “different from, or in addition to” the federal ones, and that relate to safety and effectiveness. § 360k(a). We turn to the first question. In Medtronic, Inc. v. Lohr, 518 U.S. 470 (1996), . . . this Court interpreted the MDA’s preemption provision [and] concluded that federal manufacturing and labeling requirements applicable across the board to almost all medical devices did not pre-empt the common-law claims of negligence and strict liability at issue in [the case]. The federal requirements, we said, were not requirements specific to the device in question—they reflected “entirely generic concerns about device regulation generally.” While we disclaimed a conclusion that general federal requirements could never pre-empt, or [that] general state duties [could] never be pre-empted, we held that no pre-emption occurred in the case at hand based on a careful comparison between the state and federal duties at issue. Even though substantial-equivalence review under § 510(k) is device specific, Lohr also rejected the manufacturer’s contention that § 510(k) approval [(which the device at issue in the case had received)] imposed device-specific “requirements.” We regarded the fact that products entering the market through § 510(k) may be marketed only so long as they remain substantial equivalents of

the relevant pre-1976 devices as a qualification for an exemption rather than a requirement. Premarket approval, in contrast, imposes “requirements” under the MDA as we interpreted it in Lohr. Unlike general labeling duties, premarket approval is specific to individual devices. And it is in no sense an exemption from federal safety review—it is federal safety review. Thus, the attributes that Lohr found lacking in § 510(k) review are present here. While § 510(k) is “focused on equivalence, not safety” (quoting Lohr), premarket approval is focused on safety, not equivalence. While devices that enter the market through § 510(k) have “never been formally reviewed under the MDA for safety or efficacy” (quoting Lohr), the FDA may grant premarket approval only after it determines that a device offers a reasonable assurance of safety and effectiveness. § 360e(d). And while the FDA does not require that a device allowed to enter the market as a substantial equivalent “take any particular form for any particular reason” (quoting Lohr), the FDA requires a device that has received premarket approval to be made with almost no deviations from the specifications in its approval application, for the reason that the FDA has determined that the approved form provides a reasonable assurance of safety and effectiveness. We turn, then, to the second question: whether the Riegels’ common-law claims rely upon “any requirement” of New York law applicable to the catheter that is “different from, or in addition to” federal requirements and that “relates to the safety or effectiveness of the device or to any other matter included in a requirement applicable to the device.” § 360k(a). Safety and effectiveness are the very subjects of the Riegels’ common-law claims, so the critical issue is whether New York’s tort duties constitute “requirements” under the MDA. In Lohr, five Justices [expressed the view] that commonlaw causes of action for negligence and strict liability do



Chapter Twenty Product Liability

impose “requirement[s]” and would be pre-empted by federal requirements specific to a medical device [if such devicespecific requirements, not present in Lohr, were present in an appropriate case]. We adhere to that view. In interpreting two other statutes we have likewise held that a provision pre-empting state “requirements” pre-empted common-law duties. Bates v. Dow Agrosciences LLC, 544 U.S. 431 (2005), found common-law actions to be pre-empted by a provision of the Federal Insecticide, Fungicide, and Rodenticide Act that said certain states “shall not impose or continue in effect any requirements for labeling or packaging in addition to or different from those required under this subchapter.” Cipollone v. Liggett Group, Inc., 505 U.S. 504 (1992), held [certain] common-law [claims] pre-empted by a provision of the Public Health Cigarette Smoking Act of 1969, which said that “[n]o requirement or prohibition based on smoking and health shall be imposed under state law with respect to the advertising or promotion of any cigarettes” whose packages were labeled in accordance with federal law. Congress is entitled to know what meaning this Court will assign to terms regularly used in its enactments. Absent other indication, reference to a state’s “requirements” includes its common-law duties. As the plurality opinion said in Cipollone, common-law liability is “premised on the existence of a legal duty,” and a tort judgment therefore establishes that the defendant has violated a state-law obligation. And while the commonlaw remedy is limited to damages, a liability award[, as noted in Cipollone,] “can be, indeed is designed to be, a potent method of governing conduct and controlling policy.” In the present case, there is nothing to contradict this normal meaning. To the contrary, in the context of this legislation excluding common-law duties from the scope of pre-emption would make little sense. State tort law that requires a manufacturer’s catheters to be safer, but hence less effective, than the model the FDA has approved disrupts the federal scheme no less than state regulatory law to the same effect. Indeed, one would think that tort law, applied by juries under a negligence or strict-liability standard, is less deserving of preservation. A state statute, or a regulation adopted by a state agency, could at least be expected to apply cost-benefit analysis similar to that applied by the experts at the FDA: How many more lives will be saved by a device which, along with its greater effectiveness, brings a greater risk of harm? A jury, on the other hand, sees only the cost of a more dangerous design, and is not concerned with its benefits; the patients who reaped those benefits are not represented in court. As Justice Breyer explained in [his concurring opinion in] Lohr, it is

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implausible that the MDA was meant to “grant greater power (to set state standards different from, or in addition to, federal standards) to a single state jury than to state officials acting through state administrative or legislative lawmaking processes.” That perverse distinction is not required or even suggested by the broad language Congress chose in the MDA, and we will not turn somersaults to create it. The dissent would narrow the pre-emptive scope of the term “requirement” on the ground that it is “difficult to believe that Congress would, without comment, remove all means of judicial recourse” for consumers injured by FDA-approved devices (quoting Justice Ginsburg’s dissent). But, as we have explained, this is exactly what a pre-emption clause for medical devices does by its terms. It is not our job to speculate upon congressional motives. If we were to do so, however, the only indication available—the text of the statute—suggests that the solicitude for those injured by FDA-approved devices, which the dissent finds controlling, was overcome in Congress’s estimation by solicitude for those who would suffer without new medical devices if juries were allowed to apply the tort law of 50 states to all innovations. The Riegels contend that the duties underlying negligence, strict-liability, and implied-warranty claims are not pre-empted even if they impose “requirements,” because general commonlaw duties are not requirements maintained “‘with respect to devices.’” Again, a majority of [the justices] suggested otherwise in Lohr. And with good reason. The language of the statute does not bear the Riegels’ reading. The MDA provides that no state “may establish or continue in effect with respect to a device . . . any requirement” relating to safety or effectiveness that is different from, or in addition to, federal requirements. § 360k(a). The Riegels’ suit depends upon New York’s “continu[ing] in effect” general tort duties “with respect to” Medtronic’s catheter. Nothing in the statutory text suggests that the pre-empted state requirement must apply only to the relevant device, or only to medical devices and not to all products and all actions in general. State requirements are pre-empted under the MDA only to the extent that they are “different from, or in addition to” the requirements imposed by federal law. § 360k(a)(1). Thus, § 360k does not prevent a state from providing a damages remedy for claims premised on a violation of FDA regulations; the state duties in such a case parallel, rather than add to, federal requirements. Court of Appeals judgment in favor of Medtronic affirmed.

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Part Four Sales

Problems and Problem Cases 1. Brian Felley went to the home of Thomas and Cheryl Singleton to look at a used car that the Singletons had offered for sale. The car, a six-year-old Ford Taurus, had approximately 126,000 miles on it. Felley test-drove the car and discussed its condition with the Singletons. The Singletons told him that the car was in “good mechanical condition” and that they had experienced no brake problems. This was a primary consideration for Felley, who purchased the car from the Singletons for $5,800. Felley soon began experiencing problems with the car. On the second day after he bought it, he noticed a problem with the clutch. Over the next few days, the clutch problem worsened to the point where he was unable to shift the gears, no matter how far he pushed in the clutch pedal. He had to pay $942.76 for the removal and repair of the clutch. Within the first month that Felley owned the car, it developed serious brake problems, the repairs of which cost Felley more than $1,400. Felley brought a small claims action against the Singletons, claiming that they had made and breached an express warranty to him. At trial, an expert witness testified that based on his examination of the car and discussion with Felley about the car and other factors, it was his opinion that the car’s brake and clutch problems probably existed when Felley bought the car. The trial court ruled in Felley’s favor and ordered the Singletons to pay him $2,343.03. On appeal, the Singletons argued that what they said to Felley about the car did not constitute an express warranty and that they therefore should not have been held liable. Were they correct? 2. Hilda Forbes was the driver in an accident in which the front end of her car struck another vehicle. The driver’s airbag did not deploy, and she sustained serious injuries. She later filed suit against the car’s manufacturer because of the failure of the airbag to deploy. The owner’s manual for the car—a manual prepared by the manufacturer—contained a statement that if a front-end collision was “hard enough,” the air bag would deploy. Although Forbes did not read the manual before buying the car, she told the salesman with whom she negotiated the purchase that a working air bag was important to her. The salesman informed Forbes of the gist of what the owner’s manual said about a functioning air bag. In her lawsuit, Forbes presented the testimony of an expert witness who offered the opinion that the collision in which she was involved was severe enough to cause a properly functioning airbag to deploy. Under the circumstances, did the owner’s manual’s “hard enough”

statement constitute an express warranty concerning the airbag. If so, why? If not, why not? If the “hard enough” statement constituted an express warranty, was the warranty breached? 3. In October 2002, Tina and Thad Crowe purchased a 1999 Dodge Durango automobile from CarMax Auto Superstores, Inc. They received a 30-day/1,000-mile express warranty from CarMax. In addition, the Crowes purchased an 18-month/18,000-mile “Mechanical Repair Agreement” (MRA). The obligated party on this extended warranty was a corporation other than CarMax. Over the course of the next year, the Crowes brought the vehicle to CarMax and other repair facilities numerous times for a variety of repairs. All repairs within the original and extended warranty periods were done at little or no cost to the Crowes. However, the Crowes lost confidence in the vehicle because of the numerous times repairs had been necessary. In May 2003, the Crowes sued CarMax, contending that CarMax had breached the implied warranty of merchantability. After the trial court granted summary judgment in favor of CarMax, the Crowes appealed to the Georgia Court of Appeals. Should the Crowes win the summary judgment? 4. Yong Cha Hong bought take-out fried chicken from a Roy Rogers Family Restaurant owned by the Marriott Corporation. While eating a chicken wing from her order, she bit into an object that she perceived to be a worm. Claiming permanent injuries and great physical and emotional upset from this incident, Hong sued Marriott in federal district court. She claimed that Marriott had breached the implied warranty of merchantability. After introducing an expert’s report opining that the object in the chicken wing was not a worm but was instead the chicken’s aorta or trachea, Marriott moved for summary judgment. What two alternative tests might the court have applied in deciding whether the chicken wing was merchantable? Which of the two alternative tests did the court decide to apply? Under that test, was Marriott entitled to summary judgment? 5. In 1994, David and Corrine Bako signed a contract with Don Walter Kitchen Distributors (DW) for the purchase and installation of cabinets in their new home. DW ordered the cabinets from a manufacturer, Crystal Cabinet Works. Crystal shipped the cabinets to DW, which installed them in the Bakos’ residence. Soon after the installation, Corrine Bako contacted a DW employee, Neil Mann, and asked whether DW could provide a stain to match the kitchen cabinets. She informed Mann that the stain would be applied to



Chapter Twenty Product Liability

the wood trim primarily on the first floor of the house. Mann ordered two one-gallon cans of stain from Crystal, which shipped the stain to DW in unmarked cans. There were no labels, instructions, or warnings regarding improper use or application of the stain. The cans arrived at DW’s store in unmarked cardboard boxes and were delivered to the Bakos in this manner. The stain in the cans turned out to be lacquer-based. Shortly thereafter, Corrine Bako again contacted Mann about purchasing additional stain in a slightly different color to apply to a hardwood floor. At Mann’s suggestion, she contacted Crystal’s paint lab and spoke with a Crystal employee. The Crystal employee shipped the Bakos a series of samples from which Corrine ordered two gallons of stain. This stain was also a lacquer-based stain and was shipped directly from Crystal to the Bakos in unmarked cans. Once again, there were no instructions for use, no warning regarding improper use or application of the product, no label indicating that it was a lacquer-based stain, and no label indicating that a special topcoat was required because it was a lacquer-based stain. The Bakos applied the stain to their floor.   The Bakos then obtained a polyurethane topcoat sealant and applied it to the wood surfaces they had stained with the stain purchased from DW and Crystal. Following this application of the sealant, all of the stained and sealed areas suffered severe and permanent damage as a result of the nonadherence of the polyurethane sealant to the lacquer-based stain. Evidence adduced at the trial of the case referred to below established that lacquerbased stains are incompatible with the polyurethane topcoat that the Bakos applied to their home’s wood surfaces. In October 1996, the Bakos filed suit against Crystal and DW for breach of the implied warranty of merchantability and breach of the implied warranty of fitness for a particular purpose. They also claimed that the defendants had been negligent. An Ohio trial court found for the Bakos and held the defendants liable for approximately $25,000 in compensatory damages. Contending that the Bakos should not have prevailed on any of their claims, Crystal appealed to the Court of Appeals of Ohio. How did the appellate court rule on the Bakos’ two breach of implied warranty claims? 6. Connie Daniell attempted to commit suicide by locking herself inside the trunk of her Ford LTD. She remained in the trunk for nine days but survived after finally being rescued. Later, Daniell brought a negligence action against Ford in an effort to recover for her resulting physical and psychological injuries. She contended that the LTD was defectively designed

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because its trunk did not have an internal release or opening mechanism. She also argued that Ford was liable for negligently failing to warn her that the trunk could not be unlocked from within. Was Ford liable for negligent design and/or negligent failure to warn? 7. In 2001, Donald Malen purchased a Yard-Man riding mower at a Home Depot store. The mower was manufactured by MTD Products in 1998 and was advertised as “Reconditioned Power Equipment” with a “Full Manufacturer’s Warranty.” The mower was designed with a safety interlock system. One component of that system was the Operator Presence Control, or OPC, a device that kills the engine if the operator rises from the seat without first disengaging the cutting blade and setting the parking brake. A second component was the “no cut in reverse” switch, or NCR, which kills the engine if the operator shifts into reverse without first disengaging the blade. The American National Standards Institute (“ANSI”), a voluntary organization that develops nationwide consensus standards for a variety of devices and procedures, did not make an NCR compulsory until 2003, but by 1996 the organization had mandated that riding mowers had to have an OPC that would stop the engine and fully arrest the blade within five seconds of being triggered. Before Malen purchased the mower, he tested it under the supervision of a Home Depot sales employee. During that test ride, Malen never rose from the seat with the engine running. A label on the mower in front of the seat warned the operator with these statements: DO NOT OPERATE THE UNIT WHERE IT COULD SLIP OR TIP. BE SURE BLADE(S) AND ENGINE ARE STOPPED BEFORE PLACING HANDS OR FEET NEAR BLADE(S). BEFORE LEAVING THE OPERATOR’S POSITION, DISENGAGE BLADE(S), PLACE THE SHIFT LEVER IN NEUTRAL, ENGAGE THE PARKING BRAKE, SHUT OFF AND REMOVE KEY.

  Between 2001 and 2004, Malen operated the mower 30 to 50 times without incident. But in October 2004 he was mulching leaves with the mower and wedged the right front tire over a curb. He tried without success to free the machine by rocking his weight in the seat and shifting gears between forward and reverse. At that point Malen raised the cutting deck, removed his foot from the pedal which engages the blade, and started to dismount. But he did not turn off the engine or listen to confirm whether the blade had stopped spinning. It had not. As Malen rose from the seat and stepped off

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Part Four Sales

the mower, his left foot slipped under the cutting deck and was struck by the rotating blade. The lacerations to the sole of his foot were severe, and he permanently lost full use of his foot. Neither the OPC nor the NCR functioned when the accident occurred.   Malen sued MTD Products and Home Depot on strict liability and negligence grounds. He contended that the mower was negligently manufactured and unreasonably dangerous because its OPC was not connected and thus inoperable. He also contended that the mower was negligently designed because MTD Products had shunned a “fail safe” system that would have made the cutting blade unusable even without the OPC connected. The court granted summary judgment in favor of the defendants, concluding that Malen’s own actions were the sole proximate cause of his injury. Was the court correct in granting summary judgment to the defendants? 8. Chefik Simo, an 18-year-old first-year student on the varsity soccer team at Furman University, was a passenger in a 2000 Mitsubishi P45 Montero Sport, a sport-utility vehicle designed, manufactured, and sold by Mitsubishi Motors Corp. and Mitsubishi Motors North America (collectively referred to here as “Mitsubishi”). Simo suffered severe injuries when the Montero Sport rolled over on an interstate highway after the driver suddenly steered left to avoid another vehicle and then attempted to correct his course by quickly turning back to the right. While the vehicle was on its side, it was struck by a Federal Express truck. In the litigation referred to below, Simo presented testimony that he was the top soccer recruit in the country the year he entered college and was among the best players on the United States’ “Under-20” national team. Simo had intended to begin his professional career in Europe following the conclusion of the soccer season at Furman. Many European teams, including some at the top levels, had expressed interest in signing Simo when he became available.   Simo’s injuries from the accident included a fractured shoulder blade, a fractured pelvis, a dislocated shoulder, a ruptured small intestine, a broken wrist, a knee dislocation in his left leg involving a complete separation of the thigh bone from the shin bone, and tears of three of the four major ligaments in the knee. He suffered irreparable nerve damage that resulted in a “drop foot.” As a result of these injuries, Simo underwent a number of surgeries and incurred more than $277,000 in medical bills. He engaged in arduous rehabilitation efforts in an attempt to resume his soccer career. When he returned to the field, however, he ended up overcompensating for his injuries to his left side, leading to painful stress

fractures that forced him to terminate his comeback. Simo filed a strict liability lawsuit against Mitsubishi. Based on what you have studied in Chapter 20, what elements would Simo need to prove in order to win his strict liability case? What test would the court be likely to apply in determining whether strict liability should apply? What types of damages would Simo be entitled to obtain if he establishes liability on the part of Mitsubishi? Would the lost career opportunity in soccer be something accounted for in any award of damages to Simo? 9. Sandra Goodin purchased a new Hyundai Sonata automobile in November 2000 from an Evansville, Indiana, dealer. The Sonata’s manufacturer, Hyundai Motor America, provided a written express warranty of a limited nature, but the dealer did not furnish an express warranty. The contract of sale between the dealer and Goodin contained the dealer’s disclaimer of the implied warranty of merchantability. Because Hyundai provided a written warranty, the federal Magnuson-Moss Warranty Act prohibited Hyundai from disclaiming the implied warranty of merchantability. For a two-year period that ran essentially from the time of purchase, Goodin complained that the car vibrated excessively and that its brakes groaned, squeaked, and made a grinding noise when applied. Various repairs were performed by the dealer that sold Goodin the car and by another Hyundai dealer. Hyundai Motor America’s limited warranty covered most of these repairs. Goodin incurred the cost of other repairs conducted after the expiration of Hyundai’s limited warranty. None of the repairs, however, completely took care of the problems Goodin had consistently pointed out.   In April 2002, Goodin’s attorney retained an expert to examine the car. The expert noted the brake-related problems and the excessive vibration and expressed the view that the car was “defective and unmerchantable at the time of manufacture and unfit for operation on public roadways.” In October 2002, a district service manager for Hyundai inspected and test-drove Goodin’s car. Although he did not notice excessive vibration or the brake-related noises about which Goodin complained, he heard “a droning noise” that probably resulted from a failed wheel bearing. The district service manager said he regarded the wheel bearing problem as a serious one that should have been covered by Hyundai’s limited warranty. Goodin later sued Hyundai in an Indiana court for breach of express warranty and breach of the implied warranty of merchantability. Over Hyundai’s objection, the trial judge’s instructions



Chapter Twenty Product Liability

to the jury on the implied warranty of merchantability claim made no mention of any privity requirement. The jury returned a verdict for Hyundai on Goodin’s breach of express warranty claim, but awarded Goodin $3,000 on her claim for breach of the implied warranty of merchantability.  Did the court rule correctly when it did so? 10. Matthew Kovach, a nine-year-old child, was admitted to Surgicare LLC (Surgicare) to undergo a scheduled adenoidectomy. While he recovered in the ambulatory surgery center, a nurse administered Capital of Codeine, an opiate, to him. To administer the drug, the nurse used a graduated medicine cup (the Cup), manufactured and/or sold by various parties that later became defendants in the case described below. (Those defendants will be referred to here as the Cup Defendants.) The Cup is made of flexible translucent plastic that is not completely clear and denotes various volume measurement graduation markings, including milliliters (ml), drams, ounces, teaspoons, tablespoons, and cubic centimeters. These measurement markers are located on the interior surface of the Cup and have a similar translucency as the Cup. The vertical distance between the ml volume graduation markings varies: the smallest volume of ml measurement for the graduations between empty and 10 ml is 2.5 ml; while the smallest volume of ml measurement for the graduations between 10 ml and 30 ml is 15 ml. The Cup holds 30 ml or more of medicine when full. Matthew was prescribed 15 ml, or one-half of the Cup’s volume, of Capital of Codeine. Although the nurse stated that she gave Matthew only 15 ml of Codeine, Matthew’s father, Jim Kovach, who was in the room at the time, testified that the Cup was completely full. Matthew drank all of the medicine in the Cup. After being discharged from Surgicare and arriving home, Matthew went into respiratory arrest. He was transported to a hospital, where he was pronounced dead of asphyxia due to an opiate overdose. The autopsy revealed that Matthew’s blood contained between 280 and 344 nanograms per ml of codeine, more than double the recommended therapeutic level of the drug.  Jim and Jill Kovach (Matthew’s mother) filed suit in an Indiana trial court against the Cup Defendants, asserting claims for (1) breach of the implied warranty of merchantability, (2) breach of the implied warranty of fitness for a particular purpose, (3) negligent design, and (4) strict liability. Their claims centered around contentions that the design of the Cup was defective,

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largely because its translucency and lack of clear, easily distinguishable measurement markings led to a danger of measurement errors, and because the Cup Defendants issued no warning to the effect that the Cup should not be used when a precise measurement of medication quantity was important. By way of affidavit, the Kovaches’ expert witness, a pharmacy professor with many years of experience, offered an opinion consistent with the above contentions regarding the Cup’s design and lack of warning. The trial court granted the Cup Defendants’ motion for summary judgment on each of the claims filed against them by the Kovaches. Did the trial court rule correctly in doing so? In your answer, consider each of the four claims brought by the plaintiffs. 11. Duane Martin, a small farmer, placed an order for cabbage seed with the Joseph Harris Company, a large national producer and distributor of seed. Harris’s order form included the following language: NOTICE TO BUYER: Joseph Harris Company, Inc. warrants that seeds and plants it sells conform to the label descriptions as required by Federal and State seed laws. IT MAKES NO OTHER WARRANTIES, EXPRESS OR IMPLIED, OF MERCHANTABILITY, FITNESS FOR PURPOSE, OR OTHERWISE, AND IN ANY EVENT ITS LIABILITY FOR BREACH OF ANY WARRANTY OR CONTRACT WITH RESPECT TO SUCH SEEDS OR PLANTS IS LIMITED TO THE PURCHASE PRICE OF SUCH SEEDS OR PLANTS.

All of Harris’s competitors used similar clauses in their contracts.  After Martin placed his order, and unknown to Martin, Harris stopped using a cabbage seed treatment that had been effective in preventing a certain cabbage fungus. Later, Martin planted the seed he had ordered from Harris, but a large portion of the resulting crop was destroyed by fungus because the seed did not contain the treatment Harris had previously used. Martin sued Harris for his losses under the implied warranty of merchantability.  Which portion of the notice quoted above is an attempted disclaimer of implied warranty liability, and which is an attempted limitation of remedies? Will the disclaimer language disclaim the implied warranty of merchantability under UCC § 2-316(2)? If Martin had sued under the implied warranty of fitness for a particular purpose, would the disclaimer language disclaim that implied warranty as well? Assuming that the disclaimer and the remedy limitation contained the correct legal boilerplate needed to make them effective,

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Part Four Sales

what argument could Martin still make to block their operation? What are his chances of success with this argument? 12. William Croskey was seriously injured in July 2000 when his girlfriend’s 1992 BMW automobile overheated and he opened the hood to add fluid. Because the plastic neck on the car’s radiator failed, scalding radiator fluid spewed out and came in contact with Croskey, severely burning him. Relying on diversity of citizenship jurisdiction, Croskey filed suit in the U.S. District Court for the Eastern District of Michigan against the car’s manufacturer, Bayerische Motoren Werk Aktiengesellschaft (BMW AG), and the North American distributor of BMW vehicles, BMW of North America (BMW NA). Croskey pleaded two alternative claims: (1) negligent design on the part of BMW AG and (2) negligent failure to warn on the part of BMW AG and BMW NA. Deciding an evidentiary question prior to trial, the district court ruled that Croskey could use evidence of substantially similar incidents of plastic neck failure if those incidents came to the attention of the defendants and if the incidents occurred between 1991 and the date Croskey was injured. However, the court allowed this evidence to be used only in regard to the negligent failure to warn claim, and prohibited its use in regard to the negligent design claim. The court also ruled that concerning the negligent failure to warn claim, the defendants could introduce evidence of the number of BMWs sold with plastic-necked radiators between 1994 (when the defendants first learned of a neck failure) and the date of the Croskey incident. The purpose of such evidence was to show the likelihood—or lack of likelihood—of a neck failure. The case proceeded to trial. Rejecting Croskey’s negligent design and negligent failure to warn claims, the jury returned a verdict in favor of the defendants. Croskey appealed to the U.S. Court of Appeals for the Sixth Circuit. Should the court of appeals reverse the district court’s decision? 13. Richard Jimenez was injured when a disc for the handheld electric disc grinder he had purchased from Sears Roebuck shattered while he used the grinder to smooth down a steel weld. When Jimenez brought a strict liability lawsuit against Sears, the defendant argued that he had misused the grinder and that this misuse caused his injury. Assuming that Sears was right, what effect would this have in a state that has not adopted comparative negligence or comparative fault? What effect would it have in a comparative fault state?

14. Standard Candy Co., a Tennessee firm, produces candy bars, including one known as the “Goo Goo Cluster.” The Goo Goo Cluster candy bar contains peanuts provided to Standard Candy by an outside supplier. When James Newton II purchased a Goo Goo Cluster and bit into it, he encountered what he claimed to be an undeveloped peanut. Newton maintained that biting the undeveloped peanut caused him to experience a damaged tooth as well as recurring jaw-locking and hearing-loss problems. Newton sued Standard Candy and pleaded the following alternative claims: breach of the implied warranty of merchantability, negligent manufacture, negligent failure to warn, and strict liability. Concerning the breach of implied warranty of merchantability claim, what two tests might the court choose from in determining whether the Goo Goo Cluster Newton purchased was unmerchantable? Was the Goo Goo Cluster unmerchantable under either or both of these tests? What would Newton need to establish in order to win on the other three claims (the two negligence claims and the strict liability claim)? On which of those three claims would Newton stand the best chance of succeeding? 15. James Bainbridge and Daniel Fingarette formulated a plan for a three-dimensional photography business through four independent companies. In January 1988, Bainbridge met with officials of the Minnesota Mining & Manufacturing Company (3M) to seek assistance with the three-dimensional film development process. In mid-1989, 3M formulated a new emulsion that it claimed would work well with the film development process. 3M apparently understood that this emulsion would be used in combination with a backcoat sauce that 3M had also developed. In December 1989, 3M began selling the new emulsion and backcoat sauce to two of the claimants’ four companies, but not to the two others. After Bainbridge and Fingarette began using 3M’s new emulsion, they encountered a problem with the film development process: The photographs faded, losing their three-dimensional effect. By early 1990, the claimants experienced a significant decline in camera sales. 3M eventually solved the problem, but the claimants’ business ultimately failed.  The four companies established by Bainbridge and Fingarette sued 3M in a Texas trial court for breach of express and implied warranties. They argued that the photographic fading was caused by the incompatibility of 3M’s new emulsion and its old backcoat sauce. The jury concluded that 3M breached an express warranty for the emulsion and implied warranties for the



Chapter Twenty Product Liability

emulsion and the backcoat sauce. Applying Minnesota law, the trial court awarded the four firms $29,873,599 in lost profits. An intermediate appellate court upheld this award. The Supreme Court of Texas withheld final judgment and certified the following question to the Supreme Court of Minnesota: “For breach of warranty under [Minnesota’s version of UCC section 2-318], is a seller liable to a person who never acquired any goods from the seller, directly or indirectly, for pure economic damages (e.g., lost profits), unaccompanied by any injury to the person or the person’s property?” This question arose because two of the plaintiff companies, while suffering losses due to 3M’s breaches of warranty, had not dealt directly with 3M. How did the Supreme Court of Minnesota answer the certified question? 16. Steven Taterka purchased a new Ford Mustang from a Ford dealer. More than two years later, after Taterka had put 75,000 miles on the car and Ford’s express warranty had expired, he discovered that the taillight assembly gaskets on his Mustang had been installed in such a way that water was permitted to enter the taillight assembly, causing rust to form. Even though the rusting problem was a recurrent one of which Ford was aware, Ford did nothing for Taterka. Was Ford liable to Taterka under the implied warranty of merchantability? 17. On February 28, 2005, David Dobrovolny purchased a 2005 F-350 pickup truck, which had been manufactured by Ford Motor Co. The truck caught fire in Dobrovolny’s driveway on April 16, 2006. No one was physically injured, and no property other than the truck was damaged. The truck was completely destroyed. Dobrovolny filed suit against Ford on May 20, 2009. In his complaint, Dobrovolny alleged that the defective nature of the truck caused it to catch fire. He pleaded three alternative claims—breach of the implied warranty of merchantability, negligence, and strict liability—in an effort to recover damages for the loss he sustained as a result of purchasing a defective truck. Ford filed a motion to dismiss each of the claims. On what basis would Ford have argued that the breach of implied warranty of merchantability claim should be dismissed? On what basis would Ford have argued that the negligence and strict liability claims should be dismissed? How did the court rule on Ford’s motion to dismiss? 18. Iowa residents Robert and DeAnn Wright sued various cigarette manufacturers in a federal district court in an effort to obtain damages for harms allegedly

20-45

resulting from Robert’s cigarette smoking. The plaintiffs pleaded a number of alternative claims, including strict liability. The defendants filed a motion to dismiss, but the federal court largely overruled it. Thereafter, the defendants asked the federal court to certify questions of law to the Iowa Supreme Court, in accordance with an Iowa statute. Concluding that the case presented potentially determinative state law questions as to which there was either no controlling precedent or ambiguous precedent, the federal court certified questions to the Iowa Supreme Court regarding the use of strict liability principles in design defect cases. In answering the certified questions, the Iowa Supreme Court adopted the design defect rules proposed in the Restatement (Third) of Torts: Product Liability. Therefore, what controlling rules did that court identify in answering the certified questions? What test did it say courts should apply in design defect cases? What did it say a plaintiff in a design defect case must prove? 19. A General Motors pickup truck driven by Paul Babcock went off the road and struck a tree. The accident rendered Mr. Babcock a paraplegic. Roughly a year later, he died as a result of complications from his injuries. The executor of his estate, Frances Babcock, sued General Motors (GM) on behalf of the estate and herself. According to the plaintiff’s version of the facts, Mr. Babcock was wearing his seat belt prior to the accident but as soon as pressure was exerted on it, the belt unbuckled and released because of a condition known as “false latching.” The plaintiff claimed that the false-latching condition existed because of negligent design and/or mechanism and that the resulting failure of the seat belt in Mr. Babcock’s pickup was a substantial factor in causing Mr. Babcock’s severe— and ultimately fatal—injuries.  In addition to various witnesses who testified that Mr. Babcock always wore his seat belt when he was driving, Dr. Malcolm Newman testified as an expert witness for the plaintiff. He was a structural and mechanical engineering specialist with significant involvement in accident reconstruction and analysis of automobile restraint systems. Employing a method used by accident reconstruction specialists, Dr. Newman reviewed photos and other materials given to him and formed opinions as to how fast Mr. Babcock’s pickup was traveling when it left the highway and hit the tree. He testified that in his opinion, the “impact” speed was between 20 and 25 miles per hour and the Babcock truck had been traveling at 35 to 45 miles per hour at the time it left the highway. Dr. Newman also opined

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that the normal wear and tear associated with continued use of the buckle would increase the danger of false latching. Using a Volvo seat belt buckle, he demonstrated that the Volvo design eliminated the risk that false latching would occur. Dr. Newman noted that the buckle on the GM truck evidently had been tested pursuant to the Federal Motor Vehicle Safety Standards. He offered the view that any testing done by GM had not included testing for false latching. After the jury returned a verdict holding GM liable on the plaintiff’s negligence claim, GM appealed. Could GM properly have been held liable even though nothing it did or failed to do caused Mr. Babcock’s truck to leave the highway and strike a tree? Did the plaintiff sufficiently prove what was necessary to establish negligent design and/or negligent testing on the part of GM? 20. Rita Emeterio bought disposable butane lighters for use at her bar. Her daughter, Gloria Hernandez, took lighters from the bar time to time for her personal use. Hernandez’s five-year-old daughter, Daphne, took a lighter from her mother’s purse on the top shelf of a closet in her grandparents’ home. Using the lighter, Daphne started a fire in which her two-year-old brother, Ruben, was severely burned. On Ruben’s behalf, Hernandez sued the manufacturers and distributors of the lighter, Tokai Corporation and Scripto-Tokai Corporation (collectively, “Tokai”), in the U.S. District Court for the Western District of Texas. Asserting a strict liability claim, Hernandez alleged that the lighter was defectively designed and unreasonably dangerous because it did not have a child-resistant safety mechanism that would have prevented or substantially reduced the

likelihood of a child’s using it to start a fire. Tokai moved for summary judgment, contending that a disposable lighter is a simple household tool intended for adult use only, and that a manufacturer has no duty to incorporate child-resistant features into a lighter’s design to protect unintended users—children—from obvious and inherent dangers. Tokai also noted that adequate warnings against access by children were provided with its lighters, even though that danger was obvious and commonly known. In response to Tokai’s motion, Hernandez argued that because an alternative design in existence at the time the lighter at issue was manufactured and distributed would have made the lighter safer in the hands of children, it remained for the jury to decide whether the lighter was defective under Texas’s common-law risk-utility test. The federal district court granted summary judgment for Tokai. Hernandez appealed to the U.S. Court of Appeals for the Fifth Circuit. The Fifth Circuit then certified the following question of state law to the Supreme Court of Texas: Under the Texas Products Liability Act of 1993, can the legal representative of a minor child injured as a result of the misuse of a product by another minor child maintain a defective-design products liability claim against the product’s manufacturer where the product was intended to be used only by adults, the risk that children might misuse the product was obvious to the product’s manufacturer and to its intended users, and a safer alternative design was available?

How did the Supreme Court of Texas answer the certified question?

CHAPTER 21

Performance of Sales Contracts

S

arah Saunders was interested in purchasing a new hybrid-fueled vehicle. Using the web page of a large-volume dealer in a nearby city, she provided the dealer with the make, model, color, and primary options for the vehicle she was seeking. The dealer indicated that he could obtain a vehicle meeting Sarah’s specifications, quoted her a very favorable price, and offered to deliver the vehicle to her at the apartment house where she lived. Sarah accepted the offer and wired a deposit to the dealer. When the vehicle arrived, the truck driver refused to unload it from the car carrier or let Sarah inspect it until she had given him a certified check for the balance due. Then he gave her the title to the vehicle, unloaded it, and drove away. Sarah subsequently discovered a number of scratches in the paint and that some of the options she had bargained for—such as a sunroof—were not on the vehicle. When she complained to the dealer, he offered her a monetary “allowance” to cover the defects. She also discovered that the vehicle had a tendency to stall and have to be restarted when she stopped at intersections. Despite repeated trips to the nearby city to have the dealer remedy the problem, those efforts have been unavailing. Sarah has indicated that she wants to return the vehicle to the dealer and get a vehicle that performs properly, but the dealer insists that she has to give him additional time to try to fix it. This situation raises a number of legal questions that, among others, will be discussed in this chapter, including: • Did Sarah have the right to inspect the vehicle before she paid the balance of the purchase price? • When Sarah discovered the scratches on the vehicle and that it did not conform to the contract specifications, could she have refused to accept the car and required the dealer to provide one that met the contract? • Does Sarah have the right to return the defective vehicle to the dealer and obtain either a new vehicle or her money back, or must she give the dealer the opportunities he wants to try to remedy the defect? • If the dealer knew the vehicle he was delivering to Sarah did not conform to the contract and was damaged, was it ethical for him to deliver it anyway?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 21-1 Explain what is meant by the terms good faith, course of dealing, and usage of trade as they pertain to the performance of sales contracts. 21-2 List the basic obligations and rights of the buyer and seller concerning the delivery of and payment for goods. 21-3 Explain when acceptance of goods occurs, what the effect of accepting goods is, and when a buyer who has accepted goods has the right to revoke such acceptance.

21-4 Discuss the buyer’s rights and duties on improper delivery of goods as well as the seller’s right to cure a defective delivery. 21-5 Indicate when a party to a contract has the right to seek assurances from the other party that it will perform its obligations. 21-6 Evaluate when a party will have its performance excused on the grounds of commercial impracticability.

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IN THE TWO PREVIOUS chapters, we discussed the formation and terms of sales contracts, including those terms concerning express and implied warranties. In this chapter, the focus is on the legal rules that govern the performance of contracts. Among the topics covered are the basic obligations of the buyer and seller with respect to delivery and payment, the rights of the parties when the goods delivered do not conform to the contract, and the circumstances that may excuse the performance of a party’s contractual obligations.

General Rules

the contract or in carrying out the transaction [1-201(19)]. And, in the case of a merchant, good faith means honesty in fact as well as the observance of reasonable commercial standards of fair dealing in the trade [2-103(1)(b)]. Thus, if the contract requires the seller to select an assortment of goods for the buyer, the selection must be made in good faith; the seller should pick out a reasonable assortment [2-311]. It would not, for example, be good faith to include only unusual sizes or colors.

Course of Dealing The terms in the contract be-

Explain what is meant by the terms good faith, course

tween the parties are the primary means for determining the obligations of the buyer and seller. The meaning of those terms may be explained by looking at any performance that has already taken place. For example, a contract may call for periodic deliveries of goods. If the seller has made a number of deliveries without objection by the buyer, the way the deliveries were made shows how the parties intended them to be made. Similarly, if there were any past contracts between the parties, the way the parties interpreted those contracts is relevant to the interpretation of the present contract. If there is a conflict between the express terms of the contract and the past course of dealing between the parties, the express terms of the contract prevail [1-205(4)]. In the case below, Grace Label, Inc. v. Kliff, the court looked to the prior dealing between the parties to explain or supplement the terms of a current contract between the parties.

performance of sales contracts.

Usage of Trade In many kinds of businesses, there are

The parties to a contract for the sale of goods are obligated to perform the contract according to its terms. The Uniform Commercial Code (UCC) gives the parties great flexibility in deciding between themselves how they will perform a contract. The practices in the trade or business as well as any past dealings between the parties may supplement or explain the contract. The UCC gives both the buyer and the seller certain rights, and it also sets out what is expected of them on points that they did not deal with in their contract. It should be kept in mind that the UCC changes basic contract law in a number of respects.

Good Faith LO21-1 of dealing, and usage of trade as they pertain to the

The buyer and seller must act in good faith in the performance of a sales contract [1-203].1 Good faith is defined to mean “honesty in fact” in performing the duties assumed in The numbers in brackets refer to sections of the Uniform Commercial Code. 1

customs and practices of the trade that are known by people in the business and that are usually assumed by parties to a contract for goods of that type. Under the UCC, the parties and courts may use these trade customs and practices—known as usage of trade—in interpreting a contract [2-202, 1-205]. If there is a conflict between the express terms of the contract and trade usage, the express terms prevail [1-205(4)].

Ethics and Compliance in Action What Should You Do When the Price Rises—or Falls? When goods that are the subject of a contract are in significantly shorter supply than when the agreement was made and the price has risen, the seller may be tempted to look for an excuse so that he can sell to someone else and realize a greater profit. This situation often arises in the sale of commodities, such as crops, fuel oil, gasoline, and natural gas. Similarly, if goods are in significantly more plentiful supply

than when a contract was made, a buyer might be tempted to create an excuse to cancel so that she could buy elsewhere at a lower price. When, if ever, is a seller or buyer ethically justified in trying to find a way out of a contractual obligation because the supply or market conditions have so changed that he or she can make a much better deal elsewhere? Concomitantly, are there circumstances under which the other party, acting in an ethically responsible manner, should voluntarily release the disadvantaged party from his or her contractual commitment?



Chapter Twenty-One Performance of Sales Contracts

An example of usage of trade comes from the building supply business where one common lumber item is referred to as a “two-by-four” and might be assumed to measure two inches by four inches by someone not familiar

21-3

with trade practice. If you were to buy two-by-fours of varying lengths from your local lumberyard or building supply store, you would find that they in fact measure 1⅞ inches by 3¼ inches.

Grace Label, Inc. v. Kliff   355 F. Supp. 2d 965 (S.D. Iowa 2005) Steve Kliff, a citizen of California, is a sole proprietor in the business of brokering printing projects. On May 24, 2002, Barcel S.A. de C.V. (Barcel), a Mexican company, by purchase order contracted with Kliff for at least 47,250,000 foil trading cards bearing the likeness of Britney Spears. Barcel is a large, multinational corporation that sells a variety of food products. It indicated that the cards would be placed in snack-food packaging and would come in direct contact with the food contents. On May 30, Kliff by purchase order contracted with Grace Label to produce the Spears cards. Grace is an Iowa corporation engaged in the business of manufacturing pressure-sensitive labels and flexible packaging. The purchase order described the product as a “Foil Trading Card (Direct Food Contact Compatible).” It also specified the printing process was to use “FDA Varnish,” which Grace Label understood it was to use to accomplish the food contact compatibility requirement. Grace Label did not have any direct communication with Barcel because Kliff did not want it to be in touch with his customer. The Spears job was the third or fourth Barcel job Grace Label had worked on with Kliff in about a year’s time. Two of the jobs were arranged while Kliff was employed by Chromium Graphics; together, they involved 58,000,000 “scratch off” game piece cards, where customers rubbed off a coating to determine if they had won a prize. In February 2002, Kliff arranged for Grace Label to do the “Ponte Sobre Ruedas Job,” which involved printing about 42,000,000 “peel apart” game piece cards, whereby consumers peeled off a top layer to see if they had won a prize. The Spears card was simply a trading card with no “scratch off” or “peel apart” feature. The Spears card was varnished on both sides; the others were varnished on one side. The “direct food compatible” description appeared only in the Spears card purchase order. All of the cards manufactured by Grace Label for the various Barcel projects were inserted in packages of Barcel’s snack-food products. On several occasions, Kliff advised Grace Label that he wanted the same materials used for the Spears cards as had been used on the prior jobs. The adhesive used on the Chromium Graphics cards was Rad-Cure 12PSFLV, as specified by Chromium Graphics. This particular adhesive is not listed on the Rad-Cure website as being among Rad-Cure’s FDA (Food & Drug Administration) food-grade adhesives—but Grace Label was unaware of this. Other than ordering the FDA-approved varnish, Grace Label did nothing to determine if the other materials used to produce the Spears cards were compatible for direct contact with food items. Before its work for Barcel, Grace Label had not produced a product intended to be in direct contact with food—and it assumed that the materials it was told to use had been approved by Chromium Graphics or Barcel. Grace Label produced prototype cards, using leftover materials from the past Barcel jobs (except for the foil, which has no odor), and submitted them to Barcel, through Kliff, for approval. Grace Label understood that Barcel was interested in the size and weight of the cards to make sure they would fit in the Barcel dispensing units. Kliff was on the Grace Label premises during the first week of production and had many boxes of cards brought to him for inspection. He raised no issues concerning the cards. On June 28, 2002, Grace Label shipped 17,138,000 production cards directly to Barcel. An additional 7,500,000 cards were shipped to Barcel on July 5, 2002. After receipt of the production cards, Barcel complained to Kliff that the cards emitted a foul odor and were not fit for use in the potato chip bags for which they were intended. Grace Label suggested they be aired out to eliminate the odor. Barcel attempted to do this—but the odor persisted despite Grace Label’s contention that the Spears production cards smelled the same as the cards for the other Barcel jobs that Grace Label had printed and that had been accepted by Kliff and Barcel. Barcel rejected the cards under its contract with Kliff before the final production of cards was shipped from Grace Label. Kliff thereupon canceled the remaining order with Grace Label. Beyond a $90,000 down payment, Kliff did not pay Grace Label the contract amount for the cards. Grace Label then brought suit against Kliff for breach of contract. Kliff contended that the cards smelled bad and that the smell was caused by a chemical (beta-phenoxyethyl acrylate [BPA]) in the adhesive, which was not direct food compatible. Kliff’s expert stated that the BPA was undetectable in the prototype cards but that in the production cards, the concentration of BPA far exceeded that in uncured or cured Rad-Cure. Grace Label’s response was that Kliff specified and approved of the material components of the cards and it relied on Kliff and Barcel to select appropriate material as it had no expertise in the area. This argument would require the court to consider the course of dealing between the parties; Kliff objected to the introduction of this evidence.

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Walters, Chief United States Magistrate Judge The parol evidence rule does not bar the course of dealing between the parties. The UCC codifies a commercial version of the rule: Terms with respect to which the confirmatory memoranda of the parties agree or which are otherwise set forth in a writing intended as a final expression of their agreement with respect to such terms as are included therein and may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agreement but may be explained or supplemented (a) by a course of dealing or usage of trade . . . or by course of performance. [2-202(a)]. “Course of dealing” is a defined term meaning “a sequence of previous conduct between the parties to a particular transaction which is fairly to be regarded as establishing a common basis for interpreting their expressions and other conduct.” [1-205(3)]. A course of dealing “gives particular meaning to and supplements or qualifies terms of an agreement.” [1-205(3)].

Modification Under the UCC, consideration is not

required to support a modification or rescission of a contract for the sale of goods. However, the parties may specify in their agreement that modification or rescission must be in writing, in which case a signed writing is necessary for enforcement of any modification to the contract or its rescission [2-209].

Waiver In a contract that entails a number of instances

of partial performance (such as deliveries or payments) by one party, the other party must be careful to object to any late deliveries or payments. If the other party does not object, it may waive its rights to cancel the contract if other deliveries or payments are late [2-208(3), 2-209(4)]. For

“Whenever reasonable” express terms and the course of dealing are to be construed consistent with each other. The rule incorporated in the UCC reflects the commonsense assumption that the course of prior dealings between the parties and usages of trade were taken for granted when the contract document was phrased. [Author’s note: The court then held that the written contract could be explained or supplemented by “course of dealing” between the parties. Such evidence would be intended not to change or vary the contract terms, but rather to explain what the parties meant by them. At the same time, the court concluded that there were genuine issues of material fact that precluded giving summary judgment at this time. These included (1) whether the parties intended, on the basis of successful use of adhesive and other material on prior jobs, that the trading cards made with the same materials would be “direct food compatible” within the meaning of the contract and (2) whether the odor on the cards was worse than what had been accepted before.] Motion for summary judgment denied.

example, a contract calls for a fish wholesaler to deliver fish to a supermarket every Thursday and for the supermarket to pay on delivery. If the fish wholesaler regularly delivers the fish on Friday and the supermarket does not object, the supermarket will be unable to cancel the contract for that reason. Similarly, if the supermarket does not pay cash but sends a check the following week, then unless the fish wholesaler objects, it will not be able to assert the late payments as grounds for later canceling the contract. A party that has waived rights to a portion of the contract not yet performed may retract the waiver by giving reasonable notice to the other party that strict performance will be required. The retraction of the waiver is effective unless it would be unjust because of a material change of position by the other party in reliance on the waiver [2-209(5)].

CYBERLAW IN ACTION The Internet and E-Commerce Facilitate Contract Modifications Buyers and sellers sometimes change parts of their contracts after formation. For example, the buyer may need the goods slightly sooner or somewhat later than originally planned. Or the seller may be able to supply only yellow life jackets instead of the buyer’s preferred blue and red mix of life jackets. So long as the parties agree to change the

particulars of the performance contracted for, an event that Article 2 calls a “modification,” they may change their contract. Modifications are quite common in deals between two merchants and are not uncommon in sales in which one lay buyer and one merchant participate. Let’s assume that the buyer decides that her customers like the first shipment of goods under a contract so much that she should order more. To change the quantity in her office, she can do several



Chapter Twenty-One Performance of Sales Contracts

things—call the seller, or send a revised contract for the seller to sign and return. E-commerce makes this easier—the buyer can send an e-mail asking the seller to send more of the same goods, preferably by specifying the number above that provided in the earlier agreement that the buyer now wishes to buy. If the buyer bought three $60 life jackets for her own use, Article 2 allows a court to enforce the seller’s commitment to sell three at $60 each even without worrying about the statute of frauds in Section 2-201. However, if the buyer wanted to increase her order from 3 to 15 life jackets, the dollar amount of the purchase would rise above $500—and courts would not enforce the larger purchase unless the deal met the statute of frauds. How does the Internet help buyers and sellers who want to be able to enforce their agreements in court if the other party does

Assignment Under the UCC, the buyer and/or the seller may delegate their duties to someone else. If there is a strong reason for having the original party perform the duties, perhaps because the quality of the performance might differ otherwise, the parties may not delegate their duties. Also, they may not delegate their duties if the parties agree in the contract that there is to be no assignment of duties. However, they may assign rights to receive ­performance—for example, the right to receive goods or payment [2-210].

Delivery LO21-2

List the basic obligations and rights of the buyer and seller concerning the delivery of and payment for goods.

Basic Obligation The

basic duty of the seller is to deliver the goods called for by the contract. The basic duty of the buyer is to accept and pay for the goods if they conform to the contract [2-301]. The buyer and seller may agree that the goods are to be delivered in several lots or installments. If there is no such agreement, then a single delivery of all the goods must be made. Where delivery is to be made in lots, the seller may demand the price of each lot upon delivery unless there has been an agreement for the extension of credit [2-307].

Place of Delivery The

buyer and seller may agree on the place where the goods will be delivered. If no such agreement is made, then the goods are to be delivered at the seller’s place of business. If the seller

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not perform? Using either the federal E-Sign law or state-enacted versions of the Uniform Electronic Transactions Act (UETA), the party seeking to enforce the larger quantity could send an e-mail or message using a click-through form provided by a seller’s website, and could use that e-mail or other electronically revised order to show the fact of the revision to the “order” and, as applicable, the existence of a reply message from the seller confirming the seller’s agreement to the change. As a further example of how e-mail and the Internet assist sales transactions, sellers now routinely send or post confirmations that shipment has occurred. These messages help buyers plan for the arrival of goods, otherwise keep track of delays in orders that they may need to act upon, and also check that their insurance is effective for a particular purchase or that their warehouse is ready to receive the goods sent.

does not have a place of business, then delivery is to be made at his home. If the goods are located elsewhere than the seller’s place of business or home, the place of delivery is the place where the goods are located [2-308].

Seller’s Duty of Delivery The seller’s basic ob-

ligation is to tender delivery of goods that conform to the contract with the buyer. Tender of delivery means that the seller must make the goods available to the buyer. This must be done during reasonable hours and for a reasonable period of time, so that the buyer can take possession of the goods [2-503]. The contract of sale may require the seller merely to ship the goods to the buyer but not to deliver the goods to the buyer’s place of business. If this is the case, the seller must put the goods into the possession of a carrier, such as a trucking company or a railroad. The seller must also make a reasonable contract with the carrier to take the goods to the buyer. Then, the seller must notify the buyer that the goods have been shipped [2-504]. Shipment terms were discussed in Chapter 19, Formation and Terms of Sales Contracts. If the seller does not make a reasonable contract for delivery or notify the buyer and a material delay or loss results, the buyer has the right to reject the shipment. Suppose the goods are perishable, such as fresh produce, and the seller does not ship them in a refrigerated truck or railroad car. If the produce deteriorates in transit, the buyer can reject the produce on the ground that the seller did not make a reasonable contract for shipping it. In some situations, the goods sold may be in the possession of a bailee such as a warehouse. If the goods are

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Part Four Sales

covered by a negotiable warehouse receipt, the seller must endorse the receipt and give it to the buyer [2-503(4) (a)]. This enables the buyer to obtain the goods from the warehouse. Such a situation exists when grain being sold is stored at a grain elevator. The law of negoti- able documents of title, including warehouse receipts, is discussed in Chapter 23, Personal Property and Bailments. If the goods in the possession of a bailee are not covered by a negotiable warehouse receipt, then the seller must notify the bailee that it has sold the goods to the buyer and must obtain the bailee’s consent to hold the goods for delivery to the buyer or release the goods to the buyer. The risk of loss as to the goods remains with the seller until the bailee agrees to hold them for the buyer [2-503(4)(b)].

Inspection and Payment Buyer’s Right of Inspection Normally,

the buyer has the right to inspect the goods before he accepts or pays for them. The buyer and seller may agree on the time, place, and manner in which the buyer will inspect the goods. If no agreement is made, then the buyer may inspect the goods at any reasonable time and place and in any reasonable manner [2-513(1)]. If the shipping terms are cash on delivery (COD), then the buyer must pay for the goods before inspecting them unless they are marked “Inspection Allowed.” However, if it is obvious even without inspection that the goods do not conform to the contract, the buyer may reject them without paying for them first [2-512(1)(a)]. For example, if a farmer contracted to buy a bull and the seller delivered a cow, the farmer would not have to pay for it. The fact that a buyer may have to pay for goods before inspecting them does not deprive the buyer of remedies against the seller if the goods do not conform to the contract [2-512(2)]. If the goods conform to the contract, the buyer must pay the expenses of inspection. However, if the goods are nonconforming, he may recover his inspection expenses from the seller [2-513(2), 2-715(1)].

Payment The buyer and seller may agree in their con-

tract that the price of the goods is to be paid in money or in other goods, services, or real property. If all or part of the price of goods is payable in real property, then only the transfer of goods is covered by the law of sales of goods. The transfer of the real property is covered by the law of real property [2-304].

The contract may provide that the goods are sold on credit to the buyer and that the buyer has a period of time to pay for them. If there is no agreement for extending credit to the buyer, the buyer must pay for them upon delivery. The buyer usually can inspect goods before payment except where the goods are shipped COD, in which case the buyer must pay for them before inspecting them. Unless the seller demands cash, the buyer may pay for the goods by personal check or by any other method used in the ordinary course of business. If the seller demands cash, the seller must give the buyer a reasonable amount of time to obtain it. If payment is made by check, the payment is conditional on the check’s being honored by the bank when it is presented for payment [2-511(3)]. If the bank refuses to pay the check, the buyer has not satisfied the duty to pay for the goods. In that case, the buyer does not have the right to retain the goods and must give them back to the seller.

Acceptance, Revocation, and Rejection Explain when acceptance of goods occurs, what the

LO21-3 effect of accepting goods is, and when a buyer who has

accepted goods has the right to revoke such acceptance.

Acceptance Acceptance

of goods occurs when a buyer, after having a reasonable opportunity to inspect them, either indicates that he will take them or fails to reject them. To reject goods, the buyer must notify the seller of the rejection and specify the defect or nonconformity. If a buyer treats the goods as if he owns them, the buyer is considered to have accepted them [2-606]. For example, Ace Appliance delivers a new large flatscreen television set to Baldwin. Baldwin has accepted the set if, after trying it and finding it to be in working order, she says nothing to Ace or tells Ace that she will keep it. Even if the set is defective, Baldwin is considered to have accepted it if she does not give Ace timely notice that she does not want to keep it because it is not in working order. If she takes the set to her vacation home even though she knows that it does not work properly, this is also an acceptance. In the latter case, her use of the television set would be inconsistent with its rejection and the return of ownership to the seller.



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The Global Business Environment Assurance of Payment Perhaps the most important provisions in the international sales contract cover the manner by which the buyer pays the seller. Frequently, a foreign buyer’s contractual promise to pay when the goods arrive does not provide the seller with sufficient assurance of payment. The seller may not know the overseas buyer well enough to determine the buyer’s financial condition or inclination to refuse payment if the buyer no longer wants the goods when they arrive. When the buyer fails to make payment, the seller will find it difficult and expensive to pursue its legal rights under the contract. Even if the seller is assured that the buyer will pay for the goods on arrival, the time required for shipping the goods often means that payment is not received until months after shipment. To solve these problems, the seller often insists on receiving an irrevocable letter of credit. The buyer obtains a letter of credit from a bank in the buyer’s country. The letter of credit obligates the buyer’s bank to pay the amount of the sales contract to the seller. To obtain payment, the seller must produce a negotiable bill of lading and other documents proving that it shipped the goods required by the sales contract in conformity with the terms of the letter of credit.* A letter of credit is irrevocable when the buyer’s bank cannot withdraw its obligation to pay without the consent of the seller and the buyer. Letters of credit may be confirmed or advised. Under a confirmed letter of credit, the seller’s bank agrees to assume liability on the letter of credit. Typically, under a confirmed letter of credit, the buyer’s bank issues a letter of credit to the seller; the seller’s bank confirms the letter of credit; the seller delivers the goods to a carrier; the carrier issues a negotiable bill of lading to the seller; the seller delivers the bill of lading to the seller’s bank and presents a draft** drawn on the buyer demanding payment for the goods; the seller’s bank pays the seller for the goods; the buyer’s bank reimburses the seller’s bank; and the buyer reimburses its bank.

With an advised letter of credit, the seller’s bank merely acts as an agent for collection of the amount owed to the seller. The seller’s bank acts as agent for the seller by collecting from the buyer’s bank and giving the payment to the seller. The buyer’s bank is reimbursed by the buyer. The confirmed letter of credit is the least risky payment method for sellers. The confirmation is needed because the seller, unlike the confirming bank, may not know any more about the financial integrity of the issuing bank than it knows about that of the buyer. The seller has a promise of immediate payment from an entity it knows to be financially solvent—the confirming bank. If the draft drawn pursuant to the letter of credit is not paid, the seller may sue the confirming bank, which is a bank in his home country. Under the confirmed letter of credit, payment is made to the seller well before the goods arrive. Thus, the buyer cannot claim that the goods are defective and refuse to pay for them. When the goods are truly defective on arrival, however, the customer can commence an action for damages against the seller based on their original sales contract. Figure 21.1 summarizes the confirmed letter of credit transaction.

Conforming and Nonconforming Documents In a letter of credit transaction, the promises made by the buyer’s and seller’s banks are independent of the underlying sales contract between the seller and the buyer. Therefore, when the seller presents a bill of lading and other documents that conform to the terms of the letter of credit, the issuing bank and the confirming bank are required to pay, even if the buyer refuses to pay its bank or even, generally, if the buyer claims to know that the goods are defective. However, if the bill of lading or other required documents do not conform to the terms of the letter of credit, a bank may properly refuse to pay. A bill of lading is nonconforming when, for example, it indicates the wrong goods were shipped, states the wrong person to receive the goods, or states a buyer’s address differently than the letter of credit.

*A bill of lading is a document issued by a carrier acknowledging that the seller has delivered particular goods to it and entitling the holder of the bill of lading to  receive these goods at the place of destination. Bills of lading are discussed in Chapter 23. **A draft is a negotiable instrument by which the drawer (in this case, the seller) orders the drawee (the buyer) to pay the payee (the seller). Drafts are discussed in Chapter 31.

If a buyer accepts any part of a commercial unit of goods, he is considered to have accepted the whole unit [2-606(2)]. A commercial unit is any unit of goods that is treated by commercial usage as a single whole. It can be a single article (such as a machine), a set or quantity of articles (such as a dozen, bale, gross, or carload), or any other unit treated as a single whole [2-105(6)]. Thus, if a bushel

of apples is a commercial unit, then a buyer purchasing 10 bushels of apples who accepts 8½ bushels is considered to have accepted 9 bushels. In the Weil v. Murray case, which follows, the buyer was considered to have accepted goods that it had handled inconsistently with a claim of rejection and return of ownership of the goods to the seller.

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Part Four Sales

Figure 21.1 Confirmed Letter of Credit Transaction

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11. Buyer’s bank presents draft and transfers bill of lading to buyer

2. Buyer requests letter of credit from its bank

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9. Seller’s bank transfers draft and bill of lading to buyer’s bank

10. Buyer’s bank pays draft

Seller’s bank

Weil v. Murray   161 F. Supp. 2d 250 (S.D.N.Y. 2001) On October 19, 1997, Mark Murray, a New York art dealer and gallery owner, traveled to Montgomery, Alabama, to view various paintings in the art collection owned by Robert Weil. Murray examined one of the paintings under ultraviolet light—a painting by Edgar Degas titled Aux Courses. Murray discussed the Degas with Ian Peck, another art dealer, who indicated an interest in buying it and asked Murray to arrange to have it brought to New York. Murray and Weil executed an agreement that provided for consignment of the Degas to Murray’s gallery “for a private inspection in New York for a period of a week from November 3” to be extended only with the express permission of the consignor. The director of Murray’s Gallery picked up the painting, which was subsequently shown by Murray to Peck. Peck agreed to purchase the painting for $1,225,000 with Murray acting as a broker. On November 8, Murray advised Weil that he had a buyer for the Degas, and they orally agreed to the sale. Subsequently, they entered into a written agreement for the sale of the painting for $1 million that indicated, among other things, that if Weil did not receive full payment by December 8, Murray would disclose the name of the undisclosed principal on whose behalf he was acting. Neither Murray nor anyone else ever paid Weil the $1 million. Nonetheless, Murray maintained possession of the Degas from November 3, 1997, through March 25, 1998, when Weil requested its return. At some point in mid-November, Weil and Peck took the



Chapter Twenty-One Performance of Sales Contracts

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Degas to an art conservator. A condition report prepared by the conservator and dated December 3, 1997, showed that the conservator had cleaned the painting and sought to correct some deterioration. Weil brought an action to recover the price of the painting from Murray. Mukasey, District Judge The undisputed facts establish also that Murray accepted the Degas. “Goods that a buyer has in its possession necessarily are accepted or rejected by the time a reasonable opportunity for inspecting them passes.” Murray first inspected the Degas under an ultraviolet light when he viewed it at the Weils’ home in late October. Murray had the opportunity to further examine the Degas at his gallery in New York pursuant to the consignment agreement and his continued possession of the painting following the expiration of the consignment agreement. It is also undisputed that Murray was present when Simon Parkes assessed the condition of the painting sometime between November 3 and November 19, 1997. Not only did Murray have a reasonable time to inspect the goods, but also it is undisputed that he actually did inspect the Degas. There is no evidence that Murray found the painting unsatisfactory or nonconforming. See Integrated Circuits Unltd. v. E. F. Johnson Co., 875 F.2d 1040, 1042 (2d Cir. 1989) (discussing acceptance as the failure to make an effective rejection after a reasonable time to inspect). Although the question of whether the buyer has had a reasonable time to inspect is generally a question for the trier of fact, no reasonable jury could

Effect of Acceptance Once a buyer has accepted

goods, he cannot later reject them unless, at the time they were accepted, the buyer had reason to believe that the nonconformity would be cured. By accepting goods, the buyer does not forfeit or waive all remedies against the seller for any nonconformities in the goods. However, if the buyer wishes to hold the seller responsible, he must give the seller timely notice that the goods are nonconforming. The buyer is obligated to pay for goods that are accepted. If the buyer accepts all of the goods sold, she is, of course, responsible for the full purchase price. If the buyer accepts only part of the goods, she must pay for that part at the contract rate [2-607(1)]. Explain when acceptance of goods occurs, what the

LO21-3 effect of accepting goods is, and when a buyer who has

accepted goods has the right to revoke such acceptance.

Revocation of Acceptance Under

certain circumstances, a buyer may revoke or undo the acceptance. A buyer may revoke acceptance of nonconforming goods where (1) the nonconformity substantially impairs

find that Murray did not accept the Degas in light of the undisputed facts that he inspected the Degas on at least two occasions, signed the written agreement, and continued to retain possession of the Degas. See Sessa v. Riegle, 427 F. Supp. 760, 767 (D.C. Pa. 1977) (finding acceptance when buyer was permitted unlimited inspection of a horse and then indicated that he would buy the horse). Moreover, it is undisputed that, without Weil’s consent, Murray, at a minimum, permitted the painting to be cleaned and restored in late November or early December. Murray’s participation in the alteration of the painting, regardless of whether such alteration increased its value, was an act inconsistent with Weils’ ownership. See In re Fran Char Press, Inc., 55 B.R. 55, 57 (Bankr. E.D.N.Y. 1985) (finding that buyer had accepted posters by taking possession of them and mounting them on cardboard); Industria De Calcados Martini Ltd. v. Maxwell Shoe Co., 630 N.E.2d 299 (Mass. App. Ct. 1994) (finding acceptance where buyer had shoes refinished). The Weils have established that Murray agreed to purchase the Degas, accepted it, and nonetheless failed to pay the purchase price. Summary judgment granted in favor of the Weils.

the value of the goods and (2) the buyer accepted them without knowledge of the nonconformity because of the difficulty of discovering the nonconformity or the buyer accepted the goods because of the seller’s assurances that it would cure the defect [2-608(1)]. The buyer must exercise her right to revoke acceptance within a reasonable time after the buyer discovers or should have discovered the nonconformity. Revocation is not effective until the buyer notifies the seller of the intention to revoke acceptance. After a buyer revokes acceptance, her rights are the same as they would have been if the goods had been rejected when delivery was offered [2-608]. The Pittman v. Henry Moncure Motors case, which follows, illustrates some of the considerations involved in determining whether a buyer acted reasonably to revoke acceptance. The right to revoke acceptance could arise, for example, where Arnold buys a new car from Dealer. While driving the car home, Arnold discovers that it has a seriously defective transmission. When she returns the car to Dealer, Dealer promises to repair it, so Arnold decides to keep the car. If Dealer does not fix the transmission after repeated efforts to fix it, Arnold could revoke her acceptance on the

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Part Four Sales

grounds that the nonconformity substantially impairs the value of the car, that she took delivery of the car without knowledge of the nonconformity, and that her acceptance was based on Dealer’s assurances that he would fix the car. Similarly, revocation of acceptance might be involved where a serious problem with the car not discoverable by inspection shows up in the first month’s use.

Revocation must occur prior to any substantial change in the goods, however, such as serious damage in an accident or wear and tear from using them for a period of time. What constitutes a “substantial impairment in value” and when there has been a “substantial change in the goods” are questions that courts frequently have to decide when an attempted revocation of acceptance results in a lawsuit.

Pittman v. Henry Moncure Motors    87 UCC Rep. 2d 619 (N.C. Ct. App. 2015)

On January 10, 2003, Ashley Keith Pittman and DeAnna Pittman entered into a contract with Moncure Motors for the sale, delivery, and setup of a manufactured home for a total price of $92,135. That price included $15,000 in “optional equipment,” $9,500 of which was for a brick foundation. The Pittmans intended it to be their primary residence. At Moncure’s request, Ashley Pittman contracted with a mason to build a foundation for the home and with a contractor to perform the rest of the setup of the home. This entailed lifting the walls and the roof, including putting braces on the rafters, attaching plywood to the roof, and nailing extra shingles. The home was manufactured by Crestline Homes, a company that subsequently filed for bankruptcy. It was delivered to the Pittmans’ lot in two sections wrapped in plastic wrap seal in May 2003. In transit, wind and rain ripped the plastic of one of the sections all the way down its side, causing water to enter into it. After both sections were delivered, more rain fell and entered into the exposed section. Prior to the setup, Ashley Pittman and Philip Moncure, the president and general manager of Moncure Motors, together saw that one of the sections had suffered water damage from the leakage. After the foundation was built and the home was lifted onto the foundation by crane, the contractor erected the roof. However, he improperly installed the roof. Although Ashley Pittman told Moncure that “this is not what I paid for” and to “take the home back,” Moncure assured him that he would address the problems with the home. Part of the home was gutted, cleaned of mold, and rebuilt. In September 2003, the Pittmans moved into the house; subsequently, they experienced severe water leakage through the roof as well as a number of other problems with the interior and exterior of the home. Moncure unsuccessfully attempted to address these problems over the next year and, in September 2004, the Pittmans, through their attorney, demanded a replacement home from Moncure Motors and Crestline. Following the September 2004 letter, the parties agreed that Crestline would be given a further opportunity to cure the defects in the home, and Moncure Motors would be financially responsible for the repairs covered by warranty. While over the next two years the roof, vinyl siding, and electrical circuit breakers were replaced, many defects, including problems with the electrical system, persisted. The Pittmans then brought suit against Moncure Motors and Crestline alleging breach of warranty and seeking a refund of the full purchase price as buyers who had justifiably revoked their acceptance of the purchase price. The trial court awarded the Pittmans damages for breach of warranty in the amount of $92,135 plus interest at the legal rate from September 1, 2004, the date the trial court found that the Pittmans had made it unequivocally clear they had rescinded the contract. The trial court further specified that upon Moncure Motors’s payment of the damages, it would be entitled to recover the manufactured home from the Pittmans’ property upon no less than six months’ notice. Moncure and Crestline Homes appealed. Geer, Judge  The UCC’s warranty of implied merchantability guarantees, among other things, that goods are fit for the ordinary purposes for which such goods are used. Implicit to a home’s fitness for use as a dwelling is that it be free of major defects. The evidence

presented at trial overwhelmingly supports the conclusion that the home was not fit for use as a dwelling unit. We next address the trial court’s determination that the Pittmans “elected to rescind” the purchase of the manufactured home by their “words and conduct.” Although “rescission” is not a remedy



Chapter Twenty-One Performance of Sales Contracts

available under the UCC, section 2-608 provides for the similar remedy of revocation of acceptance. After accepting goods from a seller, 1. The buyer may revoke his acceptance of a lot or commercial unit whose nonconformity substantially impairs its value to him if he accepted it (a) On the reasonable assumption that its nonconformity would be cured and it has not been seasonably cured; or (b) Without discovery of such nonconformity if his acceptance was reasonably induced either by the difficulty of discovery before acceptance or by the seller’s assurances. A buyer who revokes has the same rights and duties with respect to the goods as if he had rejected them. Section 2-608(3). Formal notice that acceptance is being revoked is not necessary; any conduct by the buyer manifesting to the seller that he is seriously dissatisfied with the goods and expects redress or satisfaction is sufficient. Although the trial court referred to the remedy of rescission, our appellate courts have concluded that references to the remedy of rescission should be treated as revocations of acceptance. Accordingly, we must determine whether the trial court’s findings are sufficient to support the conclusion that the Pittmans revoked their acceptance. After making findings regarding the substantial defects in the manufactured home, the trial court determined that the Pittmans by “words and conduct” elected to rescind the purchase of the dwelling. The court found that a reasonable person in the same or similar circumstances would consider the breach a substantial deprivation of the material benefit of the purchase of the dwelling. After the Pittmans gave Moncure Motors notice of the breach, Moncure Motors “attempted to repair and correct the water damage and the workmanlike setup of the dwelling in a reasonable and timely manner, but failed to be successful in doing so.” Based on these findings, the trial court concluded that the Pittmans “justifiably rescinded the sale/purchase of the manufactured mobile home.” We hold that the record contains ample evidence to support the findings regarding the defects, notice of those defects to Moncure Motors, the Pitt- mans’s attempts to reject acceptance of the manufactured home by demanding replacement of the home, and Moncure Motors’ inability to repair and correct the defects. The evidence is sufficient to support a determination that the Pittmans initially revoked acceptance of the purchase of their home. Nonetheless, the defendants contend that the Pittmans’s uninterrupted residence in the home, for at least 11 years, should ultimately be read as the Pittmans’s acceptance of the home and its nonconformities. The reasonableness of continued use of defective goods after revocation may depend on whether “(1) the seller tendered

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instructions concerning return of the rejected goods upon notice of the revocation; (2) business needs or personal circumstances compelled the buyer’s continued use; (3) the seller continued to offer assurances that the nonconformities would be cured or that the buyer would be recompensed for dissatisfaction and inconvenience during the period of continued use; (4) the seller acted in good faith; and (5) the seller suffered undue prejudice as a result of the continued use.” [Citation omitted.] Here, pursuant to Crestline’s promise to make further repairs following the September 2004 letter, numerous attempts were made to address continued defects in the home, including, among other things, replacing the roof, vinyl siding, and electric circuit breakers. Yet, despite these attempted repairs, the record and transcript are replete with references to problems that had not been repaired at the time of trial. Further, Mr. Pittman testified that he has been continuously dissatisfied with the home: “[I]t is steady stuff wrong. It has never been right. . . . And, I feel like when I paid that money—I can understand a few things being wrong, but I think it went overboard.” Mr. Pittman testified that he would have returned the home to Moncure Motors, but Moncure Motors would not allow that. He also testified that he and his family would have walked away from the home if they were not indebted on it and the home were not on their family’s land. Nothing in the record suggests that the Pittmans ever indicated to the defendants that they were even remotely satisfied with the home. Contrary to defendants’ contention that the Pittmans ultimately accepted the egregiously defective home, the evidence shows that if the Pittmans at all waived revocation of acceptance after giving notice via the September 2004 letter, such waiver was made on the condition that the repairs would be made to the Pittmans’s satisfaction. The evidence was uncontradicted that the Pittmans would have walked away from the home but for the facts that Moncure Motors refused tender of the home; the home was placed on the Pittmans’s family land; the Pittmans were indebted on it; after giving notice of revocation of acceptance, the Pittmans agreed to allow Moncure Motors and Crestline more time to attempt repairs; and the subsequent numerous attempts to address the defects in the home were unsuccessful. Based on that evidence, the conditions necessary for the Pitt- mans to waive their revocation of acceptance failed to materialize. We also note that there is no evidence that the defendants were prejudiced by the continued use: Mr. Moncure testified that it cost less to attempt repairs than to replace the home, and Moncure Motors acquiesced in Crestline’s decision to attempt further repairs. Judgment for the Pittmans affirmed.

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Part Four Sales

Buyer’s Rights on Improper Delivery Discuss the buyer’s rights and duties on improper

LO21-4 delivery of goods as well as the seller’s right to cure a

defective delivery.

If the goods delivered by the seller do not conform to the contract, the buyer has several options. The buyer can (1) reject all of the goods, (2) accept all of them, or (3) accept any commercial units and reject the rest [2-601]. The buyer, however, cannot accept only part of a commercial unit and reject the rest. The buyer must pay for the units accepted at the price per unit provided in the contract. Where the contract calls for delivery of the goods in separate installments, the buyer’s options are more limited. The buyer may reject an installment delivery only if the nonconformity substantially affects the value of that delivery and cannot be corrected by the seller in a timely fashion. If the nonconformity is relatively minor, the buyer must accept the installment. The seller may offer to replace the defective goods or give the buyer an allowance in the price to make up for the nonconformity [2-612]. For example, a produce wholesaler agrees to provide a grocer with 10 crates of lettuce each week for the next year. This would be an installment contract. If one week about half the lettuce in one of the crates has rotted, the buyer likely would have to accept the shipment and settle for an adjustment in the price for that crate. If six of the crates contained rotten lettuce, the seller would either have to promptly remedy the nonconforming delivery and send six replacement crates, or the buyer would be able to reject the entire shipment on the grounds that the nonconformity (the six crates of rotten lettuce) substantially affected the value of the entire delivery that week.

Where the nonconformity or defect in one installment impairs the value of the whole contract, the buyer may treat it as a breach of the whole contract but must proceed carefully so as not to reinstate the remainder of the contract [2-612(3)].

Rejection If a buyer has a basis for rejecting a deliv-

ery of goods, the buyer must act within a reasonable time after delivery. The buyer must also give the seller notice of the rejection, preferably in writing [2-602]. The buyer should be careful to state all of the defects on which he is basing the rejection, including all of the defects that a reasonable inspection would disclose. This is particularly important if these are defects that the seller might cure (remedy) and the time for delivery has not expired. In that case, the seller may notify the buyer that he intends to redeliver conforming goods. If the buyer fails to state in connection with his rejection a particular defect that is ascertainable by reasonable inspection, he cannot use the defect to justify his rejection if the seller could have cured the defect had he been given reasonable notice of it. In a transaction taking place between merchants, the seller has, after rejection, a right to a written statement of all the defects in the goods on which the buyer bases his right to reject, and the buyer may not later assert defects not listed in justification of his rejection [2-605]. If the buyer wrongfully rejects goods, she is liable to the seller for breach of the sales contract [2-602(3)]. In the case that follows, Hillerich & Bradsby v. Charles Products, the court addressed the question of whether a buyer had acted in a timely fashion to notify the seller of a defect in products it had delivered to it for sale in a museum store.

CYBERLAW IN ACTION Providing Notice Sections 2-602 and 2-607 require that the buyer notify the seller if the buyer wishes to reject goods the seller has tendered to the buyer, or if the buyer decides to revoke acceptance of goods that the seller has promised to repair or replace and has neither repaired nor replaced the goods as promised—or where the buyer gets goods that have a latent (hard-to-find) defect. “Notice” does not have to be in writing to be effective under 2-602 or 2-607, but many buyers prefer to have a record that they gave notice to the seller and the time of the notice

given. This reduces the risk that a court will find that the buyer’s failure to give notice deprives the buyer of her right to a remedy [see Section 2-607(3)(a)]. Electronic commerce tools, including e-mail, allow buyers to provide speedy and reliable information to sellers in cases such as these. Buyers whose e-mail systems provide confirmation that the seller recipient actually has received the message about the buyer’s concerns about the goods, or who show the time and date that the intended recipient opened the e-mail, should make providing notice easier and less expensive than using traditional means of communication.



Chapter Twenty-One Performance of Sales Contracts

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Hillerich & Bradsby Co. v. Charles Products   88 UCC Rep. 2d 178 (W.D. Ky. 2015) On November 29, 2010, Charles Products entered into an agreement to provide Hillerich & Bradsby with a variety of products to be sold in Hillerich & Bradsby’s Louisville Slugger Museum Store. The products included ball and cup sets, baseball piggy banks, batter ducks, stress balls, “Bunny H2O cups,” “Kids Pop-Up Water Bottles,” “Bunny Sippy Cups,” and lunchboxes. Under the Consumer Products Safety Improvement Act of 2008 (CPSIA), manufacturers generally must provide accompanying a shipment of goods designed to be sold to children a certificate of compliance that identifies “the manufacturer or private labeler issuing the certificate and any third-party conformity assessment body on whose testing the certificate depends.” CPSIA also requires manufacturers to place permanent, distinguishing marks on children’s products and packaging. The markings are intended to enable the manufacturer as well as the ultimate purchaser to ascertain the location and date of production of the product and cohort information (including the batch, run number, or other identifying characteristic). CPSIA also mandates that children’s products generally must not contain more than 100 parts per million of total lead content. Charles Products began tendering the items about February 15, 2011. After two months of selling the items, the director of retail for the museum sent an e-mail to the regional sales representative for Charles Products, asking whether they were sure the paint on the “ball and cup” set was not lead based and whether it complied with the CPSIA regulations. In November, some nine months after Charles Products began to tender products to Hillerich & Bradsby, the director of retail again contacted the Charles representative indicating that she needed the certificates for the products they had that were intended for youth under 12. Subsequently, she also asked for test documentation that they were in compliance with the CPSIA guidelines. Further e-mail exchanges between the parties in February 2012 focused on the lack of documentation for the products. In April 2012, Charles Products was informed that one of its products—a rubber die cut mug—was tested for lead content and found to exceed the CPSIA lead limit. The following month, two other products—the baseball piggy bank and the lunchbox—were similarly found to be nonconforming due to excess lead. Hillerich & Bradsby then had to pull those items from the sales floor and sought to return them for a full refund of the purchase price. In August, after consulting with the Consumer Products Safety Commission concerning items with noncompliant tracking labels, Hillerich & Bradsby informed Charles Products it would be returning all noncompliant items. Hillerich & Bradsby had sold a substantial number of some items. For example, it sent back only 107 of 1,514 “timers” it had received, 34 of 748 “batter ducks,” 1,394 out of 4,4452 “stress balls,” and 263 of 1,001 “Big Rig Trailers.” On the other hand, it had only sold a small fraction of the amount of some other items received from Charles Products; for example, it returned 1,338 of 1,443 “Bunny H20 cups,” 1,236 out of 1,438 “Kids Pop Up Water bottles,” and 2,321 of 2,472 “#@1 Bunny Sippy Cups.” However, over a period of a year and a half, Hillerich & Bradsby had sold hundreds of products it subsequently alleged were nonconforming. Charles Products picked up the remaining products on September 14, 2012, and then hired a division of Underwriters Laboratory to review the disputed products to determine whether or not any products were noncompliant with the CPSIA and, if so, how to bring them into compliance. Charles Products advised Hillerich & Bradsby of the results on November 9. Hillerich & Bradsby then filed a breach of contract claim against Charles Products alleging noncompliance with the CPSIA, and it, in turn, filed a counterclaim for breach of contract. Simpson, Senior Judge. Both parties move for summary judgment on Hillerich & Brasby’s claim for breach of contract. The Court will grant Hillerich & Bradsby’s motion for summary judgment on its breach of contract claim relating to the baseball piggy bank and rubber die cut mug products. The court will grant Charles Products’ motion for summary judgment with respect to all other items except relating to the lunchbox. a. Timely Revocation of Tendered Goods Under Kentucky law governing the revocation of tendered goods, “where a tender has been accepted (a) the buyer must within a reasonable time after he discovers or should have discovered any breach, notify the seller of breach or be barred from any ­remedy.  .  .  .” [2-607 (emphasis added)]. Whether an action is

taken within a reasonable time “depends on the nature, purpose, and circumstances.” [1-205]. While this is generally a question for the trier of fact, “there simply are situations in which a buyer has delayed so excessively that his actions become untimely as a matter of law.” Chernick v. Casares, 759 S.W.2d 832, 834 (Ky. Ct. App. 1988). Beginning about February 15, 2011, Charles Products tendered to Hillerich & Bradsby the relevant products. Hillerich & Bradsby accepted those products and began to sell them in the museum store. While lead content in products is not readily identifiable, the lack of a certificate of compliance within a shipment or failure to properly label a product is immediately ascertainable upon delivery. Hillerich & Bradsby’s representative, Laura Ginnebaugh, knew CPSIA regulations applied to these products. Yet neither

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Part Four Sales

Ginnebaugh nor anyone at Hillerich & Bradsby contacted Charles Products concerning certificates of compliance until at the earliest November 16, 2011—approximately nine months after the initial non-conforming tender. Indeed, Ginnebaugh’s email to Doug Miller at Charles Products shows that Hillerich & Bradsby knew it should have addressed the issue earlier than nine months after it began receiving shipments. See November 18, 2011, Ginnebaugh email informing Miller that Ginnebaugh’s “quality assurance manager is asking for test documentation that we are in compliance with CPSIA guidelines. . . . I knew this was going to catch up to me.” Further, Ginnebaugh did not contact Miller about the lack of tracking labels on Charles Products’ products until February 10, 2012: “I will HAVE to have some sort of identifying number on these products. . . . I have a REALLY bad feeling about this.” (emphasis in original document). During the time of these email conservations, Hillerich & Bradsby continued selling Charles Products’ products. Hillerich & Bradsby did not remove these items from the museum store shelves until May 22, 2012, and did not inform Charles Products it was revoking acceptance of the goods until August 14, 2012—approximately a year and a half after the initial non-conforming tender. This is a situation where a buyer has delayed so excessively that his actions become untimely as a matter of law. See Knapp Shoes v. Sylvania Shoe Mfg. Corp., 72 F. 3d 190, 201 (1st Cir. 1995) (noting that under the UCC a buyer cannot “accept deliveries of a vast number of items over a period of a year and a half and then suddenly revoke the acceptance of all of them based on defects whose presence was known or suspected during the entire period”). Hillerich & Bradsby should have discovered the failure to include certificates of compliance and proper product labeling a short period after receipt, if not immediately. Instead, Hillerich & Bradsby sold hundreds of these products for approximately a year and a half. Accepting deliveries for nine months without mentioning readily identifiable defects and waiting one and a half years to revoke bars Hillerich & Bradsby from now properly revoking its contract. Whatever the reasonable amount of time to raise such issues and subsequently timely revoke a contract, no reasonable trier of fact could find that obvious and immediately ascertainable defects were timely revoked after this unreasonable, substantial delay. As an impermissible lead content is not an obvious breach, however, Hillerich & Bradsby did reasonably revoke the contract after relying on Charles Products’ assurances pertaining to the three products—baseball piggy bank, lunchbox and rubber die cut mug—containing an impermissible amount of lead. The Court will grant Charles Products’ motion for summary judgment as it pertains to Hillerich & Bradsby’s breach of contract claim for Charles Products’ failure to provide certificates of compliance and proper labeling.

b. Meaningful Opportunity to Seasonally Cure the Defects Under Kentucky law, a “buyer may revoke his acceptance of a lot or commercial unit whose nonconformity substantially impairs its value to him if he has accepted it (a) on the reasonable assumption that its nonconformity would be cured and it has not been seasonably cured. . . .” [2-608(1)]. Both parties agree Charles Products advised Hillerich & Bradsby that any defective products would be brought into conformance. The only question is whether Charles Products had reasonable time to cure the remaining defective products. As Charles Products admits the piggy bank and rubber die cup were not curable, this affirmative defense does not apply to that aspect of Hillerich & Bradsby’s claim. On May 22, 2012, a Hillerich & Bradsby representative emailed Charles Products indicating that the lunchboxes were nonconforming. Emails prior to that date inquiring whether the products were generally conforming did not give Charles Products sufficient notice that the lunchboxes did not conform. General inquiry emails are not the same as demanding specific products to be cured or an affirmative statement of non-compliance. After receiving Hillerich & Bradsby’s test reports on the lead content of the lunchboxes, Charles Products emailed Hillerich & Bradsby saying that it was looking at curing the defect by switching the handles on the lunchbox with a compliant part. Approximately three weeks later, Hillerich & Bradsby informed Charles Products that it was revoking the acceptance of goods. The facts suggest that Charles Products would have had difficulties in contacting its overseas manufacturer to replace the defective handles in a short period of time. While a trier of fact could find that Charles Products was given a reasonable amount of time to cure the defect, there remains a genuine issue of material fact on whether Hillerich & Bradsby allowed Charles Products a meaningful opportunity to cure the defects. The Court will deny both parties’ motion for summary judgment as it pertains to Hillerich & Bradsby’s breach of contract claim based on Charles Products’ supplying lunchboxes with an impermissible lead content. c. Baseball Piggy Bank and Rubber Die Cut Mug The parties agree the baseball piggy bank and rubber die cut mug contained impermissible amounts of lead under the CPSIA. Charles Products “has conceded liability on these products and agreed to provide [Hillerich & Bradsby] a credit when the parties still had a commercial relationship.” The Court will grant Hillerich & Bradsby’s motion for summary judgment in part for breach of contract due to the baseball piggy bank and rubber die cut mug containing impermissible amounts of lead.



Chapter Twenty-One Performance of Sales Contracts

Right to Cure If the seller has some reason to believe

that the buyer would accept nonconforming goods, then the seller can take a reasonable time to reship conforming goods. The seller has this opportunity even if the original time for delivery has expired. For example, Ace Manufacturing contracts to sell 200 red, white, and blue soccer balls to Sam’s Sporting Goods, with delivery to be made by April 1. On March 1, Sam’s receives a package from Ace containing 200 all-white soccer balls and refuses to accept them. Ace can notify Sam’s that it intends to cure the improper delivery by supplying 200 red, white, and blue soccer balls, and it has until April 1 to deliver the correct balls to Sam’s. If Ace thought that Sam’s would accept the all-white soccer balls because on past shipments Sam’s did not object to the substitution of white balls for red, white, and blue balls, then Ace has a reasonable time even after April 1 to deliver the red, white, and blue soccer balls [2-508].

Buyer’s Duties after Rejection If the buyer

is a merchant, then the buyer owes certain duties concerning the goods that he rejects. First, the buyer must follow any reasonable instructions that the seller gives concerning disposition of the goods. The seller, for example,

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might request that the rejected goods be shipped back to the seller. If the goods are perishable or may deteriorate rapidly, then the buyer must make a reasonable effort to sell the goods. The seller must reimburse the buyer for any expenses that the buyer incurs in carrying out the seller’s instructions or in trying to resell perishable goods. In reselling goods, the buyer must act reasonably and in good faith [2-603(2) and (3)]. If the rejected goods are not perishable or if the seller does not give the buyer instructions, then the buyer has several options. First, the buyer can store the goods for the seller. Second, the buyer can reship them to the seller. Third, the buyer can resell them for the seller’s benefit. If the buyer resells the goods, the buyer may keep his expenses and a reasonable commission on the sale. If the buyer stores the goods, the buyer should exercise care in handling them. The buyer also must give the seller a reasonable time to remove the goods [2-604]. If the buyer is not a merchant, then her obligation after rejection is to hold the goods with reasonable care for a sufficient time to give the seller an opportunity to remove them. The buyer is not obligated to ship the goods back to the seller [2-602].

CONCEPT REVIEW Acceptance, Revocation, and Rejection Acceptance

1. Occurs when buyer, having had a reasonable opportunity to inspect goods, either (a) indicates he will take them or (b) fails to reject them. 2. If buyer accepts any part of a commercial unit, he is considered to have accepted the whole unit. 3. If buyer accepts goods, he cannot later reject them unless at the time they were accepted the buyer had reason to believe that the nonconformity would be cured. 4. Buyer is obligated to pay for goods that are accepted.

Revocation

1. Buyer may revoke acceptance of nonconforming goods where (a) the nonconformity substantially impairs the value of the goods and (b) buyer accepted the goods without knowledge of the nonconformity because of the difficulty of discovering the nonconformity or buyer accepted because of assurances by the seller. 2. Right to revoke must be exercised within a reasonable time after buyer discovers or should have discovered the nonconformity. 3. Revocation must be invoked before there is any substantial change in the goods. 4. Revocation is not effective until buyer notifies seller of his intent to revoke acceptance.

Rejection

1. Where the goods delivered do not conform to the contract, buyer may (a) reject all of the goods, (b) accept all of the goods, or (c) accept any commercial unit and reject the rest. Buyer must pay for goods accepted. 2. Where the goods are to be delivered in installments, an installment delivery may be rejected only if the nonconformity substantially affects the value of that delivery and cannot be corrected by the seller. 3. Buyer must act within a reasonable time after delivery.

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Part Four Sales

Assurance, Repudiation, and Excuse Indicate when a party to a contract has the right to seek

LO21-5 assurances from the other party that it will perform its

obligations.

Assurance The

buyer or seller may become concerned that the other party may not be able to perform his contract obligations. If there is a reasonable basis for that concern, the buyer or seller can demand assurance from the other party that the contract will be performed. If such assurances are not given within a reasonable time not exceeding 30 days, the party is considered to have repudiated the contract [2-609].

Anticipatory Repudiation Sometimes,

one of the parties to a contract repudiates the contract by advising the other party that he does not intend to perform his obligations. When one party repudiates the contract, the other party may suspend his performance. In addition, he may either await performance for a reasonable time or use the remedies for breach of contract that are discussed in Chapter 22 [2-610]. Suppose the party who repudiated the contract changes his mind. Repudiation can be withdrawn by clearly indicating that the person intends to perform his obligations. The repudiating party must do this before the other party has

canceled the contract or has materially changed position, for example, by buying the goods elsewhere [2-611].

Excuse LO21-6

Evaluate when a party will have its performance excused on the grounds of commercial impracticability.

Unforeseen events may make it difficult or impossible for a person to perform his contractual obligations. The UCC rules for determining when a person is excused from performing are similar to the general contract rules. General contract law uses the test of impossibility. In most situations, however, the UCC uses the test of commercial impracticability. The UCC attempts to differentiate events that are unforeseeable or uncontrollable from events that were part of the risk borne by a party. If the goods required for the performance of a contract are destroyed without fault of either party prior to the time that the risk of loss passed to the buyer, the contract is voided [2-613]. Suppose Jones agrees to sell and deliver an antique table to Brown. The table is damaged when Jones’s antiques store is struck by lightning and catches fire. The specific table covered by the contract was damaged without fault of either party prior to the time that the risk of loss was to pass to Brown. Under the UCC, Brown has the option of either canceling the contract or accepting the table with an allowance in the purchase price to compensate for the damaged condition [2-613].

The Global Business Environment Insecurity in International Transactions The Convention on Contracts for the International Sale of Goods (CISG) has provisions concerning insecurity, assurance, and anticipatory repudiation that parallel those in the UCC. Under Article 71 of CISG, a party may suspend performance of his obligations if, after the contract is entered, it “becomes apparent that the other party will not perform a substantial part of his obligations as a result of: (a) a serious deficiency in his ability to perform or his creditworthiness; or (b) his conduct in preparing to perform or in performing the contact.” The party suspending performance must immediately give notice to the other party and must continue with performance if the other party provides adequate assurance of its performance. Under Article 72 of CISG, if prior to the date of performance of a contract, it is clear that one of the parties will “commit a

fundamental breach of contract,” the other party may declare the contract avoided. If time allows, the party intending to declare the contract avoided must give reasonable notice to the other party in order to permit him to provide adequate assurance of his performance. However, such notice need not be provided if the other party has declared that he will not perform the contract. A German court* upheld an Italian shoe manufacturer’s decision to avoid a contract and awarded damages against the German buyer. The German company had ordered 140 pairs of winter shoes from the Italian manufacturer. After the shoes were manufactured, the Italian seller demanded security for the sales price as the buyer had other accounts payable to the seller still outstanding. When the buyer neither paid nor provided security, the seller declared the contract avoided and resold the shoes to other retailers. The court allowed the seller to recover the difference between the contract price and the price it obtained in the substitute transactions.

*Oberlandesgericht Dusseldorf, 17 U 146/93, Jan. 14, 1994 (Germany), 1 UNILEX D. 1994-1 (M. J. Bonnell, ed.)



Chapter Twenty-One Performance of Sales Contracts

If unforeseen conditions cause a delay or the inability to make delivery of the goods and thus make performance impracticable, the seller is excused from making delivery. However, if a seller’s capacity to deliver is only partially affected, the seller must allocate production in any fair and reasonable manner among his customers. The seller has the option of including any regular customer not then under contract in his allocation scheme. When the seller allocates production, he must notify the buyers [2-615]. When a buyer receives this notice, the buyer may either terminate the contract or agree to accept the allocation [2-616]. For example, United Nuclear contracts to sell certain quantities of fuel rods for nuclear power plants to a number of electric utilities. If the federal government limits the amount of uranium that United has access to, so that United is unable to fill all of its contracts, United is excused

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from full performance on the grounds of commercial impracticability. However, United may allocate its production of fuel rods among its customers by reducing each customer’s share by a certain percentage and giving the customers notice of the allocation. Then, each utility can decide whether to cancel the contract or accept the partial allocation of fuel rods. In the absence of compelling circumstances, courts do not readily excuse parties from their contractual obligations, particularly where it is clear that the parties anticipated a problem and sought to provide for it in the contract. In the case that follows, Rochester Gas and Electric Corporation v. Delta Star, a court rejected a seller’s contention that a significant increase in its cost of materials created a commercial impracticability, excusing it from its obligation to perform the contract at the agreed-upon price.

Rochester Gas and Electric Corporation. v. Delta Star    68 UCC Rep. 2d 130 (W.D.N.Y. 2009)

On June 15, 2005, Delta Star agreed to sell Rochester Gas and Electric (RG&E) eight electrical transformers as specified in subsequent purchase orders issued by RG&E. The agreement provided, among other things, that “prices stated on the face of the Purchase Order shall be considered firm, unless otherwise noted, and Delta Star warrants that said prices do not exceed the prices allowed by any federal, state or local law, regulation, or order.” In July, Delta Star received RG&E’s purchase orders for the purchase of eight transformers at a price of $616,780 per unit and a total price of $5,586,664. The agreement also contained a force majeure clause that read as follows: Force Majeure. Any delay or failure in the performance by either Party hereunder shall be excused if and to the extent caused by the occurrence of a Force Majeure. For purposes of this Agreement, Force Majeure shall mean a cause or event that is not reasonably foreseeable or otherwise caused by or under the control of the Party claiming Force Majeure, including acts of God, fires, floods, explosions, riots, wars, hurricane, sabotage terrorism, vandalism, accident, restraint of government, governmental acts, injunctions, labor strikes, other than those of Seller or its suppliers, that prevent Seller from furnishing the materials or equipment, and other like events that are beyond the reasonable expectation and control of the Party affected thereby, despite such Party’s reasonable efforts to prevent, avoid, delay, or mitigate the effect of such acts, events or occurrences, and which . . . are not attributable to a Party’s failure to perform its obligations under this Agreement. During the fall of 2005, the demand for the type of steel used in the transformers outstripped the supply as buyers in China and India began paying a premium over other markets for such steel. On December 21, 2005, Delta Star sent a letter to its customers stating, among other things: Delta Star received notification from our sole electrical steel supplier, AK Steel, Butler, PA, that they will not guarantee any core steel production as of December 7. Delta Star has relied upon this relationship for roughly forty years but now must quickly look to other suppliers. . . . Another factor that has definitely had an effect is the increase in distribution transformer demand due to the hurricanes hitting off the gulf coast. . . .  The predictable result of this is dramatically overall higher prices and some designs requiring modification to accommodate other grades of steel. . . .  The grave reality of the situation is that Delta Star has no choice but to submit these increased prices to its customers. This is a force majeure condition impossible for us to predict and impossible for us to deal with in any other way. . . . The letter further stated that Delta Star anticipated the per unit increase in price for RG&E’s transformers to be $67,183, for a total increase of $537,464.

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Part Four Sales

RG&E advised Delta Star that it appeared to be rejecting its obligation to deliver the transformers for the price specified in the Agreement and asked Delta Star “to provide adequate assurance that it will perform the Agreement in accordance with its terms.” When following discussions between the parties, assurances satisfactory to RG&E were not forthcoming, it notified Delta Star on February 7, 2006, that it considered its actions as a repudiation of the Agreement, and thus it was terminating the Agreement effective immediately. RG&E brought suit against Delta Star for breach of contract. Delta Star then asserted affirmative defenses, including the doctrine of commercial impracticability, force majeure, and failure of presupposed conditions. Experts for both parties stated that the desired steel was available, albeit at much higher prices, and one noted that while the steel was very difficult to obtain, Delta Star was able to secure a new supplier at such higher price. A March 2005 magazine article admitted into evidence indicated that from December 20, 2004, steel prices were increasing, dropping, rebounding, and dropping and suggested the need for clear provisions in contracts indicating which party is to assume the risk of a change in material prices. Siragusa, District Judge The defense of commercial impracticability implicates the Uniform Commercial Code. Section 2-615 of the UCC, Excuse by Failure of Presupposed Conditions, states in relevant part: Except so far as a seller may have assumed a greater obligation and subject to the preceding section on substituted performance: (a) Delay in delivery in or non-delivery in whole or in part by a seller who complies with paragraphs (b) and (c) is not a breach of his duty under a contract for sale if performance as agreed has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made or by compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid. N.Y. U.C.C. Section 2-615(a) (2004). Official Comment four under this section states: 4. Increased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters the essential nature of the performance. Neither is a rise or a collapse in the market in itself a justification, for that is exactly the type of business risk which business contracts made at fixed prices are intended to cover. But a severe shortage of raw materials or of supplies due to a contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply or the like, which either causes a marked increase in cost or altogether prevents the seller from securing supplies necessary to his performance is within the contemplation of this section. U.C.C. Section 2-615 Comment 4. A New York court addressed the application of this section in Maple Farms, Inc. v. City School District of the City of Elmira, 352 N.Y.S.2d 784 (1974). There, the plaintiff sought to be relieved from a fixed price contract for supplying milk to the school district in the face of ever-rising milk prices which would have caused a substantial loss on the contract. The New York court found that,

“the contingency causing the increase in the price of raw milk was not totally unexpected.” Consequently, the court concluded that, [t]here is no precise point, though such could conceivably be reached, at which an increase in cost of raw goods above the norm would be so disproportionate to the risk assumed as to as to amount to “impracticability” in a commercial sense. However, we cannot say on these facts that the increase here has reached the point of “impracticality” in performance of this contract in light of the risks that we find were assumed by the plaintiff. Section 2-615 also addresses governmental interference, by stating in an official comment that, “[h]owever, governmental interference cannot excuse unless it truly ‘supervenes’ in such a manner as to be beyond the seller’s assumption of risk.” In Maple Farms, the governmental action was setting the price of milk, subsidizing it for the school district, and selling grain to Russia. Here, the allegation is that government-run companies in China are buying up the M3 steel, causing the subsequent shortage in this country. However, as Delta Star pointed out in its letter to RG&E, a suitable replacement steel, M4, was available, albeit at a higher price. The March 2005 magazine article indicates that from December 20, 2004, headlines showed that steel prices were increasing, dropping, rebounding, and dropping. One of the suggestions contained in the article is the “need for clear bid documents specifying which party is to assume the risk of a change in material prices.” Here, both affiants stated that M4 steel was available, albeit at a much higher price. “While it was also very difficult to obtain, ultimately Delta Star was able to secure a new supplier, albeit at a much higher price.” To paraphrase the Second Circuit, “the mere fact that this undertaking may have become burdensome, as a result of subsequent, perhaps unanticipated developments, does not operate to relieve [Delta Star] of its obligation.” For the foregoing reasons, RG&E’s application to strike Delta Star’s defense of the doctrine of commercial impracticability . . . is granted.



Chapter Twenty-One Performance of Sales Contracts

Problems and Problem Cases 1. Cavenish Farms owns a potato processing facility. Mathiason Farms and Valley View Farms (“the Growers”) are in the business of raising potatoes. In 2005, Cavenish and the Growers entered into contracts whereby each of the Growers agreed to grow 25,000 hundredweight of russet Burbank potatoes on certain designated fields and sell them to Cavenish. The contracts specified that they were for “crop year 2005,” and Cavenish agreed to pay a base price of $4.70 per hundredweight for “usable potatoes.” The Growers could not sell potatoes grown on the designated fields unless Cavenish first rejected or released them.  In November 2005, Cavenish made advance payments to the Growers as required by the contracts. It thereafter became apparent that there were problems with the quality of the potatoes, and the Growers attempted to recondition the potatoes by warming the piles. Cavenish refused to make the next scheduled advance payments due on February 15, 2006. Cavenish inspected two loads of potatoes in late February 2006 and determined that they were not acceptable. On March 31, 2006, Cavenish e-mailed the Growers that it was rejecting the potatoes and sent a formal letter of rejection on April 3, 2006. By that time the potatoes had deteriorated and were unmarketable.  Cavenish sued the Growers, seeking return of the advance payments as well as damages for failure to deliver potatoes as promised. The Growers counterclaimed, arguing, among other things, that Cavenish had breached the implied covenant of good faith and acted in bad faith by delaying its notice of rejection of the 2005 crop, thereby precluding the Growers from selling the potatoes to another buyer before they totally deteriorated. Cavenish took the position that it had the right under the contract to accept or reject the potatoes at any time up until July 31, 2006, without breaching the contract. Should the court find that Cavenish acted in bad faith in delaying its notice of rejection for more than a month after it had decided to reject the potatoes? 2. Harold Ledford agreed to purchase three used Mustang automobiles (a 1966 Mustang coupe, a 1965 fastback, and a 1966 convertible) from J. L. Cowan for $3,000. Ledford gave Cowan a cashier’s check for $1,500 when he took possession of the coupe, with the understanding he would pay the remaining $1,500 on the delivery of the fastback and the convertible. Cowan arranged for Charles Canterberry to deliver the remaining vehicles to Ledford. Canterberry dropped the convertible off at a lot owned by Ledford and proceeded to Ledford’s residence to deliver the fastback.

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He refused to unload it until Ledford paid him $1,500. Ledford refused to make the payment until he had an opportunity to inspect the convertible, which he suspected was not in the same condition that it had been in when he purchased it. Canterberry refused this request and returned both the fastback and the convertible to Cowan. Cowan then brought suit against Ledford to recover the balance of the purchase price. Was Ledford entitled to inspect the car before he paid the balance due on it? 3. Spada, an Oregon corporation, agreed to sell Belson, who operated a business in Chicago, Illinois, two carloads of potatoes at “$4.40 per sack, FOB Oregon shipping point.” Spada had the potatoes put aboard the railroad cars; however, he did not have floor racks used in the cars under the potatoes as is customary during winter months. As a result, there was no warm air circulating and the potatoes were frozen while in transit. Spada claims that his obligations ended with the delivery to the carrier and that the risk of loss was on Belson. What argument would you make for Belson? 4. In April, Reginald Bell contracted to sell potatoes to Red Ball Potato Company for fall delivery. The contract specified that the potatoes were to be “85 percent U.S. 1’s.” In Red Ball’s dealing with Bell and other farmers, potatoes were delivered and paid for in truckload quantities. In the fall, Bell delivered several truckloads of potatoes. Samples of each load were taken for testing, and most of the loads were determined to be below 85 percent U.S. No. 1. What options are open to Red Ball? 5. James Shelton is an experienced musician who operates the University Music Center in Seattle, Washington. On Saturday, Barbara Farkas and her 22-year-old daughter, Penny, went to Shelton’s store to look at violins. Penny had been studying violin in college for approximately nine months. Mrs. Farkas and Penny advised Shelton of the price range in which they were interested, and Penny told him she was relying on his expertise. He selected a violin for $368.90, including case and sales tax. Shelton claimed that the instrument was originally priced at $465 but that he discounted it because Mrs. Farkas was willing to take it on an “as is” basis. Mrs. Farkas and Penny alleged that Shelton represented that the violin was “the best” and “a perfect violin for you” and that it was of high quality. Mrs. Farkas paid for it by check. On the following Monday, Penny took the violin to her college music teacher, who immediately told her that it had poor tone and a crack in the body and that it was not the right instrument for her. Mrs. Farkas telephoned Shelton and asked for a refund. He refused, saying that she had purchased and accepted the violin

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Part Four Sales

on an “as is” basis. Had Farkas “accepted” the violin so that it was too late for her to “reject” it? 6. Maxwell Shoe Co., a wholesale shoe distributor, ordered a quantity of shoes from Martini Industries. When Maxwell Shoe received the shipment, it discovered that all of the shoes were cracked and peeling. Maxwell Shoe contacted Martini Industries and stated that it was rejecting the shipment because the shoes were defective. Maxwell Shoe wanted to ship the shoes back to Martini Industries but received no communication from Martini Industries regarding what was to be done with the shipment. Maxwell Shoe did not pay the remainder owed for the shipment and stopped payment on the check that had been initially issued for the order. Subsequently, Maxwell Shoe had the shoes refinished by another company and distributed and sold the shoes. Martini Industries sued for the value of the shipment. Did Maxwell Shoe accept the shipment of shoes and owe Martini Industries for the goods? 7. On May 23, Deborah McCullough, a secretary, purchased a Chrysler LeBaron from Bill Swad ChryslerPlymouth. The automobile was covered by both a limited warranty and a vehicle service contract (extended warranty). Following delivery, McCullough advised the salesperson that she had noted problems with the brakes, transmission, air conditioning, paint job, and seat panels, as well as the absence of rust-proofing. The next day, the brakes failed and the car was returned to the dealer for the necessary repairs. When the car was returned, McCullough discovered that the brakes had not been properly repaired and that none of the cosmetic work had been done. The car was returned several times to the dealer to correct these problems and others that developed subsequently. On June 26, the car was again returned to the dealer, who kept it for three weeks. Many of the defects were not corrected, however, and new problems with the horn and brakes arose. While McCullough was on a shopping trip, the engine abruptly shut off and the car had to be towed to the dealer. Then, while she was on her honeymoon, the brakes again failed. The car was taken back to the dealer with a list of 32 defects that needed correction. After repeated efforts to repair the car were unsuccessful, McCullough sent a letter to the dealer calling for rescission of the purchase, requesting return of the purchase price, and offering to return the car on receipt of shipping instructions. She received no answer and continued to drive it. McCullough then filed suit. In the following May, the dealer refused to do any further work on the car, claiming that it was in satisfactory condition.

By the time of the trial, in June of the next year, it had been driven 35,000 miles, approximately 23,000 of which had been logged after McCullough mailed her notice of revocation. By continuing to operate the vehicle after notifying the seller of her intent to rescind the sale, did McCullough waive her right to revoke her original acceptance? 8. Walters, a grower of Christmas trees, contracted to supply Traynor with “top-quality trees.” When the shipment arrived and was inspected, Traynor discovered that some of the trees were not top quality. Within 24 hours, Traynor notified Walters that he was rejecting the trees that were not top quality. Walters did not have a place of business or an agent in the town where Traynor was. Christmas was only a short time away. The trees were perishable and would decline in value to zero by Christmas Eve. Walters did not give Traynor any instructions, so Traynor sold the trees for Walters’s account. Traynor then tried to recover from Walters the expenses he incurred in caring for and selling the trees. Did the buyer act properly in rejecting the trees and reselling them for the seller? 9. Haralambos Fekkos purchased from Lykins Sales & Service a Yammar Model 165D, 16-horsepower diesel tractor and various implements. On Saturday, April 27, Fekkos gave Lykins a check for the agreed-on purchase price, less trade-in of $6,596, and the items were delivered to his residence. The next day, while attempting to use the tractor for the first time, Fekkos discovered it was defective. The defects included a dead battery requiring jump starts, overheating while pulling either the mower or tiller, missing safety shields over the muffler and the power takeoff, and a missing water pump. On Monday, Fekkos contacted Lykins’s sales representative, who believed his claims to be true and agreed to have the tractor picked up from Fekkos’s residence; Fekkos also stopped payment on his check. Fekkos placed the tractor with the tiller attached in his front yard as near as possible to the front door without driving it onto the landscaped area closest to the house. Fekkos left the tractor on the lawn because his driveway was broken up for renovation and his garage was inaccessible and because the tractor would have to be jump-started by Lykins’s employees when they picked it up. On Tuesday, Fekkos went back to Lykins’s store to purchase an Allis-Chalmers tractor and reminded Lykins’s employees that the Yammar tractor had not been picked up and remained on his lawn. On Wednesday, May 1, at 6:00 A.M., Fekkos discovered that the tractor was missing although the tiller had been unhitched and remained in the yard. Later that day, Lykins



Chapter Twenty-One Performance of Sales Contracts

picked up the remaining implements. The theft was reported to the police. On several occasions, Fekkos was assured that Lykins’s insurance would cover the stolen tractor, that it was Lykins’s fault for not picking it up, and that Fekkos had nothing to worry about. However, Lykins subsequently brought suit against Fekkos to recover the purchase price of the Yammar tractor. Was Fekkos liable for the purchase price of the tractor that had been rejected and was stolen while awaiting pickup by the seller? 10. Creusot-Loire, a French manufacturing and engineering concern, was the project engineer to construct ammonia plants in Yugoslavia and Syria. The design process engineer for the two plants—as well as a plant being constructed in Sri Lanka—specified burners manufactured by Coppus Engineering Corporation. After the burner specifications were provided to Coppus, it sent technical and service information to Creusot-Loire.  Coppus expressly warranted that the burners were capable of continuous operation using heavy fuel oil with combustion air preheated to 260 degrees Celsius. The warranty extended for one year from the start-up of the plant but not exceeding three years from the date of shipment. In January 1989, Creusot-Loire ordered the burners for the Yugoslavia plant and paid for them;

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in November 1989, the burners were shipped to Yugoslavia. Due to construction delays, the plant was not to become operational until the end of 1993. In 1991, however, Creusot-Loire became aware that there had been operational difficulties with the Coppus burners at the Sri Lanka and Syria plants and that efforts to modify the burners had been futile. Creusot-Loire wrote to Coppus expressing concern that the burners purchased for the Yugoslavia plant, like those in the other plants, would prove unsatisfactory and asking for proof that the burners would meet contract specifications. When subsequent discussions failed to satisfy Creusot-Loire, it requested that Coppus take back the burners and refund the purchase price. Coppus refused. Finally, Creusot-Loire indicated that it would accept the burners only if Coppus extended its contractual guarantee to cover the delay in the start-up of the Yugoslavia plant and if Coppus posted an irrevocable letter of credit for the purchase price of the burners. When Coppus refused, Creusot-Loire brought an action for breach of contract, seeking a return of the purchase price. Coppus claimed that Creusot-Loire’s request for assurance was unreasonable. How should the court rule?

CHAPTER 22

Remedies For Breach of Sales Contracts

K

athy is engaged to be married. She contracts with the Bridal Shop for a custom-designed bridal gown in size 6 with delivery to be made by the weekend before the wedding. Kathy makes a $1,500 deposit against the contract price of $4,500. If the dress is completed in conformance with the specifications and on time, then Kathy is obligated to pay the balance of the agreed-on price. But what happens if either Kathy or the Bridal Shop breaches the contract? For example: • If Kathy breaks her engagement and tells the Bridal Shop that she is no longer interested in having the dress before the shop has completed making it, what options are open to the Bridal Shop? Can it complete the dress or should it stop work on it? • If the Bridal Shop completes the dress but Kathy does not like it and refuses to accept it, what can the Bridal Shop do? Can it collect the balance of the contract price from Kathy, or must it first try to sell the dress to someone else? • If the Bridal Shop advises Kathy that it will be unable to complete the dress in time for the wedding, what options are open to Kathy? If she has another dress made by someone else, or purchases a ready-made one, what, if any, damages can she collect from the Bridal Shop? • If the Bridal Shop completes the dress but advises Kathy it plans to sell it to someone else who is willing to pay more money for it, does Kathy have any recourse? • Would it be ethical for the Bridal Shop to sell the dress to someone else who offers more money for it?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 22-1 Recall the basic objective of the remedies provided for by the UCC for a breach of a contract for the sale of goods. 22-2 Explain what is meant by the term liquidated damages and discuss when the UCC allows the enforcement of a liquidated damages clause in a contract for the sale of goods. 22-3 Recall the statute of limitation provided in the UCC that is applicable to lawsuits alleging breach of a contract for the sale of goods. 22-4 List and describe the remedies that the UCC makes available to an injured seller.

22-5 List and describe the remedies that the UCC makes available to an aggrieved buyer. 22-6 Explain what is meant by the term cover in the context of a contract for the sale of goods. 22-7 Explain what is meant by the terms incidental damages and consequential damages and indicate when an injured buyer is able to recover consequential damages. 22-8 Discuss when an aggrieved buyer has a right to specific performance of a contract for the sale of goods.

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Recall the basic objective of the remedies provided LO22-1 for by the UCC for a breach of a contract for the sale of goods.

USUALLY, BOTH PARTIES TO a contract for the sale of goods perform the obligations that they assumed in the contract. Occasionally, however, one of the parties to a contract fails to perform his obligations. When this happens, the Uniform Commercial Code (UCC) provides the injured party with a variety of remedies for breach of contract. This chapter will set forth and explain the remedies available to an injured party, as well as the UCC’s rules that govern buyer– seller agreements as to remedies and the UCC’s statute of limitations. The objective of the UCC remedies is to put the injured person in the same position that he would have been in if the contract had been performed. Under the UCC, an injured party may not recover consequential or punitive damages unless such damages are specifically provided for in the UCC or in another statute [1-106].1

Agreements as to Remedies Explain what is meant by the term liquidated damages and discuss when the UCC allows the enforcement of LO22-2 a liquidated damages clause in a contract for the sale of goods.

The buyer and seller may provide their own remedies in the contract, to be applied in the event that one of the parties fails to perform. They may also limit either the remedies that the law makes available or the damages that can be covered [2-719(1)]. If the parties agree on the amount of damages that will be paid to the injured party, this amount is known as liquidated damages. An agreement for liquidated damages is enforced if the amount is reasonable and if actual damages would be difficult to prove in the event of a breach of the contract. The amount is considered reasonable if it is not so large as to be a penalty or so small as to be unconscionable [2-718(1)]. The numbers in brackets refer to sections of the Uniform Commercial Code. 1

For example, Carl Carpenter contracts to build and sell a display booth for $5,000 to Hank Hawker for Hawker to use at the state fair. Delivery is to be made to Hawker by September 1. If the booth is not delivered on time, Hawker will not be able to sell his wares at the fair. Carpenter and Hawker might agree that if delivery is not made by ­September 1, Carpenter will pay Hawker $2,750 as liquidated damages. The actual sales that Hawker might lose without a booth would be very hard to prove, so Hawker and Carpenter can provide some certainty through the liquidated damages agreement. Carpenter then knows what he will be liable for if he does not perform his obligation. Similarly, Hawker knows what he can recover if the booth is not delivered on time. The $2,750 amount is probably reasonable. If the amount were $500,000, it likely would be void as a penalty because it is way out of line with the damages that Hawker would reasonably be expected to sustain. And if the amount were too small, say $10, it might be considered unconscionable and therefore not enforceable. If a liquidated damages clause is not enforceable because it is a penalty or unconscionable, the injured party can recover the actual damages that he suffered. Liability for consequential damages resulting from a breach of contract (such as lost profits or damage to property) may also be limited or excluded by agreement. The limitation or exclusion is not enforced if it would be unconscionable. Any attempt to limit consequential damages for injury caused to a person by consumer goods is considered prima facie unconscionable [2-719(3)]. Suppose an automobile manufacturer makes a warranty as to the quality of an automobile that is purchased as a consumer good. It then tries to disclaim responsibility for any person injured if the car does not conform to the warranty and to limit its liability to replacing any defective parts. The disclaimer of consequential injuries in this case would be unconscionable and therefore would not be enforced. Exclusion of or limitation on consequential damages is permitted where the loss is commercial, as long as the exclusion or limitation is not unconscionable. Where circumstances cause a limited remedy agreed to by the parties to fail in its essential purpose, the limited remedy is not enforced, and the general UCC remedies are available to the injured party. These principles are illustrated in the following case, Helena Chemical Co. v. Williamson.

Helena Chemical Co. v. Williamson   86 UCC Rep. 2d 180 (W.D. La. 2015) Lavelle Williamson began farming in 2010. Prior to that time, he had marked timber and worked in the oilfield industry and as a painter. He had a tenth-grade education. Until 2010, Williamson had never purchased seeds or chemicals for farming purposes. During his first year of farming, he sought to purchase goods and services from Helena Chemical Company. Helena presented him with a Credit Sales and Services Agreement,



Chapter Twenty-Two Remedies for Breach of Sales Contracts

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which he signed. The terms were not discussed or explained to him. Between 2010 and 2013, Williamson purchased seed, fertilizer, and chemicals from Helena under the Agreement. The Agreement was not superseded or canceled at any time. For the 2013 crop, Helena provided certain goods and services to Williamson, including corn seed and soybeans and related products, for a total price of $79,188.50. After Helena’s delivery, Williamson had difficulty getting the corn seed out of Helena’s tender. He contacted Helena’s sales representative to complain about the issue but proceeded with planting the corn seed. Williamson’s corn seed failed to germinate, and a sufficient stand of corn was not realized for the 2013 crop year. He contended that the corn seed was wet when it was delivered to him in Helena’s tender, and as a result, the wet corn seed absorbed more chemicals than it normally would, resulting in a loss of at least 80 bushels of corn per acre. Helena contended that Williamson’s corn crop failure was a result of his own improper application of fertilizer. Williamson made one payment to Helena, but then made no further payments. Helena brought suit to recover the balance of the amount owing to it. Williamson filed a counterclaim based on negligence, claiming that he suffered damages in the amount of $148,964.15 for decreased corn production, $64,439.16 for loss of a higher contract price, and $13,491.50 for increased farming expenses for the 2013 crop year. Helena moved for summary judgment on the counterclaim, arguing that as a matter of law, the clear and unambiguous language in the Agreement prevented Williamson from recovering consequential damages. Williamson opposed the motion and argued that the exclusion/limitation of remedies provision in the Agreement was unenforceable under Tennessee law. The Agreement provided, in pertinent part: THE EXCLUSIVE REMEDY FOR ANY CAUSE OF ACTION BY OR ON BEHALF OF PURCHASER UNDER THIS STATEMENT AND RELATED TRANSACTION(S) IS A CLAIM FOR DAMAGES AND IN NO EVENT SHALL DAMAGES OR ANY OTHER RECOVERY OF ANY KIND . . . EXCEED THE PRICE OF THE SPECIFIC GOODS OR SERVICES WHICH CAUSE THE ALLEGED LOSS, DAMAGE, INJURY OR OTHER CLAIM. NEITHER SHALL HELENA  . . .  BE LIABLE, AND ANY AND ALL CLAIMS AGAINST HELENA . . . ARE WAIVED FOR SPECIAL, DIRECT OR CONSEQUENTIAL DAMAGES, OR EXPENSES, OF ANY NATURE, INCLUDING, BUT NOT LIMITED TO, LOSS OF PROFITS OR INCOME, CROP OR PROPERTY LOSS OR DAMAGE, LABOR CHARGES AND FREIGHT CHARGES, WHETHER OR NOT BASED ON HELENA’S, ITS OFFICERS’, DIRECTORS’, EMPLOYEES’ AND/OR AFFLIATES’ NEGLIGENCE, BREACH OF WARRANTY, STRICT LIABILITY IN TORT, OR ANY OTHER CAUSE OF ACTION. THE FOREGOING CONDITIONS OF SALE AND LIMITATIONS OF WARRANTY LIABILITY MAY BE VARIED OR WAIVED ONLY BY AGREEMENT IN WRITING SIGNED BY A DULY AUTHORIZED REPRESENTATIVE OF HELENA.

James, District Judge Tennessee Code Annotated 2-719 provides: (1) Subject to the provisions of subsections (2) and (3) of this section and of the preceding section on liquidation and limitation of damages: (a) The agreement may provide for remedies in addition 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 agreed to be exclusive, in which case it is the sole remedy. (2) Where circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in chapters 1–9 of this title. (3) Consequential damages may be limited or excluded unless the limitation 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. [emphasis added] The comments following the statute explain: 1. Under this section parties are left free to shape their remedies to their particular requirements and reasonable agreements limiting or modifying remedies are to be given effect.  However, it is of the essence of a sales contract that at least minimum adequate remedies be available. If the parties intend to conclude a contract for sale within this Article they must accept the legal consequence that there be at least a fair quantum of remedy for breach of the obligations or duties outlined in the contract. Thus, any clause purporting to modify or limit the remedial provisions of this Article in an unconscionable manner is subject to deletion and in that event, the remedies made available by this Article are applicable as if the stricken clause had never existed. Similarly, under subsection (2), where an apparently

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Part Four Sales

fair and reasonable clause because of circumstances fails in its purpose or operates to deprive either party of the substantial value of the bargain, it must give way to the general remedy provisions of this Article.

 . . . 

2. Subsection (3) recognizes the validity of clauses limiting or excluding consequential damages but makes it clear that they may not operate in an unconscionable manner. Actually such terms are merely an allocation of unknown or undeterminable risks. The seller in all cases is free to disclaim warranties in the manner provided in 2-316. Thus, Tennessee permits the limitation of remedies unless circumstances cause the remedy to fail of its essential purpose. Specifically, commercial parties may limit or exclude consequential damages unless the limitation or exclusion is unconscionable. In this case at the time the Agreement was entered, Williamson was a first time farmer with a tenth grade education and no apparent experience in the agricultural industry. He needed the goods and services Helena provided to begin his farming career. Helena then presented him with an agreement which had to be signed if he wished to purchase from Helena. Although the Agreement was not prima facie unconscionable under Tennessee law and commercial parties are presumed to have engaged in permissible dealings, this simply was not a commercial contract between two parties on equal footing. Williamson was in no position to bargain and thus signed an Agreement which left him without recourse, even if Helena’s action resulted in substantial damages to him. Under these circumstances, and finding the decisions of every other court to consider this issue persuasive, the Court finds that the exclusion/limitations of remedies provision is unconscionable and unenforceable. Further, even if the provision survived an unconscionability review, the Court also finds that the remedy provision fails of its

Statute of Limitations Recall the statute of limitation provided in the UCC that

LO22-3 is applicable to lawsuits alleging breach of a contract for

the sale of goods.

The UCC provides that a lawsuit for breach of a sales contract must be filed within four years after the breach occurs. The parties to a contract may shorten this period to one year,

essential purpose. Failure of essential purpose as codified in the Tennessee Code Annotated section 2-719 is concerned with the essential purpose of the remedy chosen by the parties, and in contrast to the unconscionability provisions, this code provision is concerned only with novel circumstances not contemplated by the parties. The most frequent application of 2-719(2) occurs when under a limited “repair and replacement” remedy, the seller is unwilling or unable to repair the defective goods within a reasonable period of time. Thus the remedy fails of its essential purpose, i.e., fails to cure the defect. In this case, a repair or replace remedy was not included in the Agreement and obviously would have served no purpose. The Agreement does not use the word “refund” but does provide that damages or any other recovery of any kind against Helena “may not exceed the price of the specific goods or services which cause the alleged loss, damage, injury or other claim.” Thus, under the Agreement, Williamson can recover the cost of the corn seed which allegedly caused the loss, i.e., a refund. Typically, under Tennessee law, a refund is a minimum adequate remedy. However, in this case, the refund of the purchase price is a totally inadequate remedy in the agricultural context. The true value of the seeds only comes from the crop yielded which is preceded by considerable time and cost expended by the farmer. A farmer’s lost growing season and the accompanying loss of expected profits due to the defective seeds clearly is not compensated by simply replacing or refunding the price of the defective seeds. Williamson suffered the loss, not of corn seed, but of his corn crop. Thus, this court, like the other courts who have considered the issue, finds that the exclusion/limitations of remedies provision in the Agreement fails of its essential purpose. If he can prove Helena’s negligence at trial, then Williamson is not prevented by the Agreement from seeking consequential damages.

but they may not extend it for longer than four years [2-725]. Normally, a breach of warranty is considered to have occurred when the goods are delivered to the buyer. However, if the warranty covers future performance of goods (e.g., a warranty on a tire for four years or 40,000 miles), then the breach occurs at the time the buyer should have discovered the defect in the product. If, for example, the buyer of the tire discovers the defect after driving 25,000 miles on the tire over a three-year period, he would have four years from that time to bring any lawsuit to remedy the breach.



Chapter Twenty-Two Remedies for Breach of Sales Contracts

Seller’s Remedies LO22-4

List and describe the remedies that the UCC makes available to an injured seller.

Remedies Available to an Injured Seller A

buyer may breach a contract in a number of ways. The most common are (1) by wrongfully refusing to accept goods, (2) by wrongfully returning goods, (3) by failing to pay for goods when payment is due, and (4) by indicating an unwillingness to go ahead with the contract. When a buyer breaches a contract, the seller has a number of remedies under the UCC, including the right to: • Cancel the contract [2-703(f)]. • Withhold delivery of undelivered goods [2-703(a)]. • Complete manufacture of unfinished goods and identify them as to the contract or cease manufacture and sell for scrap [2-704]. • Resell the goods covered by the contract and recover damages from the buyer [2-706]. • Recover from the buyer the profit that the seller would have made on the sale or the damages that the seller sustained [2-708]. • Recover the purchase price of goods delivered to or accepted by the buyer [2-709].

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goods that could be resold readily at the contract price. However, a seller would not be justified in completing specially manufactured goods that could not be sold to anyone other than the buyer who ordered them. The purpose of this rule is to permit the seller to follow a reasonable course of action to mitigate (minimize) the damages. The hypothetical case at the beginning of the chapter posits a customer who contracts with the Bridal Shop for the creation of a custom-designed bridal gown in size 6 and then seeks to cancel the order before the Bridal Shop has completed it. What options are open to the Bridal Shop? Can it complete the dress and recover the full contract price from the customer, or should it stop work on it? What facts would be important to your decision? As you reflect on these questions, you might consider the facts set out in problem case 4 at the end of this chapter, where a manufacturer of pool tables stopped work on some customized pool tables. What considerations does it suggest that the Bridal Shop might be advised to take into account in deciding whether or not to continue work on the bridal gown?

Resale of Goods If

the seller sets aside goods intended for the contract or completes the manufacture of such goods, he is not obligated to try to resell the goods to someone else. However, he may resell them and recover damages. The seller must make any resale in good faith and in a commercially reasonable manner. If the seller does so, he is entitled to recover from the In addition, a buyer may become insolvent and thus buyer as damages the difference between the resale price unable to pay the seller for goods already delivered or for and the price the buyer agreed to pay in the contract goods that the seller is obligated to deliver. When a seller [2-706]. learns of a buyer’s insolvency, the seller has a number of If the seller resells, he may also recover incidental damremedies, including the right to: ages, but the seller must give the buyer credit for any ex• Withhold delivery of undelivered goods [2-703(a)]. penses that the seller saved because of the buyer’s breach • Recover goods from a buyer upon the buyer’s insolvency of contract. Incidental damages include storage charges [2-702]. and sales commissions paid when the goods were resold • Stop delivery of goods that are in the possession of a car[2-710]. Expenses saved might be the cost of packaging the rier or other bailee before they reach the buyer [2-705]. goods and∕or shipping them to the buyer. If the buyer and seller have agreed as to the manner Cancellation and Withholding of Delivery  in which the resale is to be made, the courts will enforce the agreement unless it is found to be unconscionable When a buyer breaches a contract, the seller has the right to [2-302]. If the parties have not entered into an agreement cancel the contract and to hold up her own performance of as to the resale of the goods, they may be resold at public the contract. The seller may then set aside any goods that were or private sale, but in all events, the resale must be made intended to fill her obligations under the contract [2-704]. in good faith and in a commercially reasonable manner. If the seller is in the process of manufacturing the goods, The seller should make it clear that the goods he is selling she has two choices. She may complete manufacture of the are those related to the broken contract. goods, or she may stop manufacturing and sell the uncomIf the goods are resold at a private sale, the seller must pleted goods for their scrap or salvage value. In choosing give the buyer reasonable notification of his intention to between these alternatives, the seller should select the alresell [2-706(3)]. If the resale is a public sale, such as an ternative that will minimize the loss [2-704(2)]. Thus, a auction, the seller must give the buyer notice of the time seller would be justified in completing the manufacture of

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Part Four Sales

and place of the sale unless the goods are perishable or threaten to decline in value rapidly. The sale must be made at a usual place or market for public sales if one is reasonably available; if the goods are not within the view of those attending the sale, the notification of the sale must state the place where the goods are located and provide for reasonable inspection by prospective bidders. The seller may bid at a public sale [2-706(4)]. The purchaser at a public sale who buys in good faith takes free from any rights of the original buyer even though the seller has failed to conduct the sale in compliance with the rules set out in the UCC [2-706(5)]. The seller is not accountable to the buyer for any profit that the seller makes on a resale [2-706(6)].

Recovery of the Purchase Price In the nor-

mal performance of a contract, the seller delivers conforming goods (goods that meet the contract specifications) to the buyer. The buyer accepts the goods and pays for them. The seller is entitled to the purchase price of all goods accepted by the buyer. She also is entitled to the purchase price of all goods that conformed to the contract and were lost or damaged after the buyer assumed the risk for their loss [2-709]. The case below, Beau Townsend Ford Lincoln v. Don Hinds Ford, illustrates the principle that a buyer is liable for the purchase price of goods that have been received and accepted and is not relieved of that obligation where

he erroneously makes payment to someone other than the seller with whom he is contractually obligated to pay. For example, a contract calls for Frank, a farmer, to ship 1,000 dozen eggs to Sutton, a grocer, with shipment “FOB Frank’s Farm.” If the eggs are lost or damaged while on their way to Sutton, she is responsible for paying Frank for them. Risk of loss is discussed in Chapter 19, Formation and Terms of Sales Contracts. In one other situation, the seller may recover the purchase or contract price from the buyer. This is where the seller has made an honest effort to resell the goods and was unsuccessful or where it is apparent that any such effort to resell would be unsuccessful. This might happen where the seller manufactured goods especially for the buyer and the goods are not usable by anyone else. Assume that Sarton’s Supermarket sponsors a bowling team. Sarton’s orders six green-and-red bowling shirts to be embroidered with “Sarton’s Supermarket” on the back and the names of the team members on the pocket. After the shirts are completed, Sarton’s wrongfully refuses to accept them. The seller will be able to recover the agreed purchase price if it cannot sell the shirts to someone else. If the seller sues the buyer for the contract price of the goods, she must hold the goods for the buyer. Then, the seller must turn the goods over to the buyer if the buyer pays for them. However, if resale becomes possible before the buyer pays for the goods, the seller may resell them. Then, the seller must give the buyer credit for the proceeds of the resale [2-709(2)].

Beau Townsend Ford Lincoln v. Don Hinds Ford 93 UCC Rep. 2d 1052 (S.D. Ohio 2017) In September 2015, Beau Townsend Ford Lincoln entered into a fleet deal with a customer for seventy-five Ford Explorers. That deal, however, fell through, and Beau Townsend Ford’s Commercial Sales Manager sold some of the vehicles to retail customers and then reached out to other Ford dealers in the region to ascertain their interest in buying some of the vehicles. Don Hinds Ford agreed to pay Beau Townsend Ford $736,225.40 to purchase 20 Ford Explorers. Beau Townsend Ford was obligated to deliver the vehicles to Don Hinds Ford. Past vehicle trades between the two dealers had been for one or two vehicles at a time and had typically been paid through a check, delivered at the same time the vehicles were picked up. In this instance, the arrangement was worked out through e-mail exchanges, and there was no formal written contract. At the time the Commercial Account Manager at Don Hinds Ford inquired about receiving invoices and titles for the vehicles, he indicated that Don Hinds Ford would be paying by check. This was the first time there was any reference to the manner of payment. A short time later, he received an e-mail from the Commercial Sales Manager’s account at Beau Townsend Ford indicating that Beau Townsend Ford would prefer a wire transfer, and attached some wiring instructions. The attachment indicated that the purchase monies for the 20 Explorers were to be sent by wire transfer to a Bank of America Account in Missouri City, Texas, for the benefit of “K.B. KEY LOGISTICS LLC.” Don Hinds Ford made the requested wire transfers over a three-day period (because of daily transfer limits on its bank account) and began picking up the vehicles from Beau Townsend Ford’s dealership in Vandalia, Ohio, and transporting them to its location in Fishers, Indiana. On October 7, 2015, the day the last vehicles were picked up, it received an e-mail confirming the receipt of the final installment of the wired funds. The money received in the account was either withdrawn or transferred out of the account, with the last withdrawal occurring on October 13, 2015.



Chapter Twenty-Two Remedies for Breach of Sales Contracts

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For nearly a week thereafter, Don Hinds Ford believed the story was over. It had been given the titles to the vehicles (in this case, the Manufacturer’s Certificates of Origin), was allowed to drive all of the Explorers back to Indiana, and had wired over $730,000. On October 13, Don Hinds Ford received from an e-mail from Beau Townsend Ford stating it had not been paid and inquiring when it should expect to receive payment (by check). Don Hinds Ford communicated that it had already sent payment pursuant to the wiring instructions it had received. A subsequent investigation discovered that the Commercial Sales Manager’s e-mail account had been compromised. A filter had been set up that removed all of the Commercial Sales Manager’s e-mails in his inbox and forwarded them to a third party, who then sent replies back to the original sender in a way that appeared to come from the Commercial Sales Manager’s account. Beau Townsend Ford utilized a third-party “webmail” interface that allowed the users to set up certain rules for forwarding their e-mail to other e-mail addresses. The Commercial Sales Manager indicated he was not aware of the forwarding rules that had been put in place on his account. A subsequent investigation indicated that on September 28, 2015, someone in Nigeria had created a new e-mail address in the name of the Commercial Sales Manager on Google’s Gmail service. Beau Townsend Ford demanded that Don Hinds Ford immediately return the 20 Ford Explorers on the grounds that it had not received payment and had the right to reclaim the vehicles. Don Hinds Ford responded to the demand, noting that payment had been made in accordance with the wiring instructions from Beau Townsend Ford’s Commercial Sales Manager. It also indicated that its position was that it had no knowledge of any false or misleading statements and as such was a good-faith purchaser for value. Beau Townsend Ford then filed suit against Don Hinds Ford seeking the agreed-upon purchase price of the 20 vehicles for which it had not received payment. Rose, United States District Judge. The instant case provides a reminder that on the internet, no one knows you’re a dog. Quite possibly no one figures out you’re a Nigerian swindler. The swindler having made off with a princely sum, the Court must determine which party shall be paupered. In Ohio, the essential elements of a breach of contract claim are: (1) a binding contract or agreement was formed; (2) the non-breaching party performed its contractual obligations; (3) the other party failed to fulfill its contractual obligations without legal excuse; and (4) the non-breaching party suffered damages as a result of the breach. Damages are not awarded for mere breach alone. Rather the damages that can be awarded for breach of contract are those which are the natural or probable consequence of the breach of contract or damages that were within the contemplation of both parties at the time of making the contract. To prove the first element of a breach of contract claim, that a binding contract or agreement was formed, a party must establish the essential elements of a contract: (1) an offer; (2) an acceptance; (3) a meeting of the minds; (4) exchange of consideration; and (5) certainty as to the essential terms of the contract. A contract is formed when there is mutual consent and consideration. Don Hinds Ford and Beau Townsend Ford agreed that Beau Townsend Ford would sell to Don Hinds Ford 20 Ford Explorers and that Don Hinds Ford would pay Beau Townsend Ford the amount of $736,225.40. Don Hinds Ford asserts that the parties modified this contract to include a term concerning payment, that payment was to be made by wire transfer. That Don Hinds received an email from Beau Townsend Ford’s email account does not make this amendment a contractual term, what is required is a meeting of the minds, agreement in fact. In order to constitute a valid contract there must be a “meeting of the minds” of the parties which is achieved by both an offer

and acceptance of the contract’s provisions. See Grant v. DeGryse, 1991 WL 254211 (Ohio App. 1991) (finding terms to which the parties had not agreed to be unenforceable). Ohio Revised Code lists a seller’s principal remedies upon a buyer’s breach. When a buyer fails to pay the price as it becomes due, the seller may recover the price of goods accepted. When a buyer accepts goods, the buyer must pay for such goods. Don Hinds Ford accepted the 20 Ford Explorers from Beau Townsend Ford. Therefore, Beau Townsend Ford is entitled to be paid by Don Hinds Ford. Accordingly, summary judgment will be granted in favor of Beau Townsend Ford and against Don Hinds Ford. While Don Hinds Ford claims the result is unjust in light of the fact it wired funds to the Bank of America account based on the instructions that appeared to come from Beau Townsend Ford, that transfer does not satisfy its obligation to Beau Townsend Ford. Here there was no meeting of minds to a contractual provision that payment is to be made by wire transfer. The Court notes that Don Hines Ford is not a “good faith purchaser for value” by virtue of having wired money to the Bank of America account of K.B. KEY LIOGISTICS in Missouri City, Texas. A “good faith purchaser for value” purchases from a seller that obtained “voidable” title from a previous seller. The subsequent purchaser acquires “good title” despite irregularities in the transaction by which the seller obtained the property. Neither is the “good faith purchaser” doctrine implicated as between the original seller and the subsequent seller, Beau Townsend Ford and Don Hinds Ford. While parties that purchased the 20 Ford Explorers from Don Hinds Ford might qualify as “good faith purchasers for value” such that Beau Townsend Ford cannot seek relief from such subsequent purchasers, the subsequent sales do not extinguish Don Hinds Ford’s original obligation to Beau Townsend Ford. Accordingly, the “good faith purchaser” doctrine

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has no application and Don Hinds Ford owes Beau Townsend Ford $736,225.40. Don Hinds Ford’s defense of equitable estoppel also is unprevailing. Under the doctrine of equitable estoppel, relief is precluded where one party induces another to believe certain facts are true and the other party changes his position in reasonable reliance to his detriment. Equitable estoppel requires that the proponent prove four elements: (1) that the adverse party made a factual misrepresentation; (2) that the misrepresentation was misleading; (3) that the misrepresentation induced actual reliance which was reasonable and in good faith; and (4) the proponent suffered detriment due to the reliance. As to the first element, a showing of fraud is necessary. It was not Beau Townsend Ford that instructed Don Hinds Ford to send funds to “K.B. KEY LOGISTICS, L.L.C.” in Missouri City, Texas. Beau Townsend Ford made no representation to Don Hinds Ford regarding such “wire instructions,” much less any misrepresentation that would satisfy the first element of equitable estoppel. Since there were no misrepresentations, Don Hinds Ford’s equitable estoppel defense fails. Both parties would each have the Court find that the other was in the best position to avoid the misfortune that occurred in this case. If there is a policy inherent in the UCC rules for the allocation of losses due to fraud, it surely is that the loss be placed on the party in the best position to prevent it. Beau Townsend Ford asserts Don Hinds Ford was in the best position to prevent the loss, pointing out “red flags” that it believes should have alerted Don Hinds Ford that the wiring

instructions were likely sent by an “imposter.” Beau Townsend points to the fact that the parties’ previous transactions, involving one or two vehicles at a time, were handled by way of checks; that the beneficiary of the fraudulent wiring instructions was “K.B. KEY LOGISTICS LLC,” not Beau Townsend Ford; that the wiring instructions were sent in substandard English; and that the wiring instructions provided that the funds should be sent to an account in Missouri City, Texas, whereas Beau Townsend Ford is located in Vandalia, Ohio. Don Hines Ford points to Beau Townsend Ford’s unsecured email and to the slow response to signs that something was amiss. Here, both parties were negligent in their business practices. It cannot be said that either was obviously in the best position to protect their own interest. Beau Townsend Ford should have maintained a more secure email system and taken quicker action upon learning it had been compromised. Don Hinds Ford should have ascertained that an actual agent of Beau Townsend Ford was requesting that it send money by wire transfer. Additionally, Ohio courts have held that the doctrine of equitable estoppel will not be used to benefit parties who were negligent in their business transactions, and who obviously were in the best position to protect their own interest. Again, because both parties were capable of preventing the loss, this principle does not apply.

Damages for Rejection or Repudiation 

The seller may recover as damages the difference between the contract price and the market price at the time and place the goods were to be delivered to the buyer. The seller also may recover any incidental damages but must give the buyer credit for any expenses that the seller has saved [2-708(1)]. This measure of damages most commonly is sought by a seller when the market price of the goods dropped substantially between the time the contract was made and the time the buyer repudiated the contract.

When the buyer refuses to accept goods that conform to the contract or repudiates the contract, the seller does not have to resell the goods. The seller has two other ways of determining the damages that the buyer is liable for because of the breach of contract: (1) the difference between the contract price and the market price at which the goods are currently selling and (2) the “profit” that the seller lost when the buyer did not go through with the contract [2-708].

Summary Judgment for Beau Townsend Ford on its breach of contract claim and Don Hinds Ford is ordered to pay Beau Townsend Ford the sum of $736,225.40.

The Global Business Environment Seller’s Remedies in International Transactions Under the Convention on Contracts for the International Sale of Goods (CISG), an aggrieved seller has five potential remedies when the buyer breaches the contract: (1) suspension of the seller’s performance, (2) “avoidance” of the contract, (3) reclamation of the goods in the buyer’s possession,

(4) an action for the price, and (5) an action for damages. The last two remedies can be pursued only in a judicial proceeding. As noted in Chapter 21 (see The Global Business Environment box titled “Insecurity”), the seller may “suspend its performance” when it is apparent the other party to the contract will not be performing its obligations, for example, if the buyer was insolvent and unable to pay for any goods delivered to it.



Chapter Twenty-Two Remedies for Breach of Sales Contracts

Avoidance of a contract—which, under the CISG, essentially means canceling the contract—is a remedy most commonly utilized by buyers because the initial performance called for in contracts typically rests with the seller—for example, to deliver specified goods. When a seller has not been paid for goods, it may “avoid” the contract and seek their return from the buyer. If the buyer has possession of the goods when the contract is avoided, he must take reasonable steps to preserve them. Where the goods are perishable, the buyer might try to sell them for the seller’s account but is not required to follow a seller’s instructions to resell.

For example, on October 1, Wan Ho Manufacturing contracts with Sports Properties to sell the company 100,000 New England Patriot bobble heads at $6.50 each with delivery to be made in Boston on December 1. By December 1, the market for New England Patriot bobble heads has softened considerably because a competitor flooded the market with them first and the bobble heads are selling for $3.00 each in Boston. If Sports Properties repudiates the contract on December 1 and refuses to accept delivery of the 100,000 bobble heads, Wan Ho is entitled to the difference between the contract price of $650,000 and the December 1 market price in Boston of $300,000. Thus, Wan Ho could recover $350,000 in damages plus any incidental expenses, but less any expenses saved by it not having to ship the bobble heads to Sports Properties (such as packaging and transportation costs). If getting the difference between the contract price and the market price would not put the seller in as good a financial position as the seller would have been in if the contract had been performed, the seller may choose an alternative measure of damages based on the lost profit and overhead that the seller would have made if the sale had gone through. The seller can recover this lost profit and overhead plus any incidental expenses. However, the seller must give the buyer credit for any expenses saved as a result of the buyer’s breach of contract [2-708(2)]. Using the bobble head example, assume that the direct labor and material costs to Wan Ho Manufacturing of making the bobble heads was $2.75 each. Wan Ho could recover as damages from Sports Properties the profit Wan Ho lost when Sports Properties defaulted on the contract. Wan Ho would be entitled to the difference between the contract price of $650,000 and its direct cost of $275,000. Thus, Wan Ho could recover $375,000 plus any incidental expenses and less any expenses saved, such as the shipping costs to Boston.

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Where the seller has performed its obligations, the seller has the right to require the buyer to pay the contract price unless the seller has pursued an inconsistent remedy—such as reclaiming the goods. An aggrieved seller may also pursue an action for damages based on either (1) the difference between the contract price and the resale price (where the seller resold the goods) or (2) the difference between the contract price and the market price at the time the contract was avoided. The CISG also permits a measure of damages based on lost profits. Thus, in a number of respects, the UCC and CISG offer similar remedies to sellers.

Seller’s Remedies Where Buyer Is Insolvent If the seller has not agreed to extend credit

to the buyer for the purchase price of goods, the buyer must make payment on delivery of the goods. If the seller tenders delivery of the goods, he may withhold delivery unless the agreed payment is made. Where the seller has agreed to extend credit to the buyer for the purchase price of the goods, but discovers before delivery that the buyer is insolvent, the seller may refuse delivery unless the buyer pays cash for the goods together with the unpaid balance for all goods previously delivered under the contract [2-702(1)]. At common law, a seller had the right to rescind a sales contract induced by fraud and to recover the goods unless they had been resold to a bona fide purchaser for value. Based on this general legal principle, the UCC provides that where the seller discovers that the buyer has received goods while insolvent, the seller may reclaim the goods upon demand made within 10 days after their receipt. This right granted to the seller is based on constructive deceit on the part of the buyer. Receiving goods while insolvent is equivalent to a false representation of solvency. To protect his rights, all the seller must do is to make a demand within the 10-day period; he need not actually repossess the goods. If the buyer has misrepresented his solvency to this particular seller in writing within three months before the delivery of the goods, the 10-day limitation on the seller’s right to reclaim the goods does not apply. However, the seller’s right to reclaim the goods is subject to the rights of prior purchasers in the ordinary course of the buyer’s business, good-faith purchasers for value, creditors with a perfected lien on the buyer’s inventory [2-702(2) and (3)], and a trustee in bankruptcy. The relative rights of creditors to their debtor’s collateral are discussed in Chapter 29, Security Interests in Personal Property.

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Part Four Sales

CONCEPT REVIEW Problem

Seller’s Remedy

Buyer Refuses to Go Ahead with Contract and Seller Has Goods

1. Seller may cancel contract, suspend performance, and set aside goods intended to fill the contract. a. If seller is in the process of manufacturing, he may complete manufacture or stop and sell for scrap, picking an alternative that, in his judgment at the time, will minimize the seller’s loss. b. Seller can resell goods covered by contract and recover difference  between contract price and proceeds of resale. c. Seller may recover purchase price where resale is not possible. d. Seller may recover damages for breach based on difference between  contract price and market price, or in some cases based on lost  profits.

Goods Are in Buyer’s Possession

1. Seller may recover purchase price. 2. Seller may reclaim goods in possession of insolvent buyer by making a demand within 10 days after their receipt. If the buyer represented solvency to the seller in writing within three months before delivery, the 10-day limitation does not apply.

Goods Are in Transit

1. Seller may stop any size shipment if buyer is insolvent. 2. Seller may stop carload, truckload, planeload, or other large shipment for reasons other than buyer’s insolvency.

Seller’s Right to Stop Delivery If the seller

discovers that the buyer is insolvent, he has the right to stop the delivery of any goods that he has shipped to the buyer, regardless of the size of the shipment. If a buyer repudiates a sales contract or fails to make a payment due before delivery, the seller has the right to stop delivery of any large shipment of goods, such as a carload, a truckload, or a planeload [2-705]. To stop delivery, the seller must notify the carrier or other bailee in time for the bailee to prevent delivery of the goods. After receiving notice to stop delivery, the carrier or other bailee owes a duty to hold the goods and deliver them as directed by the seller. The seller is liable to the carrier or other bailee for expenses incurred or damages resulting from compliance with his order to stop delivery. If a nonnegotiable document of title has been issued for the goods, the carrier or other bailee does not have a duty to obey a stop-delivery order issued by any person other than the person who consigned the goods to him [2-705(3)].

Liquidated Damages If

the seller has justifiably withheld delivery of the goods because of the buyer’s breach, the buyer may recover any money or goods he has

delivered to the seller over and above the agreed amount of liquidated damages. If there is no such agreement, the seller may not retain an amount in excess of $500 or 20 percent of the value of the total performance for which the buyer is obligated under the contract, whichever is smaller. This right of restitution is subject to the seller’s right to recover damages under other provisions of the UCC and to recover the amount of value of benefits received by the buyer directly or indirectly by reason of the contract [2-718].

Buyer’s Remedies LO22-5

List and describe the remedies that the UCC makes available to an aggrieved buyer.

Buyer’s Remedies in General A

seller may breach a contract in a number of ways. The most common are (1) failing to make an agreed delivery, (2) delivering goods that do not conform to the contract, and (3) indicating that she does not intend to fulfill the obligations under the contract.



Chapter Twenty-Two Remedies for Breach of Sales Contracts

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CYBERLAW IN ACTION E-Commerce Aids Buyers Electronic commerce helps solve two of the most important concerns for buyers of goods in enforcing their rights under Article 2. The first of these relates to means by which the buyer may learn—from the seller or otherwise—of a recall that affects the goods purchased. For example, sellers could notify merchant buyers that it is notifying consumer buyers that they will need to take their cars into a dealership to have a seatbelt replaced. This early e-mail or posting on the seller’s website can alert the merchant buyer to the need to train personnel how to handle recall questions from the buyers and also how to make the needed replacement. Buyers also may be able to determine in advance of their purchases whether the goods they plan to buy have been the subject of a recall and whether the recall was voluntary (a problem found by the seller) or required by the federal government. For example, information about earlier recalls may be especially helpful to buyers of used goods, such as cars and trucks, baby items, and anything where personal safety is critically important.

A buyer whose seller breaks the contract is given a number of alternative remedies. These include: • Buying other goods (covering) and recovering damages from the seller based on any additional expense that the buyer incurs in obtaining the goods [2-712]. • Recovering damages based on the difference between the contract price and the current market price of the goods [2-713]. • Recovering damages for any nonconforming goods accepted by the buyer based on the difference in value between what the buyer got and what she should have gotten [2-714]. • Obtaining specific performance of the contract where the goods are unique and cannot be obtained elsewhere [2-716].

The second involves the buyer’s duty to give the seller “notice” if the buyer needs a remedy from the seller. As noted in Chapter 21, Sections 2-602 and 2-607 require that the buyer notify the seller if the buyer wishes to reject goods the seller has tendered, or if the buyer decides to revoke acceptance of goods that the seller has promised to repair or replace and has neither repaired nor replaced the goods as promised—or where the buyer gets goods that have a latent defect. “Notice” does not have to be in writing to be effective, but it usually is preferable to have a record that the buyer gave notice to the seller and the time of the notice given. This reduces the risk that a court will find that the buyer’s failure to give notice deprives the buyer of her right to a remedy [see Section 2-607(3)(a)]. Electronic commerce tools, including e-mail, allow buyers to provide speedy and reliable information to sellers in cases such as these. Buyers whose e-mail systems provide confirmation that the seller recipient actually has received the message about the buyer’s concerns about the goods, or who show the time and date that the intended recipient opened the e-mail, make providing notice easier and easier to document than using traditional methods of communication.

In addition, the buyer can, in some cases, recover consequential damages (such as lost profits) and incidental damages (such as expenses incurred in buying substitute goods).

Buyer’s Right to Damages Where a buyer has

rightfully rejected goods or has justifiably revoked acceptance of goods, the buyer may cancel the contract, recover as much of the purchase price as has been paid, and recover damages. Thus, while the UCC does not explicitly use the common law term rescission (discussed in Chapter 17), it does incorporate the concept. This is illustrated in the case that follows, Beer v. Bennett.

Beer v. Bennett   71 UCC Rep. 2d 507 (N.H. 2010) Bennett was a registered automobile dealer in New Hampshire doing business under the name The Nickled Stork. He posted an advertisement on his Internet website offering the following for sale: 1958 Fiat Osca Spyder 1.5 liter DOHC engine 4 speed trans. Engine and trans are out of the car, but we have most of a spare engine that comes with the car. Body is in very good condition, recently painted robin’s egg blue. Top bows will need new

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Part Four Sales

top added and some other upholstery work required, but quite rare PinninFarina coachwork, pretty vigorous performance from a well designed DOHC Italian Motor. Beer restored old cars as a hobby and had been searching for some time for a car like the one Bennett advertised. He contacted him and, after some negotiation, purchased the advertised vehicle for $6,000. He also arranged to have the car shipped to him at a cost of $1,298. On receipt of the car, Beer discovered that it was missing a number of the parts necessary to make it operable, including “a bell housing starter, generator, distributor, engine mounts, fan, exhaust manifold, and the entire hand-brake mechanism.” He contacted Bennett, but they could not resolve the issue, and Beer brought suit against Bennett. The trial court awarded damages to Beer that included a refund of the purchase price and shipping costs plus certain other costs. The court also ordered Beer to return the Fiat to Bennett upon payment of the judgment and the cost of the return shipment. If Bennett failed to make payment and arrangements for return within 60 days, he would forfeit ownership of the Fiat. Bennett appealed, claiming that the trial court failed to apply the correct measure of damages. He claimed they should have been based on the difference between what Beer paid and the value of what he received. Bennett further argued that since Beer failed to prove the value of what he received, he was not entitled to recover any damages. Hicks, Justice The terms of the remedy awarded make it clear it was not intended to be an award of actual damages. The remedy is clearly one of rescission. Specifically, we conclude that the remedy is sustainable as enforcement of a revocation of acceptance under the Uniform Commercial Code. Section 2-608 provides for revocation of acceptance of nonconforming goods by a buyer under certain circumstances. Once a valid revocation of acceptance has been made, the proper measure of damages is found in section 2-711. That section provides that a buyer who justifiably revokes acceptance may recover so much of the price as has been paid. It also provides, in part, that the buyer has a security interest in goods in his possession or control for any payments made on their price, and any expenses

Buyer’s Right to Cover LO22-6

Explain what is meant by the term cover in the context of a contract for the sale of goods.

If the seller fails or refuses to deliver the goods called for in the contract, the buyer can purchase substitute goods; this is known as cover. If the buyer does purchase substitute goods, the buyer can recover as damages from the seller the difference between the contract price and the cost of the substitute goods [2-712]. For example, Frank Farmer agrees to sell Ann’s Cider Mill 1,000 bushels of apples at $10 a bushel. Farmer then refuses to deliver the apples. Cider Mill can purchase 1,000 bushels of similar apples, and if it has to pay $15 a bushel, it can recover the difference ($5 a bushel) between what it paid ($15) and the contract price ($10). Thus, Cider Mill could recover $5,000 from Farmer.

reasonably incurred in their inspection, receipt, transportation, care, and custody. The UCC also states that a buyer who justifiably revokes acceptance has the same rights and duties with regard to the goods involved as if he had rejected them. Section 2-608(3). Therefore, where the buyer has physical possession of the goods, and after the seller has repaid the purchase price, the nonmerchant’s only duty with respect to the goods is to hold them with reasonable care at the seller’s disposition for a time sufficient to permit the seller to remove them. Section 2-602(2)(b). The remedy order here—return of the purchase price to Beer and return of the Fiat to Bennett upon his payment of the judgment and his arrangements for return shipment and payment for the same—is entirely proper under the UCC. Judgment affirmed for Beer.

The buyer can also recover any incidental damages sustained but must give the seller credit for any expenses saved. In addition, she may be able to obtain consequential damages. The buyer is not required to cover, however. If she does not cover, the other remedies under the UCC are still available [2-712].

Incidental Damages Explain what is meant by the terms incidental damages

LO22-7 and consequential damages and indicate when an

injured buyer is able to recover consequential damages.

Incidental damages include expenses that the buyer incurs in receiving, inspecting, transporting, and storing goods shipped by the seller that do not conform to those called for in the contract. Incidental damages also include any



Chapter Twenty-Two Remedies for Breach of Sales Contracts

reasonable expenses or charges that the buyer has to pay in obtaining substitute goods [2-715(1)].

Consequential Damages In

certain situations, an injured buyer is able to recover consequential damages, such as the buyer’s lost profits caused by the seller’s breach of contract. The buyer must be able to show that the seller knew or should have known at the time the contract was made that the buyer would suffer special damages if the seller did not perform his obligations. In case of commercial loss, the buyer must also show that she could not have prevented the damage by obtaining substitute goods [2-715(2)(a)]. Suppose Knitting Mill promises to deliver 15,000 yards of a special fabric to Dorsey by September 1. Knitting Mill knows that Dorsey wants to acquire the material to make garments suitable for the Christmas season. Knitting Mill also knows that in reliance on the contract with it, Dorsey will enter into contracts with stores to deliver the finished garments by October 1. If Knitting Mill fails to deliver the fabric or delivers the fabric after September 1, it may be liable to Dorsey for any consequential damages that she sustains if she is unable to acquire the same material elsewhere in time to fulfill her October 1 contracts. Consequential damages can also include an injury to a person or property caused by a breach of warranty [2-715(2)(b)]. For example, an electric saw is defective. Hanson purchases the saw, and while he is using it, the blade comes off and severely cuts his arm. The injury to Hanson is consequential damage resulting from a nonconforming or defective product. In the hypothetical case presented at the beginning of this chapter, a customer contracts with Bridal Shop to

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make a custom-designed bridal gown in size 6 in time for her wedding. The case posits the Bridal Shop advising the customer that it will not be able to complete the production of the gown in time for the wedding. If the customer “covers” by buying a gown from another wedding shop, what is the measure of damages that the customer would be entitled to? Can you think of “incidental damages” or “consequential damages” that might be incurred in this situation and that might be claimed?

Damages for Nondelivery If the seller fails or

refuses to deliver the goods called for by the contract, the buyer has the option of recovering damages for the nondelivery. Thus, instead of covering, the buyer can get the difference between the contract price of the goods and their market price at the time she learns of the seller’s breach. In addition, the buyer may recover any incidental damages and consequential damages but must give the seller credit for any expenses saved [2-713]. Suppose Biddle agreed on June 1 to sell and deliver 1,500 bushels of wheat to a grain elevator on September 1 for $7 per bushel and then refused to deliver on ­September 1 because the market price was then $10 per bushel. The grain elevator could recover $4,500 damages from Biddle, plus incidental damages that could not have been prevented by cover. The case that follows, Green Wood Industrial Company v. Forceman International Development Group, involves an award of damages in connection with a contract to sell scrap metal to a buyer in China where the goods were never shipped even though the seller fraudulently represented they had been shipped.

Green Wood Industrial Company v. Forceman International Development Group    64 UCC Rep. 2d 378 (Cal. Ct. App. 2007) Green Wood, a sole proprietorship owned and operated by Joseph Li in Hong Kong, is primarily in the business of buying scrap from sellers in the United States for resale to buyers in China. Richshine Metals Inc. (Richshine), owned and operated by its president, Christine Fan, was in the business in California of selling scrap metal for export. In the summer of 2003, Green Wood purchased approximately 680 metric tons of scrap plate metal from Richshine. Green Wood sold the scrap plate to a buyer in China. Green Wood’s buyer was very pleased with the material supplied by Richshine and wanted more. In November 2003, Green Wood placed a purchase order with Richshine to acquire 2,100 metric tons of scrap plate metal and 10,650 metric tons of scrap iron for a total purchase price of $1.89 million. Richshine was to deliver the goods directly to Green Wood’s buyer at Guangxi Port in southern China by the end of November. Green Wood was to pay a $200,000 deposit, $340,000 cash on delivery, and the balance by letter of credit. By the beginning of January 2004, Richshine had not shipped the goods. During this time frame, the price of scrap metal was rising in the world market. Li and Green Wood’s buyer were concerned that Richshine might have sold the goods to another buyer at a higher price. They agreed to make some changes in the shipping terms and to wire additional money to Richshine’s account. Green Wood

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Part Four Sales

ultimately paid Richshine $1,074,548 in advance toward the purchase price of the goods. Green Wood’s Chinese buyer funded $862,500 of that amount. Thereafter, Richshine provided packing lists, invoices, and bills of lading as well as certain certificates required by the Chinese government that the goods had been inspected (China Certification and Inspection Corporation, or CCIC, certificates). The certificates had been obtained by Forceman International Development Group Inc. (Forceman) and purported to represent they had been issued by CCIC South America and indicated that the containers with the scrap had been inspected in Tijuana, Mexico. The goods allegedly were awaiting shipment to China. Unbeknownst to Li, the packing lists provided by Richshine with respect to the purchase order were fake, the CN Link bills of lading were forgeries, and the CCIC certificates were obtained fraudulently. The goods that Richshine had purported to ship pursuant to the purchase order never existed. When the goods did not arrive, Li mounted an investigation to track down Fan and her confederates. They were eventually found in Nevada, where they had moved and were doing business under the name of Moundhouse Metals. When Li confronted Fan, telling her that if the goods did not arrive soon, Li would sue Fan, she, in essence, dared Li to do so. When further investigation made it clear the goods had never existed, Li brought suit against Richline, Fan, and Forceman for fraud and negligence. Li sought to recover, as out-of-pocket damages, $1,074,548 paid to Richline and Fan; $159,000 in lost profits that Green Wood lost as a result of the nondelivery of the goods; and $274,868 for a claim Green Wood’s buyer had made against Green Wood, apparently for its lost profits, which Green Wood had agreed to pay but had not yet paid. A jury awarded Green Wood compensatory damages of $1,508,416 plus punitive damages of $5,000, and the defendants appealed. Mosk, Judge The fraud in this case is related to the purchase order. The purchase order was a contract for the sale of goods subject to Article 2 of the Uniform Commercial Code. Accordingly, the damages available to Green Wood from the fraud are governed by UCC section 2-721, which provides for recovery on a basisof-the-bargain basis. That section provides: “Remedies for material misrepresentation or fraud include all remedies available under this section for nonfraudulent breach. Neither rescission or a claim for rescission of the contract for sale nor rejection or return of the goods shall bar or be deemed inconsistent with a claim for damage or other remedy.” Section 2-721 represents an exception to the general rule in California that a plaintiff defrauded in the purchase or sale of property may recover only out-of-pocket loss. Where, as here, a seller fails to deliver goods pursuant to a contract governed by the UCC and the buyer does not cover, the buyer’s remedy is set forth in section 2-713(1). That section provides, in pertinent part, “the measure of damages for nondelivery or repudiation by the seller is the difference between the market price at the time when the buyer learned of the breach and the contract price together with any incidental and consequential damages provided in this division (2-715), but less expenses saved in consequence of the seller’s breach” [italics added]. Green Wood did not seek damages based on the difference between contract price and market price, but rather sought its out-of-pocket damages and consequential damages based on its lost profits. Pursuant to section 2-715(2)(a), a buyer of goods for resale may generally recover its lost profits as consequential damages, provided such damage “could not reasonably be prevented by cover or otherwise. . . .”

In this case, none of the defendants offered evidence that Green Wood had failed to mitigate its consequential damages. Green Wood, however, introduced substantial evidence to sustain an award of lost profits. Green Wood presented evidence of its purchase price from Richshine, which included the cost of shipping the goods to China. Li of Green Wood testified that Green Wood sold the plate scrap to its buyer for $25 per ton more than Green Wood paid, and sold the scrap iron at $10 per ton more than Green Wood paid. Forceman had a full and fair opportunity to test Green Wood’s damage calculation through cross-examination or rebuttal. On appeal, Forceman does not identify any specific manner in which Li’s calculation was erroneous, and Forceman provides no argument or authority that the amount of lost profits awarded was excessive. Accordingly, substantial evidence supports the $159,000 award for Green Wood’s lost profits. Forceman asserts that the trial court erred in awarding Green Wood $274,868 for a claim made against Green Wood by its Chinese buyer, or an obligation of Green Wood to that buyer, for damages suffered by that buyer resulting from Green Wood’s failure to deliver the goods. We agree that as to this item, the damage award was improper. A plaintiff may not recover damages for unpaid liabilities to a third party, unless the plaintiff proves to a reasonable certainty that the liability could and would be enforced by the third party against the plaintiff or that the plaintiff otherwise could and would satisfy the obligation. Under California law, a plaintiff—whether the plaintiff’s claim sounds in contract or tort—generally cannot recover damages alleged to arise from a third-party claim against the plaintiff when caused by the defendant’s misconduct. It is clear that the mere possibility, or even probability, that an event causing damage will result from a wrongful act, does not render the act



Chapter Twenty-Two Remedies for Breach of Sales Contracts

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actionable. Accordingly, the existence of a mere liability is not the equivalent of actual damage. This is because the fact of damage is inherently uncertain in such circumstances. The facts that a third party has demanded payment by the plaintiff of a particular liability and plaintiff has admitted such liability are not, by themselves, sufficient to support an award of damages for that liability, because that third party may never attempt to force the plaintiff to satisfy the alleged obligation, and plaintiff may never pay the obligation. California law does, however, recognize that a plaintiff in a tort action may recover for a “loss reasonably certain to occur in the future.” A similar concept has been recognized by some authorities in the context of contract damages. For example, an authority states, “Indeed, in a resale situation, the buyer has been permitted to claim as consequential damages from the seller the amount of the buyer’s potential liability to its customer; if the buyer establishes the probability that the buyer will be sued by the customer, it is immaterial that the buyer has not yet been sued and made to bear the loss, and recovery is measured by the probable liability of the buyer to the customer.” Other authorities note that a plaintiff may recover for future losses if there is an appropriate showing that those losses will in fact be incurred in the future. It may be that existing California authorities generally require payment of the liability in order to include the liability as damages. But even if a liability to a third party might be included as

damages without actual payment, more certainty is required than just evidence of an obligation to pay a third party. In this case, the evidence established that, at the time of trial, Green Wood has not paid any portion of its Chinese buyer’s $274,868 claim. Although there is evidence that Green Wood had, in effect, settled the claim by agreeing to pay it, Green Wood presented no evidence that any such agreement would be enforceable in China, or that the liability could and would be enforced by the buyer in the United States or elsewhere, or that the claim will otherwise be paid. There was no evidence from which the jury could conclude that it was reasonably certain that Green Wood would ever have to pay the money. Furthermore, it appears that the Chinese buyer’s claim against Green Wood was for the buyer’s own lost profits. The only evidence regarding the Chinese buyer’s business, however, was that the buyer is a manufacturer of some kind, not a reseller. Green Wood presented no evidence to establish the fact or amount of the Chinese buyer’s lost profits other than the Chinese buyer’s mere claim. This illustrates another problem with allowing damages based on a third-party claim. If a defendant is liable for any sum a plaintiff agreed to pay a third party, that sum could be subject to unfair manipulation.

Damages for Defective Goods If a buyer ac-

For example, Al’s Auto Store sells Anders an automobile tire, warranting it to be four-ply construction. The tire goes flat when it is punctured by a nail, and Anders discovers that the tire is really only two-ply. If Anders gives the store prompt notice of the breach, she can keep the tire and recover from Al’s the difference in value between a two-ply and a four-ply tire. This remedy is illustrated in the following case, Cahaba Disaster Recovery v. Rogers.

cepts defective goods and wants to hold the seller liable, the buyer must give the seller notice of the defect within a reasonable time after the buyer discovers the defect [2-607(3)]. Where goods are defective or not as warranted and the buyer gives the required notice, she can recover damages. The buyer is entitled to recover the difference between the value of the goods received and the value the goods would have had if they had been as warranted. She may also be entitled to incidental and consequential damages [2-714].

Accordingly, the evidence is insufficient to sustain the award of $274,868 for the Chinese buyer’s claim.

Cahaba Disaster Recovery v. Rogers   76 UCC Rep. 2d 624 (S.D. Ala. 2012) On April 20, 2010, the Deepwater Horizon drilling rig exploded in the Gulf of Mexico. The resultant oil spill threatened coastal communities from Louisiana to Florida. In an effort to protect their beaches and marshlands, certain of these communities hired emergency response companies to deploy and service offshore “boom”—floating barriers designed to arrest the movement of oil-contaminated water. Among those companies was DRC Emergency Services, an Alabama-based limited liability company that in turn engaged Cahaba Disaster Recovery to locate and procure oil boom to be used for DRC’s projects.

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Part Four Sales

In April 2010, Cahaba made its first-ever purchases of small quantities of oil-containment boom and oil-absorbent boom. “Oilcontainment” boom is designed to keep oil-contaminated water in place, whereas “oil-absorbent” boom is meant to extract and retain oil while repelling water. The purchases had to conform to certain specifications in DRC’s contracts. With respect to containment boom, those specifications were quite detailed. Conversely, the absorbent boom that Cahaba was instructed to order simply had to be either five or eight inches in diameter. After a telephone exchange with Lenny Rogers, the Managing Partner of International Lining LLC on May 1, in which Cahaba’s interest in acquiring absorbent boom were made clear, Cahaba entered into a contract with International Lining for the purchase of 150,000 feet of what it believed would be “eight-inch absorbent boom” at a contract price of $200,000 plus $8,100 in freight charges for a total of $208,100. Cahaba wired the purchase price to International Lining. When the product was delivered to Cahaba on May 7, part of the delivery was accompanied by a shipping statement that referred to 13,000 lineal feet of “FOC 8” boom product. When Cahaba’s employees could not identify the type of product that Cahaba had received, they contacted Rogers. He explained that the delivered product, labeled as “Rapid Oil Containment Barrier,” but occasionally referred to by International Lining as “Fast Oil containment” or “FOC,” was a revolutionary product that could both absorb and contain oil. During a subsequent telephone conversation, Rogers assured Cahaba that the FOC boom was, in fact, absorbent boom. Cahaba then attempted, without success, to employ the FOC boom to satisfy its contracts with DRC and also to sell the boom to others responding to the Deepwater Horizon spill. Six weeks later, on June 15, 2010, Cahaba advised Rogers that the FOC boom did not meet Cahaba’s needs and that it wished to return the boom. Rogers quickly responded that International Lining would not accept any return. Subsequently, Cahaba conducted a field test of the FOC boom off the coast of Escambia, Florida—and determined that the FOC boom effectively contained, but did not absorb, oil. When Rogers was advised of the test results, he confirmed that the boom acted like a containment boom but also asserted that it also acted like an absorbent boom because oil is “almost magnetized” to the material and “I promise you that it works.” However, he did not offer to, or attempt to, replace Cahaba’s stock of FOC boom with absorbent boom. Three months later, Cahaba filed suit against Rogers and International Lining, alleging breach of contract and fraud for delivering containment boom rather than absorbent boom. In its defense, International Lining contended that it did everything it was required to do under the contract. Moreover, as an affirmative defense, International Lining asserted that under the Alabama UCC, a buyer’s acceptance of nonconforming goods precludes its right to return the goods to the seller.

DuBose, District Judge The court’s factual finding that the parties contracted for 150,000 feet of absorbent boo[m] and International Lining’s admission that the boo[m] delivered to Cahaba was not absorbent undermine its position entirely. Quite simply, International Lining’s tender of FOC boom did not conform to the terms of its contract with Cahaba and therefore constitutes nonperformance on the part of International Lining. International Lining’s delivery of non-absorbent boo[m] also constitutes a breach of International Lining’s express warranty that the boom would absorb. Alabama law provides that any description of goods which is made part of the basis of the bargain creates an express warranty that the goods shall conform to the description. In support of their affirmative defenses, International Lining relies on a provision of the Alabama Uniform Commercial Code (Section 2-607(2)) that sets forth that a buyer’s acceptance of nonconforming goods precludes its right to return the goods to the seller. While the record establishes that Cahaba accepted the FOC boom by relying on the manufacturer’s

representations that it would absorb oil and by waiting nearly seven weeks from the date of delivery to assess the validity of that assurance, the code section relied upon by International Lining also notes that a buyer who accepts nonconforming goods does not forfeit its right to otherwise recover for a seller’s breach. Section 2-607(2) states, “Acceptance does not of itself impair any other remedy provided by this article for nonconformity.” To preserve its right to recover damages, a buyer who has accepted nonconforming goods must timely notify the seller of the breach. Cahaba’s June 24, 2010 e-mail which was sent immediately after Cahaba discovered that the FOC boom was not absorbent satisfies the notice requirement. The e-mail clearly informed International Lining that testing by Cahaba revealed the FOC boom “is not an absorbent but a containment boom” and thereby presented International Lining with an unrealized opportunity to cure the nonconformity or otherwise settle with Cahaba. Accordingly, Cahaba has preserved its right to recover damages for International Lining’s established breaches.



Chapter Twenty-Two Remedies for Breach of Sales Contracts

The measure of damages for breach of warranty in regard to accepted goods is governed by Code Section 2-714, which provides in pertinent part: The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.

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International Lining is liable for the $208,100 purchase price, less the value of the FOC boom as accepted by Cahaba. The FOC boom had no value to Cahaba because it could not be deployed as absorbent boom and does not satisfy any of DRC’s specifications for containment boom. Accordingly, the difference between the value of the goods as warranted and the value at the time and place of acceptance is $208,100. Judgment for Cahaba.

Ethics and Compliance in Action Should the Buyer Get an Honest Answer? Problem case 8 at the end of this chapter is based on the following situation: Barr purchased from Crow’s Nest Yacht Sales a 31-foot Tiara pleasure yacht manufactured by S-2 Yachts. He had gone to Crow’s Nest knowing the style and type of yacht he wanted. He was told that the retail price was $102,000 but that he could purchase the model it had for $80,000. When he asked about the reduction in price, he was told that Crow’s Nest had to move it because there was a change in the model and it had new ones coming in. He was assured that the yacht was new, that there was nothing wrong

with it, and there were only 20 hours on the engine. When Barr began to use the boat, he experienced tremendous difficulties with equipment malfunctions. On examination by an expert, it was determined that the yacht had earlier been sunk in saltwater, resulting in significant rusting and deterioration in the engine, equipment, and fixtures. How would you assess the ethicality of the representations made by the salesperson in response to his question? In a case like this, should it be incumbent on the buyer to ask the “right” question in order to protect himself or herself, or should there be an ethical obligation on the seller to disclose voluntarily material facts that may be relevant to the buyer making an informed decision?

The Global Business Environment Buyer’s Remedies in International Transactions Under the Convention on Contracts for the International Sale of Goods (CISG), an aggrieved buyer has four potential types of remedies against a seller who has breached the contract: (1) “avoidance” of the contract, (2) an adjustment in the price, (3) specific performance, and (4) an action for damages. The first two remedies can be pursued without involving a court, and the last two require the buyer to initiate a judicial proceeding. As noted in Chapter 21 (see The Global Business Environment box titled “Insecurity”), a buyer has the right to suspend its performance and∕or to “avoid” a contract where the seller appears unable to perform its obligations and does not provide adequate assurances that it can and will perform. A buyer may also “avoid” the contract—which, under the CISG, essentially means “cancel” the contract—and refuse to accept and pay for goods that are so defective or nonconforming as to constitute a “fundamental breach” of the contract.

Aggrieved buyers who receive nonconforming goods “may reduce the price” paid to the seller. The CISG provides a formula for calculating the reduction that involves comparing the value of the goods actually delivered at the time they were delivered to the value that conforming goods would have had at the time of delivery. The CISG gives the aggrieved buyer a right to “require performance” by the seller. This follows the civil law principle that the best relief to the buyer is not damages but rather having the seller perform as promised. Thus, the CISG does not require that the goods must be “unique”—as the UCC does—in order for the buyer to be entitled to specific performance. While the buyer has the right to seek specific performance with the assistance of a court, the buyer also has the option of seeking damages, including consequential damages. Such damages can be based on either (1) the difference between the cost of cover and the contract price or (2) the difference between the market price and the contract price. However, unlike the UCC, the CISG requires the buyer to use the “cover” formula for calculating damages if the buyer does cover by obtaining substitute goods.

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Part Four Sales

CONCEPT REVIEW Buyer’s Remedies (on breach by seller) Problems

Buyer’s Remedy

Seller Fails to Deliver Goods or Delivers Nonconforming Goods That Buyer Rightfully Rejects or Justifiably Revokes Acceptance of

1. Buyer may cancel the contract and recover damages. 2. Buyer may “cover” by obtaining substitute goods and recover difference between contract price and cost of cover. 3. Buyer may recover damages for breach based on difference between contract price and market price.

Seller Delivers Nonconforming Goods That Are Accepted by Buyer

Buyer may recover damages based on difference between value of goods received and value of goods if they had been as warranted.

Seller Has the Goods but Refuses to Deliver Them and Buyer Wants Them

Buyer may seek specific performance if goods are unique and cannot be obtained elsewhere, or buyer may replevy (obtain from the seller) goods identified to contract if buyer cannot obtain cover.

Buyer’s Right to Specific Performance LO22-8

Discuss when an aggrieved buyer has a right to specific performance of a contract for the sale of goods.

 Sometimes, the goods covered by a contract are unique and it

is not possible for a buyer to obtain substitute goods. When this is the case, the buyer is entitled to specific performance of the contract. Specific performance means that the buyer can require the seller to give the buyer the goods covered by the contract [2-716]. Thus, the buyer of an antique automobile, such as a 1910 Ford, might have a court order for the seller to deliver the specific automobile to the buyer if it was unique or one of a kind. On the other hand, the buyer

Problems and Problem Cases 1. International Record Syndicate (IRS) hired Jeff Baker to take photographs of the musical group Timbuk-3. Baker mailed 37 “chromes” (negatives) to IRS via the business agent of Timbuk-3. When the chromes were returned to Baker, holes had been punched in 34 of them. Baker brought an action for breach of contract to recover for the damage done to the chromes. A provision printed on Baker’s invoice to IRS stated: “[r]eimbursement for loss or damage shall be determined by a photograph’s reasonable value which shall

of grain in a particular storage bin could not get specific performance if she could buy the same kind of grain elsewhere.

Buyer and Seller Agreements as to Remedies As mentioned earlier in this chapter, the parties

to a contract may provide remedies in addition to or as substitution for those expressly provided in the UCC [2-719]. For example, the buyer’s remedies may be limited by the contract to the return of the goods and the repayment of the price or to the replacement of nonconforming goods or parts. However, a court looks to see whether such a limitation was freely agreed to or whether it is unconscionable. In the latter case, the court does not enforce the limitation and the buyer has all the rights given to an injured buyer by the UCC.

be no less than $1,500 per transparency.” Baker testified that he had been paid as much as $14,000 for a photo session, which resulted in 24 photographs, and that several of them had already been resold. He also had received as little as $125 for a single photograph. He once sold a photograph taken in 1986 for $500 and sold several reproductions of it later for a total income of $1,500. Was the liquidated damages provision enforceable by Baker? 2. Lobianco contracted with Property Protection for the installation of a burglar alarm system. The contract provided in part:



Chapter Twenty-Two Remedies for Breach of Sales Contracts

Alarm system equipment installed by Property Protection is guaranteed against improper function due to manufacturing defects of workmanship for a period of 12 months. The installation of the above equipment carries a 90-day warranty. The liability of Property Protection is limited to repair or replacement of security alarm equipment and does not include loss or damage to possessions, persons, or property.

As installed, the alarm system included a standby battery source of power in the event that the regular source of power failed. During the 90-day warranty period, burglars broke into Lobianco’s house and stole $35,815 worth of jewelry. First, they destroyed the electric meter so that there was no electric source to operate the system, and then they entered the house. The batteries in the standby system were dead, and thus the standby system failed to operate. Accordingly, no outside siren was activated and a telephone call that was supposed to be triggered was not made. Lobianco brought suit, claiming damage in the amount of her stolen jewelry because of the failure of the alarm system to work properly. Did the disclaimer effectively eliminate any liability on the alarm company’s part for consequential damages? 3. On July 1, 2005, Gary Woods purchased a Maytag 30inch gas range oven from Plesser’s, a department store in Babylon, New York. The gas oven came with a warranty that provided as follows: Full One Year Warranty—Parts and Labor For one (1) year from the original retail purchase date, any part which fails in normal home use will be repaired or replaced free of charge.  . . .  The specific warranties expressed above are the ONLY warranties provided by the manufacturer. This warranty gives you specific legal rights, and you may also have other rights that vary from state to state.

On February 29, 2008, when Woods attempted to use the oven, a malfunction occurred that caused the oven to explode. Woods attributed the explosion to an alleged defect in the starter mechanism in the oven that “causes the gas valve to open in such a manner that the open valve causes the oven to fill with gas but not ignite.” On December 10, 2009, Woods brought suit against Maytag claiming, among other things, breach of express warranty. Maytag moved to dismiss the count, contending that it was barred by the four-year statute of limitations in the UCC. Woods contended

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that the warranty came within an exception to the four-year rule because it related to future performance. Should the court view the warranty as one relating to future performance? 4. Murrey & Sons Company (Murrey) was engaged in the business of manufacturing and selling pool tables. Erik Madsen was working on an idea to develop a pool table that, through the use of electronic devices installed in the rails of the table, would produce lighting and sound effects in a fashion similar to a pinball machine. Murrey and Madsen entered into a written contract whereby Murrey agreed to manufacture 100 of its M1 4-foot by 8-foot six-pocket coin-operated pool tables with customized rails capable of incorporating the electronic lighting and sound effects desired by Madsen. Under the agreement, Madsen would design the rails and provide the drawings to Murrey, which would manufacture them to Madsen’s specifications. Madsen was to design, manufacture, and install the electronic components for the tables. Madsen agreed to pay $550 per table or a total of $55,000 for the 100 tables and made a $42,500 deposit on the contract. Murrey began the manufacture of the tables while Madsen continued to work on the design of the rails and electronics. Madsen encountered significant difficulties and notified Murrey that he would be unable to take delivery of the 100 tables. Madsen then brought suit to recover the $42,500 he had paid Murrey. Following Madsen’s repudiation of the contract, Murrey dismantled the pool tables and used salvageable materials to manufacture other pool tables. A good portion of the material was simply used as firewood. Murrey made no attempt to market the 100 pool tables at a discount or at any other price in order to mitigate its damages. It claimed the salvage value of the materials it reused was $7,488. There was evidence that if Murrey had completed the tables, they would have had a value of at least $21,250 and could have been sold for at least that much and that the changes made in the frame to accommodate the electrical wiring would not have adversely affected the quality or marketability of the pool tables. Murrey said it had not completed manufacture because its reputation for quality might be hurt if it dealt in “seconds” and that the changes in the frame might weaken it and subject it to potential liability. Was Murrey justified in not completing manufacture of the pool tables?

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Part Four Sales

5. Catherine Baker purchased a fake fur coat from the Burlington Coat Factory Warehouse store in Scarsdale, New York, paying $127.99 in cash. The coat began shedding profusely, rendering the coat unwearable. The shedding was so severe that Baker’s allergies were exacerbated, necessitating a visit to her doctor and to the drugstore for a prescription. She returned the coat to the store after two days and demanded that Burlington refund her $127.99 cash payment. Burlington refused, indicating that it would give her a store credit or a new coat of equal value, but no cash refund. Baker searched the store for a fake fur of equal value and found none. She refused the store credit, repeated her demand for a cash refund, and brought a lawsuit against Burlington when it refused to make a cash refund. In its store, Burlington displayed several large signs that state, in part: WAREHOUSE POLICY Merchandise in New Condition May Be Exchanged Within 7 Days for Store Credit and Must Be Accompanied by a Ticket and Receipt. No Cash Refunds or Charge Credits. On the front of Baker’s sales receipt was the following language: Holiday Purchases May Be Exchanged Through January 11th, 1998. In House Store Credit Only. No Cash Refunds or Charge Card Credits. On the back of the sales receipt was the following language: We Will Be Happy to Exchange Merchandise in New Condition Within 7 Days When Accompanied By Ticket and Receipt. However, Because of Our Unusually Low Prices: No Cash Refunds or Charge Card Credits Will Be Issued. In House Store Credit Only.

At the trial, Baker claimed that she had not read the language on the receipt and was unaware of Burlington’s no-cash-refunds policy. The court found that Burlington had breached the implied warranty of merchantability when it sold the defective coat to Baker. Where the seller breaches the implied warranty of merchantability and the buyer returns the defective goods, is the buyer entitled to a refund of the purchase price paid for the goods? 6. Dubrow, a widower, was engaged to be married. In October, he placed a large order with a furniture store for delivery the following January. The order included rugs cut to special sizes for the prospective

couple’s new house and many pieces of furniture for various rooms in the house. One week later, Dubrow died. When the order was delivered, his only heir, his daughter, refused to take the furniture and carpeting. The furniture store then sued his estate to recover the full purchase price. It had not tried to resell the furniture and carpeting to anyone else. Under the circumstances, was the seller entitled to recover the purchase price of the goods? 7. Cohn advertised a 30-foot sailboat for sale in The New York Times. Fisher saw the ad, inspected the sailboat, and offered Cohn $4,650 for the boat. Cohn accepted the offer. Fisher gave Cohn a check for $2,535 as a deposit on the boat. He wrote on the check, “Deposit on aux sloop, D’arc Wind, full amount $4,650.” Fisher later refused to go through with the purchase and stopped payment on the deposit check. Cohn readvertised the boat and sold it for the highest offer he received, which was $3,000. Cohn then sued Fisher for breach of contract. He asked for damages of $1,679.50. This represented the $1,650 difference between the contract price and the sale price plus $29.50 in incidental expenses in reselling the boat. Is Cohn entitled to this measure of damages? 8. Barr purchased from Crow’s Nest Yacht Sales a 31foot Tiara pleasure yacht manufactured by S-2 Yachts. He had gone to Crow’s Nest knowing the style and type of yacht he wanted. He was told that the retail price was $102,000 but that he could purchase the model it had for $80,000. When he asked about the reduction in price, he was told that Crow’s Nest had to move it because there was a change in the model and it had new ones coming in. He was assured that the yacht was new, that there was nothing wrong with it, and that it had only 20 hours on the engines. Barr installed a considerable amount of electronic equipment on the boat. When he began to use it, he experienced tremendous difficulties with equipment malfunctions. On examination by a marine expert, it was determined that the yacht had earlier been sunk in saltwater, resulting in significant rusting and deterioration in the engine, equipment, and fixtures. Other experts concluded that significant replacement and repair were required; that the engines would have only 25 percent of their normal expected life; and that following its sinking, the yacht would have only half of its original value. Barr then brought suit against Crow’s Nest and S-2 Yachts for breach of warranty. To what measure of damages is Barr entitled to recover for breach of warranty?



Chapter Twenty-Two Remedies for Breach of Sales Contracts

9. De La Hoya bought a used handgun for $140 from Slim’s Gun Shop, a licensed firearms dealer. At the time, neither De La Hoya nor Slim’s knew that the gun had been stolen prior to the time Slim’s bought it. While De La Hoya was using the gun for target shooting, he was questioned by a police officer. The officer traced the serial number on the gun, determined that it had been stolen, and arrested De La Hoya. De La Hoya had to hire an attorney to defend himself against the criminal charges. De La Hoya then brought a lawsuit against Slim’s Gun Shop for breach of warranty of title. He sought to recover the purchase price of the gun plus $8,000, the amount of his attorney’s fees, as “consequential damages.” Can a buyer who does not get good title to the goods he purchased recover from the seller consequential damages caused by the breach of warranty of title?

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10. Schweber contracted to purchase a certain black RollsRoyce Corniche automobile from Rallye Motors. He made a $3,500 deposit on the car. Rallye later returned his deposit to him and told him that the car was not available. However, Schweber learned that the automobile was available to the dealer and was being sold to another customer. The dealer then offered to sell Schweber a similar car, but with a different interior design. Schweber brought a lawsuit against the dealer to prevent it from selling the Rolls-Royce Corniche to anyone else and to require that it be sold to him. Rallye Motors claimed that he could get only damages and not specific performance. Approximately 100 RollsRoyce Corniches were being sold each year in the United States, but none of the others would have the specific features and detail of this one. Is the remedy of specific performance available to Schweber?

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Chapter 23

Personal Property and Bailments

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Property

Chapter 24

Real Property

Chapter 25

Landlord and Tenant

Chapter 26

Estates and Trusts

Chapter 27

Insurance Law

Pixtal/AGE Fotostock

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CHAPTER 23

Personal Property And Bailments

C

laudio is a skilled craftsman employed by the Goldcasters Jewelry to make handcrafted jewelry. Working after his normal working hours and using materials he paid for himself, Claudio crafts a fine ring by skillfully weaving together strands of gold wire. He presents the ring to his fianće, Cheryl, as an engagement ring in anticipation of their forthcoming marriage. While visiting the restroom in a steak and ribs restaurant, Cheryl removes the ring so she can wash some barbecue sauce from her hands. In her haste to get back to her table, she leaves the ring on the washstand when she exits the restroom. Sandra, a part-time janitor for the restaurant, finds the ring and slips it into her purse. When Cheryl realizes she is missing the ring and returns to the restroom to look for it, neither the ring nor Sandra is still there. Later that evening, Sandra sells the ring to her cousin, Gloria, who gives her $200 for it. Several days later, Cheryl breaks her engagement to Claudio, telling him that she no longer loves him. Claudio asks Cheryl to return the ring, indicating that he intended for her to have it only if their engagement led to marriage. This situation raises a number of questions concerning rights and interests in personal property that will be discussed in this chapter. They include: • Between Claudio and Goldcasters, who was the owner of the ring at the time Claudio created it? • Did Claudio make an effective gift of the ring to Cheryl? Or was it a conditional gift that he could revoke when Cheryl decided to call off the marriage? • What was Sandra’s responsibility when she found the ring? Between Sandra and the restaurant, who had the ­better right to the ring? • Did Gloria become the owner of the ring when she paid the $200 to Sandra? Does Cheryl have the right to ­recover the ring from Gloria if she finds that Gloria has it? • Was it ethical for Claudio to use his employer’s tools and facilities for a personal project?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 23-1 23-2 23-3 23-4 23-5

Understand the concept of ownership of property as a bundle of rights that the law recognizes. Differentiate personal property from real property. List the primary ways to acquire ownership of personal property. Explain how the rights of finders of abandoned, lost, and mislaid property differ. List and discuss the elements that are necessary for making a valid gift of property.

23-6 23-7

List the three essential elements of a bailment. List and compare the three different types of bailments. 23-8 Explain the basic duties of the bailee and the bailor of personal property. 23-9 Discuss the special rules applicable for bailments to common carriers and hotelkeepers. 23-10 Discuss the special rules applicable to bailments covered by negotiable documents of title, including warehouse receipts and bills of lading.

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Part Five Property

Nature of Property LO23-1

Understand the concept of ownership of property as a bundle of rights that the law recognizes.

The concept of property is central to the organization of society. The essential nature of a particular society is often reflected in the way it views property, including the degree to which property ownership is concentrated in the state, the extent to which it permits individual ownership of property, and the rules that govern such ownership. History is replete with wars and revolutions that arose out of conflicting claims to, or views concerning, property. Significant documents in our Anglo-American legal tradition, such as the Magna Carta and the Constitution, deal explicitly with property rights. The word property is used to refer to something that is capable of being owned. It is also used to refer to a right or interest that allows a person to exercise dominion over a thing that may be owned or possessed. When we talk about property ownership, we are speaking of a bundle of rights that the law recognizes and enforces. For example, ownership of a building includes the exclusive right to use, enjoy, sell, mortgage, or rent the building. If someone else tries to use the property without the owner’s consent, the owner may use the courts and legal procedures to eject that person. Ownership of a patent includes the rights to produce, use, and sell the patented item and to license others to do those things. In the United States, private ownership of property is protected by the Constitution, which provides that the government shall deprive no person of “life, liberty, or property, without due process of law.” We recognize and encourage the rights of individuals to acquire, enjoy, and use property. These rights, however, are not unlimited. For example, a person cannot use property in an unreasonable manner that injures others. Also, the state has police power through which it can impose reasonable regulations on the use of property, tax it, and take it for public use by paying the owner compensation for it. Property is divided into a number of categories based on its characteristics. The same piece of property may fall into more than one class. The following discussion explores the meaning of personal property and the numerous ways of classifying property.

Classifications of Property Differentiate personal property from real

LO23-2 property.

Personal Property versus Real Property Personal property is defined by process of exclu-

sion. The term personal property is used in contrast to real property. Real property is the earth’s crust and all things firmly attached to it.1 For example, land, office buildings, and houses are considered to be real property. All other objects and rights that may be owned are personal property. Clothing, books, and stock in a corporation are examples of personal property. Real property may be turned into personal property if it is detached from the earth. Personal property, if attached to the earth, becomes real property. For example, marble in the ground is real property. When the marble is quarried, it becomes personal property, but if it is used in constructing a building, it becomes real property again. Perennial vegetation that does not have to be seeded every year, such as trees, shrubs, and grass, is usually treated as part of the real property on which it is growing. When trees and shrubs are severed from the land, they become personal property. Crops that must be planted each year, such as corn, oats, and potatoes, are usually treated as personal property. However, if the real property on which they are growing is sold, the new owner of the real property also becomes the owner of the crops. When personal property is attached to, or used in conjunction with, real property in such a way as to be treated as part of the real property, it is known as a fixture. The law concerning fixtures is discussed in Chapter 24.

Tangible versus Intangible Personal Property Personal property may be either tangible

or intangible. Tangible property has a physical existence. Cars, animals, and computers are examples. Property that has no physical existence is called intangible property. For example, rights under a patent, copyright, or trademark would be intangible property.2 The distinction between tangible and intangible property is important primarily for tax and estate planning purposes. Generally, tangible property is subject to tax in the state in which it is located, whereas intangible property is usually taxable in the state where its owner lives.

Public and Private Property Property is also

classified as public or private, based on the ownership of the property. If the property is owned by the government or a governmental unit, it is public property. If it is owned The law of real property is treated in Chapter 24. These important types of intangible property are discussed in Chapter 8. 1 2



Chapter Twenty-Three Personal Property and Bailments

by an individual, a group of individuals, a corporation, or some other business organization, it is private property.

Acquiring Ownership of Personal Property LO23-3

List the primary ways to acquire ownership of personal property.

Production or Purchase The

most common ways of obtaining ownership of property are by producing it or purchasing it. A person owns the property that she makes unless the person has agreed to do the work for another party. In that case, the other party is the owner of the product of the work. For example, a person who creates a painting, knits a sweater, or develops a computer program is the owner unless she has been retained by someone to create the painting, knit the sweater, or develop the program. Another major way of acquiring property is by purchase. The law regarding the purchase of tangible personal property (i.e., sale of goods) is discussed in Chapter 19. The scenario set out at the start of this chapter posits that Claudio, a skilled craftsman employed by Goldcasters to make handcrafted jewelry, works after his normal working hours and uses materials he paid for himself to make a gold ring. Who should be considered to be the owner of the ring at the time Claudio created it, Claudio or Goldcasters? What are the critical factors that lead you to this conclusion?

Possession of Unowned Property In very

early times, the most common way of obtaining ownership of personal property was simply by taking possession of unowned property. For example, the first person to take possession of a wild animal became its owner. Today, one may still acquire ownership of personal property by possessing it if the property is unowned. The two major examples of unowned property that may be acquired by possession are wild animals and abandoned property. Abandoned property will be discussed in the next section, which focuses on the rights of finders. The first person to take possession of a wild animal normally becomes the owner.3 To acquire ownership of a wild animal by taking possession, a person must obtain enough control over it to deprive it of its freedom. If a person fatally wounds a wild animal, the person becomes the owner. Wild As wildlife is increasingly protected by law, however, some wild animals cannot be owned because it is illegal to capture them (e.g., ­endangered species). 3

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animals caught in a trap or fish caught in a net are usually considered to be the property of the person who set the trap or net. If a captured wild animal escapes and is caught by another person, that person generally becomes the owner. However, if that person knows that the animal is an escaped animal and that the prior owner is chasing it to recapture it, then he does not become the owner.

Rights of Finders of Lost, Mislaid, and Abandoned Property LO23-4

Explain how the rights of finders of abandoned, lost, and mislaid property differ.

The old saying “finders keepers, losers weepers” is not a reliable way of predicting the legal rights of those who find personal property that originally belonged—or still belongs—to another. The rights of the finder will be determined according to whether the property he finds is classified as abandoned, lost, or mislaid. 1. Abandoned property. Property is considered to be abandoned if the owner intentionally placed the property out of his possession with the intent to relinquish ownership of it. For example, Norris takes his TV set to the city dump and leaves it there. The finder who takes possession of abandoned property with intent to claim ownership becomes the owner of the property. This means he acquires better rights to the property than anyone else in the world, including the original owner. For example, if Fox finds the TV set, puts it in his car, and takes it home, Fox becomes the owner of the TV set. 2. Lost property. Property is considered to be lost when the owner did not intend to part with possession of the property. For example, if Barber’s iPhone fell out of her handbag while she was walking down the street, it would be considered lost property. The person who finds lost property does not acquire ownership of it, but he acquires better rights to the lost property than anyone other than the true owner. For example, suppose Lawrence finds Barber’s iPhone in the grass where it fell. Jones then steals the iPhone from Lawrence’s bookbag. Under these facts, Barber is still the owner of the iPhone. She has the right to have it returned to her if she discovers where it is—or if Lawrence knows that it belongs to Barber. As the finder of lost property, however, Lawrence has a better right to the iPhone than anyone else except Barber. This means that Lawrence has the right to require Jones to return it to him if he finds out that Jones has it.  If the finder does not know who the true owner is or cannot easily find out, the finder must still return the

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Part Five Property

property when the real owner shows up and asks for the property. If the finder of lost property knows who the owner is and refuses to return it, the finder is guilty of conversion and must pay the owner the fair value of the property.4 A finder who sells the property that he has found can pass to the purchaser only those rights that he has; he cannot pass any better title to the property than he himself has. Thus, the true owner could recover the property from the purchaser. 3. Mislaid property. Property is considered to be mislaid if the owner intentionally placed the property somewhere and accidentally left it there, not intending to relinquish ownership of the property. For example, Fields places her backpack on a coatrack at Campus Bookstore while shopping for textbooks. Forgetting the backpack, Fields leaves the store and goes home. The backpack would be considered mislaid rather than lost because Fields intentionally and voluntarily placed it on the coatrack. If property is classified as mislaid, the finder acquires no rights to the property. Rather, the person in possession of the real property on which the personal property was mislaid has the right to hold the property for the true owner and has better rights to the property than anyone other than the true owner. For example, if Stevens found Fields’s backpack in Campus Bookstore, Campus Bookstore would have the right to hold the mislaid property for Fields. Stevens would acquire neither possession nor ownership of the backpack.  The rationale for this rule is that it increases the chances that the property will be returned to its real owner. A person who knowingly placed the property somewhere but forgot to pick it up might well remember later where she left the property and return for it. In the case that follows, Grande v. Jennings, the court held that money secreted in a wall of a home belonged to the estate of the person who had placed the money there rather than the current owner of the property when the money was found. In the scenario set out at the start of this chapter, Cheryl visits the restroom in a steak and ribs restaurant in order to wash some barbecue sauce from her hands. She removes her engagement ring and places it on the washstand, but in her haste to get back to her table, she leaves the ring on the washstand when she exits the washroom. Sandra, a part-time janitor for the restaurant, finds the ring, slips it in her purse, and later sells the ring to her cousin, Gloria, for $200. When Cheryl returns to the restroom to look for the ring, neither the ring nor Sandra is still there.

The tort of conversion is discussed in Chapter 6.

4

At the time Sandra discovers the ring, should it be considered abandoned, lost, or mislaid property? What factors lead you to this conclusion? What should Sandra do with the ring at that point? Between Sandra and the owner of the restaurant, who has the best claim to the ring? Among the restaurant owner, Sandra, and Cheryl, who has the best claim to it? Why? If Cheryl discovers that Gloria has the ring, does she have the right to recover it from her? Why? Some states have a statute that allows finders of property to clear their title to the property. The statutes, known as estray statutes, generally provide that the person must give public notice of the fact that the property has been found, perhaps by putting an ad in a local newspaper. All states have statutes of limitations that require the true owner of property to claim it or bring a legal action to recover possession of it within a certain number of years. A person who keeps possession of lost or unclaimed property for longer than that period of time will become its owner.

Legal Responsibilities of Finders Some

states go further and make it a criminal offense for a person who comes into control of property that he knows or learns has been lost or mislaid to appropriate the property to his own use without first taking reasonable measures to restore the property to the owner. For example, under the Georgia Code, “A person commits the offense of theft of lost or mislaid property that he knows or learns to have been lost or mislaid property when he comes into control of property that he knows or learns to have been lost or mislaid and appropriates the property to his own use without first taking reasonable measures to restore the property to the owner” (Ga. Code Ann. § 16-8-6). In a case5 under that statute, an individual was convicted of the offense when she found a bank deposit bag containing checks, deposit slips, and more than $500 in cash and subsequently attempted to cash one of the checks at a local check cashing business. The deposit bag had been misplaced while the victim was transporting it from her business located in a shopping mall to a car parked outside the mall. Some of the checks contained the victim’s phone number and address, and the finder admitted that she never contacted the victim to restore the property to her.

Shannon v. The State, 574 S.E.2d 889 (Ga. Ct. App. 2002).

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Chapter Twenty-Three Personal Property and Bailments

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CONCEPT REVIEW Rights of Finders of Personal Property Character of Property

Description

Rights of Finder

Rights of Original Owner

Lost

Owner unintentionally parted with possession

Rights superior to everyone except the owner

Retains ownership; has the right to the return of the property

Mislaid

Owner intentionally put property in a place but unintentionally left it there

None; person in possession of real property on which mislaid property was found holds it for the owner, and has rights superior to everyone except owner

Retains ownership; has the right to the return of the property

Abandoned

Owner intentionally placed property out of his possession with intent to relinquish ownership of it

Finder who takes possession with intent to claim ownership acquires ownership of property

None

Grande v. Jennings   278 P.3d 1287 (Ariz. Ct. App. 2012) When Robert Spann passed away in 2001, his daughter, Karen Spann Grande, became the personal representative of the estate. She and her sister took charge of the house, which Spann owned and resided in for many years. They made some repairs to the house and also looked for valuables their father might have left or hidden. They knew from experience that he had hidden gold, cash, and other valuables in unusual places in other homes. Over the course of seven years, they found stocks and bonds, as well as hundreds of militarystyle ammunition cans hidden throughout the house, some of which contained gold or cash. The house was sold “as is” to Sarina Jennings and Clinton McCallum in September 2008. They hired Randy Bueghly and his company, Trinidad Builders, to remodel the dilapidated house. Shortly after the work began, Rafael Cuen, a Trinidad employee, discovered two ammunition cans full of cash in a kitchen wall, went looking, and found two more cash-filled ammunition cans inside the framing of an upstairs bathroom. After Cuen reported the find to his boss, Bueghly took the four ammo cans—but did not tell the new owners about the find—and tried to secret the cans. Cuen, however, eventually told the new owners about the discovery and the police were called. The police ultimately took control of $500,000, which Bueghly had kept in a floor safe in his home. Jennings/McCallum sued Bueghly for conversion and a declaration that Bueghly had no right to the money, and Bueghly later filed a counterclaim for a declaration that he was entitled to the found funds. In the meantime, Grande filed a petition in probate court on behalf of the estate to recover the money. The two cases were consolidated in June 2009. Jennings/McCallum argued that the money belonged to them because it was found on their property. Bueghly argued that the money had been abandoned and that as the first to reduce it to his possession, he was entitled to it. Grande contended that the money had been mislaid by her father and that the estate should be recognized as the true owner. Portley, Judge Although elementary school children like to say “finders keepers,” the common law generally characterizes found property in one of four ways. Found property can be mislaid, lost, abandoned, or treasure trove. Property is “mislaid” if the owner intentionally places it in a certain place and forgets about it. “Lost” property includes property the owner unintentionally parts with through either carelessness or neglect. “Abandoned” property has been thrown away or

was voluntarily forsaken by its owner. Property is considered “treasure trove” if it is verifiably antiquated and has been concealed for so long as to indicate that the owner is probably dead or unknown. A finder’s rights depend on how a court classifies the found property. In characterizing the property, a court should consider all of the particular facts and circumstances of the case. Under the common law, the finder of lost or abandoned property and treasure trove acquires a right to possess the property against the entire world but

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Part Five Property

the rightful owner regardless of the place of finding. A finder of mislaid property, however, must turn the property over to the premises owner who has the duty to safeguard the property for the true owner. Significantly, among the various categories of found property, only lost property necessarily involves an element of involuntariness. The remaining categories entail intentional and voluntary acts by the rightful owner in depositing property in a place where someone else eventually discovers it. For example, the Iowa ­Supreme Court has stated that “mislaid property is voluntarily put in a certain place by the owner who then overlooks or forgets where the property is” and that one who finds mislaid property does not necessarily attain any rights to it because possession belongs to the owner of the premises upon which the property is found, absent a claim by the true owner. In Benjamin v. Linder ­Aviation, 534 N.W.2d 400, 406 (Iowa 1995), the court determined that packets of money found in a sealed panel of a wing during an inspection of a repossessed airplane were mislaid property because the money was intentionally placed there by one of two prior owners. Arizona follows the common law. In Strawberry Water Co. v. Paulsen, 207 P.3d 654, 661 (Ariz. Ct. App. 2008), we stated that in order to abandon personal property, one must voluntarily and intentionally give up a known right. Abandonment is a virtual throwing away of property without regard as to who may take over or carry on. Here, it is undisputed that Spann placed the cash in the ammunition cans and then hid those cans in the recesses of the house. He did not, however, tell his daughters where he had hidden the cans before he passed away. His daughters looked for and found many of the ammo cans, but not the last four. In fact, it was not until the wall-mounted toaster oven and bathroom drywall were removed, that Cuen found the remaining cash-filled cans. As a result, and as the trial court found, the funds are, as a matter of law, mislaid funds that belong to the true owner, Spann’s estate. Other state courts have also characterized found money as mislaid funds. For example, in Hill v. Shrunk, the Oregon Supreme Court held that cash, which was wrapped in oiled paper, placed in waterproof containers, and found lodged in the bottom of a natural water pool on decedent’s property, belonged to him at death, and was mislaid, rather than abandoned, lost, or treasure trove. Similarly, the Arkansas Supreme Court affirmed the trial court’s finding that a dusty cardboard box containing $38,000 and found in the ceiling of a motel room during renovation was mislaid property because the money was found where it was placed for its security, in order to shield it from unwelcome eyes.

As a result, the court affirmed the determination that the motel owner’s rights to the funds were superior to those of the whole world except the true owner. Jennings/McCallum assert, however, that the mislaid funds were abandoned because Grande consciously ignored the fact that neither she nor her sister had found all of the money that their father had withdrawn from his bank account, and did not do more to find it. We disagree. The fact that the trial court correctly determined that the funds were mislaid precludes the funds from being considered abandoned. Moreover, abandonment is generally not presumed, but must be proven. Here the facts are undisputed that the estate did not know that the money was mislaid, and did not intend to abandon the funds. In fact, the evidence is to the contrary; once Grande learned of the discovery, she filed a probate petition to recover the property. Her action as the personal representative undermines the argument that the sisters abandoned the money through conscious ignorance. Jennings/McCallum cite Michael v. First Chicago Corp. to support their argument that Grande had “constructive knowledge” of the cash hidden within the house and, therefore, abandoned the money when the house was sold. There the bank sold several filing cabinets “as is” to a used furniture dealer. Some of the cabinets were locked and, to the bank’s surprise, one of the locked cabinets contained several certificates of deposit worth approximately $6.6 million. There was evidence that the certificates were supposed to be transferred to another storage area, but bank employees overlooked the task. The court held that the relinquishment of possession, under the circumstances, without a showing of an intention to permanently give up all right to the certificates of deposit was not enough to show abandonment. Despite the argument that Grande had constructive knowledge that money and valuables had been hidden, and therefore abandoned the money when the house was sold, Michael demonstrates that the fact that neither party knew of the existence of additional ammo cans filled with cash and secreted inside the walls of the house is exactly why we cannot conclude that Grande abandoned the funds. Based on the evidence before the trial court, there were no facts from which we could begin to infer that the estate intended to relinquish any valuable items that may have been secreted within the home. In fact, the evidence is to the contrary. 

Leasing A lease of personal property is a transfer of

important way of acquiring the use of many kinds of personal property, from automobiles to farm equipment.

the right to possess and use personal property belonging to another.6 Although the rights of one who leases personal property (a lessee) do not constitute ownership of personal property, leasing is mentioned here because it is an

Accordingly, summary judgment was appropriately granted.

A lease of personal property is a form of bailment, a “bailment for hire.” Bailments are discussed later in this chapter.

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Chapter Twenty-Three Personal Property and Bailments

Articles 2 and 9 of the UCC may sometimes be applied to personal-property leases by analogy. However, rules contained in these articles are sometimes inadequate to resolve special problems presented by leasing. For this reason, a new article of the UCC dealing exclusively with leases of goods, Article 2A, was written in 1987. Forty-nine states (all except Louisiana), the District of Columbia, and the Virgin Islands have ­adopted Article 2A. LO23-5

List and discuss the elements that are necessary for making a valid gift of property.

Gifts Title to personal property may be obtained by gift. A

gift is a voluntary transfer of property to the donee (the person who receives a gift), for which the donor (the ­person who gives the gift) gets no consideration in return. To have a valid gift, all three of the following elements are necessary: 1. The donor must intend to make a gift. 2. The donor must make delivery of the gift. 3. The donee must accept the gift. The most critical requirement is delivery. The donor must actually give up possession and control of the property either to the donee or to a third person who is to hold it for the donee. Delivery is important because it makes clear to the donor that he is voluntarily giving up ownership without getting something in exchange. A promise to make a gift is usually not enforceable;7 the person must actually part with the property. In some cases, the delivery may be symbolic or constructive. For example, handing over the key to a strongbox may be symbolic delivery of the property in the strongbox. There are two kinds of gifts: gifts inter vivos and gifts causa mortis. A gift inter vivos is a gift between two living persons. For example, when Melissa’s parents give her a car for her 21st birthday, that is a gift inter vivos. A gift causa mortis is a gift made in contemplation of death. For example, Uncle Earl, who is about to undergo a serious heart operation, gives his watch to his nephew, Bart, and says that he wants Bart to have it if he does not survive the operation. A gift causa mortis is a conditional gift and is effective unless any of the following occurs: 1. The donor recovers from the peril or sickness under fear of which the gift was made, or 2. The donor revokes or withdraws the gift before he dies, or 3. The donee dies before the donor.

If one of these events takes place, ownership of the property goes back to the donor.

Conditional Gifts Sometimes

a gift is made on condition that the donee comply with certain restrictions or perform certain actions. A conditional gift is not a completed gift. It may be revoked by the donor before the donee complies with the conditions. Gifts in contemplation of marriage, such as engagement rings, are a primary example of a conditional gift. Such gifts are generally considered to have been made on an implied condition that marriage between the donor and donee will take place. The traditional rule applied in many states provides that if the donee breaks the engagement without legal justification or the engagement is broken by mutual consent, the donor will be able to recover the ring or other engagement gift. However, if the engagement is unjustifiably broken by the donor, the traditional rule generally bars the donor from recovering gifts made in contemplation of marriage. As illustrated by the Lindh case, which follows shortly, many courts have rejected the traditional approach and its focus on fault. Some states have enacted legislation prescribing the rules applicable to the return of engagement presents. In the scenario set out at the beginning of this chapter, Claudio gave the ring to Cheryl as an engagement ring in anticipation of their forthcoming marriage. Later, Cheryl breaks off the engagement, telling Claudio that she no longer loves him. Claudio then asks Cheryl to return the ring to him. What argument would Claudio make to support his claim that he has the legal right to have the ring returned to him? What argument might Cheryl make to support her contention that she should have the legal right to retain the ring? If Claudio and Cheryl lived in Pennsylvania, where the Lindh v. Surman case was decided, would Claudio be entitled to recover the ring from Cheryl? Why or why not? Would it make a difference if they lived in a state that used a fault-based approach concerning gifts given in anticipation of marriage?

Uniform Transfers to Minors Act The Uni-

form Transfers to Minors Act, which has been adopted in one form or another in every state, provides a fairly simple and flexible method for making gifts and other transfers of property to minors.8 As defined in this act, a minor is anyone under the age of 21. Under the act, an adult may transfer money, securities, real property, insurance policies, and This statute was formerly called, and is still called in some states, the Uniform Gift to Minors Act. 8

The idea is discussed in Chapter 12.

7

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Part Five Property

Lindh v. Surman   742 A.2d 643 (Pa. 1999) In August 1993, Rodger Lindh (Rodger) proposed marriage to Janis Surman (Janis). Rodger presented her with a diamond engagement ring that he had purchased for $17,400. Janis accepted the marriage proposal and the ring. Two months later, Rodger broke the engagement and asked Janis to return the ring. She did so. Rodger and Janis later reconciled, with Rodger again proposing marriage and again presenting Janis with the engagement ring. Janis accepted the proposal and the ring. In March 1994, Rodger again broke the engagement and asked Janis to return the ring. This time, however, she refused. Rodger sued her, seeking recovery of the ring or a judgment for its value. The trial court held in Rodger’s favor and awarded him damages in the amount of the ring’s value. When Janis appealed, the Pennsylvania Superior Court affirmed the award of damages and held that when an engagement is broken, the engagement ring must be returned even if the donor broke the engagement. Janis appealed to the Supreme Court of Pennsylvania.

Newman, Justice We are asked to decide whether a donee of an engagement ring must return the ring or its equivalent value when the donor breaks the engagement. We begin our analysis with the only principle on which the parties agree: that Pennsylvania law treats the giving of an engagement ring as a conditional gift. In Pavlicic v. Vogtsberger, 136 A.2d 127 (Pa. 1957), the plaintiff supplied his ostensible fiancée with numerous gifts, including money for the purchase of engagement and wedding rings, with the understanding that they were given on the condition that she marry him. When the defendant left him for another man, the plaintiff sued her for recovery of these gifts. Justice Musmanno explained the conditional gift principle: A gift given by a man to a woman on condition that she embark on the sea of matrimony with him is no different from a gift based on the condition that the donee sail on any other sea. If, after receiving the provisional gift, the donee refuses to leave the harbor—if the anchor of contractual performance sticks in the sands of irresolution and procrastination—the gift must be restored to the donor. The parties disagree, however, over whether fault [on the part of the donor] is relevant to determining return of the ring. Janis contends that Pennsylvania law . . . has never recognized a right of recovery in a donor who severs the engagement. She maintains that if the condition of the gift is performance of the marriage ceremony, [a rule allowing a recovery of the ring] would reward a donor who prevents the occurrence of the condition, which the donee was ready, willing, and eagerly waiting to perform. Janis’s argument that . . . the donor should not be allowed to recover the ring where the donor terminates the engagement has some basis in [decisions from Pennsylvania’s lower courts and in treatises]. This Court, however, has not decided the question of whether the donor is entitled to return of the ring where the donor admittedly ended the engagement. The issue we must resolve is whether we will follow the faultbased theory argued by Janis, or the no-fault rule advocated by Rodger. Under a fault-based analysis, return of the rings depends on an assessment of who broke the engagement, which necessarily

entails a determination of why that person broke the engagement. A no-fault approach, however, involves no investigation into the motives or reasons for the cessation of the engagement and requires the return of the engagement ring simply upon the nonoccurence of the marriage. The rule concerning the return of a ring founded on fault principles has superficial appeal because, in the most outrageous instances of unfair behavior, it appeals to our sense of equity. Where one of the formerly engaged persons has truly “wronged” the other, justice appears to dictate that the wronged individual should be allowed to keep the ring or have it returned, depending on whether the wronged person was the donor . . . or the donee. However, the process of determining who is “wrong” and who is “right,” when most modern relationships are complex circumstances, makes the fault-based approach less desirable. A thorough fault-based inquiry would not . . . end with the question of who terminated the engagement, but would also examine that person’s reasons. In some instances the person who terminated the engagement may have been entirely justified in his or her actions. This kind of inquiry would invite the parties to stage the most bitter and unpleasant accusations against those whom they nearly made their spouse. A ring-return rule based on fault principles will inevitably invite acrimony and encourage parties to portray their ex-fiancées in the worst possible light. Furthermore, it is unlikely that trial courts would be presented with situations where fault was clear and easily ascertained. The approach that has been described as the modern trend is to apply a no-fault rule to engagement ring cases. Courts that have applied this rule have borrowed from the policies of their respective legislatures that have moved away from the notion of fault in their divorce statutes. All fifty states have adopted some form of no-fault divorce. We agree with those jurisdictions that have looked toward the development of no-fault divorce law for a principle to decide engagement ring cases. In addition, the inherent weaknesses in any fault-based system lead us to adopt a no-fault approach to resolution of engagement ring disputes. Decision of Superior Court in favor of Rodger Lindh affirmed.



Chapter Twenty-Three Personal Property and Bailments

Cappy, Justice, dissenting The majority urges adoption of the no-fault rule to relieve trial courts from having the onerous task of sifting through the debris of the broken engagement in order to ascertain who is truly at fault. Are broken engagements truly more disturbing than cases where we ask judges and juries to discern possible abuses in nursing homes, day care centers, dependency proceedings involving abused children, and criminal cases involving horrific, irrational injuries to innocent victims? The subject matter our able trial courts address on a daily basis is certainly of equal sordidness as any fact pattern they may need to address in a simple case of who broke the engagement and why.

other property. The specific ways of doing this vary according to the type of property transferred. In general, however, the transferor (the person who gives or otherwise ­transfers the property) delivers, pays, or assigns the property to, or registers the property with, a custodian who acts for the benefit of the minor “under the Uniform Transfers to ­Minors Act.” The custodian is given fairly broad discretion to use the gift for the minor’s benefit and may not use it for the custodian’s personal benefit. The custodian may be the transferor himself, another adult, or a trust company, again depending on the type of property transferred. If the donor or other transferor fully complies with the Uniform Transfers to Minors Act, the transfer is considered to be irrevocable.

Will or Inheritance Ownership of personal prop-

erty may also be transferred upon the death of the former owner. The property may pass under the terms of a will if the will was validly executed. If there is no valid will, the property is transferred to the heirs of the owner according to state laws. Transfer of property at the death of the owner will be discussed in Chapter 26.

Confusion Title to personal property may be obtained

by confusion. Confusion is the intermixing of different owners’ goods in such a way that they cannot later be separated. For example, suppose wheat belonging to several different people is mixed in a grain elevator. If the mixing was by agreement or if it resulted from an accident without negligence on anyone’s part, each person owns his proportionate share of the entire quantity of wheat. However, a different result would be reached if the wheat was wrongfully or negligently mixed. Suppose a thief steals a truckload of Grade #1 wheat worth $8.50 a bushel from a farmer. The thief dumps the wheat into his storage bin, which contains a lower-grade

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I can envision a scenario whereby the prospective bride and her family have expended thousands of dollars in preparation for the culminating event of matrimony and she is, through no fault of her own, left standing at the altar holding the caterer’s bill. To add insult to injury, the majority would also strip her of her engagement ring. Why the majority feels compelled to ­modernize this relatively simple and ancient legal concept is beyond the understanding of this poor man. As I see no valid reason to forgo the fault-based rule for determining possession of the engagement ring under the simple concept of conditional gift law, I cannot endorse the modern trend advocated by the majority.

wheat worth $4.50 a bushel, with the result that the mixture is worth only $4.50 a bushel. The farmer has first claim against the entire mixture to recover the value of the highergrade wheat that was mixed with the lower-grade wheat. The thief, or any other person whose intentional or negligent act results in confusion of goods, must bear any loss caused by the confusion.

Accession Ownership of personal property may also

be acquired by accession. Accession means increasing the value of property by adding materials, labor, or both. As a general rule, the owner of the original property becomes the owner of the improvements. This is particularly likely to be true if the improvement was done with the permission of the owner. For example, Hudson takes his automobile to a shop that replaces the engine with a larger engine and puts in a new four-speed transmission. Hudson is still the owner of the automobile as well as the owner of the parts added by the auto shop. Problems may arise if materials are added or work is performed on personal property without the consent of the owner. If property is stolen from one person and improved by the thief, the original owner can get it back and does not have to reimburse the thief for the work done or the materials used in improving it. For example, a thief steals Rourke’s used car, puts a new engine in it, replaces the tires, and repairs the brakes. Rourke is entitled to get his car back from the thief and does not have to pay him for the engine, tires, and brakes. The result is less easy to predict, however, if property is mistakenly improved in good faith by someone who believes that he owns the property. In such a case, a court must weigh the respective interests of two innocent parties: the original owner and the improver.

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Part Five Property

For example, Johnson, a stonecarver, finds a block of limestone by the side of the road. Assuming that it has been abandoned, he takes it home and carves it into a sculpture. In fact, the block was owned by Hayes. Having fallen off a flatbed truck during transportation, the block is merely lost property, which Hayes ordinarily could recover from the finder. In a case such as this, a court could decide the case in either of two ways. The first alternative would be to give the original owner (Hayes) ownership of the improved property, but to allow the person who has improved the property in good faith (Johnson) to recover the cost of the improvements. The second alternative would be to hold that the improver, Johnson, has acquired ownership of the sculpture, but that he is required to pay the original owner the value of the property as of the time he obtained it. The greater the extent to which the improvements have increased the value of the property, the more likely it is that the court will choose the second alternative and permit the improver to acquire ownership of the improved property.

Bailments LO23-6

List the three essential elements of a bailment.

Nature of Bailments A bailment is the delivery

of personal property by its owner or someone holding the right to possess it (the bailor) to another person (the bailee) who accepts it and is under an express or implied agreement to return it to the bailor or to someone designated by the bailor. Only personal property can be the subject of bailments. Although the legal terminology used to describe bailments might be unfamiliar to most people, everyone is familiar with transactions that constitute ­bailments. For example, Lincoln takes his car to a parking garage where the attendant gives Lincoln a claim check and then drives the car down the ramp to park it. Charles borrows his neighbor’s lawn mower to cut his grass. Tara, who lives next door to Kyle, agrees to take care of Kyle’s cat while Kyle goes on a vacation. These are just a few of the everyday situations that involve bailments.

Elements of a Bailment The essential elements of a bailment are:

1. The bailor owns personal property or holds the right to possess it.

2. The bailor delivers exclusive possession of and control over the personal property to the bailee. 3. The bailee knowingly accepts the personal property with the understanding that he owes a duty to return the property, or to dispose of it, as directed by the bailor.

Creation of a Bailment A bailment is created by

an express or implied contract. Whether the elements of a bailment have been fulfilled is determined by examining all the facts and circumstances of the particular situation. For example, a patron goes into a restaurant and hangs his hat and coat on an unattended rack. It is unlikely that this created a bailment because the restaurant owner never assumed exclusive control over the hat and coat. However, if there is a checkroom and the hat and coat are checked with the attendant, a bailment will arise. If a customer parks her car in a parking lot, keeps the keys, and may drive the car out herself whenever she wishes, a bailment has not been created. The courts treat this situation as a lease of space. Suppose, however, that she takes her car to a parking garage where an attendant, after giving her a claim check, parks the car. There is a bailment of the car because the parking garage has accepted delivery and possession of the car. However, a distinction is made between the car and packages locked in the trunk. If the parking garage was not aware of the packages, it probably would not be a bailee of them as it did not knowingly accept possession of them. The creation of a bailment is illustrated in the Concept Review box.

Types of Bailments LO23-7

List and compare the three different types of bailment.

Bailments are commonly divided into three different categories: 1. Bailments for the sole benefit of the bailor. 2. Bailments for the sole benefit of the bailee. 3. Bailments for mutual benefit. The type of bailment involved in a case can be important in determining the liability of the bailee for loss of or damage to the property. As will be discussed later, however, some courts no longer rely on these distinctions when they determine whether the bailee is liable. Bailments for Benefit of Bailor A bailment for the sole benefit of the bailor is one in which the bailee renders some service but does not receive a benefit in return.



Chapter Twenty-Three Personal Property and Bailments

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CONCEPT REVIEW Creation of a Bailment Express or implied contract

Bailor (Owns or has right to possess property)

Delivery of exclusive possession of and control over property

Bailee (Knowingly accepts property with the understanding that he must return it)

Bailee has duty to return property upon termination of bailment

For example, Brown allows his neighbor, Reston, to park her car in Brown’s garage while she is on vacation. Brown does not ask for any compensation. Here, Reston, the bailor, has received a benefit from the bailee, Brown, but Brown has not received a benefit in return. Bailments for Benefit of Bailee A bailment for the sole benefit of the bailee is one in which the owner of the goods allows someone else to use them free of charge. For example, Anderson lends a lawn mower to her neighbor, Moss, so he can cut his grass. Bailments for Mutual Benefit If both the bailee and the bailor receive benefits from the bailment, it is a bailment for mutual benefit. For example, Sutton rents china for his daughter’s wedding from E-Z Party Supplies for an agreed-on price. Sutton, the bailee, benefits by being able to use the china; E-Z benefits from his payment of the rental charge. On some occasions, the benefit to the bailee is less tangible. For example, a customer checks a coat at an attended coatroom at a restaurant. Even if no charge is made for the service, it is likely to be treated as a bailment for mutual benefit because the restaurant is benefiting from the customer’s patronage.

Special Bailments Certain

professional bailees, such as innkeepers and common carriers, are treated somewhat differently by the law and are held to a higher level

of responsibility than is the ordinary bailee. The rules applicable to common carriers and innkeepers are detailed later in this chapter.

Duties of the Bailee LO23-8

Explain the basic duties of the bailee and the bailor of personal property.

The bailee has two basic duties: 1. To take care of the property that has been entrusted to her. 2. To return the property at the termination of the bailment. The following discussion examines the scope of these duties.

Duty of Bailee to Take Care of Property  The bailee is responsible for taking steps to protect the property during the time she has possession of it. If the bailee does not exercise proper care and the property is lost or damaged, the bailee is liable for negligence. The bailee would then be required to reimburse the bailor for the amount of loss or damage. If the property is lost or damaged without the fault or negligence of the bailee, however, the bailee is not liable to the bailor. The degree of care required of the bailee traditionally has depended in large part on the type of bailment involved.

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Part Five Property

1. Bailment for the benefit of the bailor. If the bailment is solely for the benefit of the bailor, the bailee is expected to exercise only a minimal, or slight, degree of care for the protection of the bailed property. He would be liable, then, only if he were grossly negligent in his care of the bailed property. The rationale for this rule is that if the bailee is doing the bailor a favor, it is not reasonable to expect him to be as careful as when he is deriving some benefit from keeping the goods. 2. Bailment for mutual benefit. When the bailment is a bailment for mutual benefit, the bailee is expected to exercise ordinary or reasonable care. This degree of care requires the bailee to use the same care a reasonable person would use to protect his own property in the relevant situation. If the bailee is a professional that holds itself out as a professional bailee, such as a warehouse, it must use the degree of care that would be used by a person in the same profession. This is likely to be more care than the ordinary person would use. In addition, a professional bailee usually has the obligation to explain any loss of or damage to property—that is, to show it was not negligent. If it cannot do so, it will be liable to the bailor. 3. Bailment for the benefit of the bailee. If the bailment is solely for the benefit of the bailee, the bailee is expected to exercise a high degree of care. For instance, a person who lends a sailboat to a neighbor would probably expect the neighbor to be even more careful with the sailboat than the owner might be. In such a case, the bailee would be liable for damage to the property if his action reflected a relatively small degree of negligence. A number of courts today view the type of bailment involved in a case as just one factor to be considered in determining whether the bailee should be liable for loss of or damage to bailed goods. The modern trend appears to be moving in the direction of imposing a duty of reasonable care on bailees, regardless of the type of bailment. This flexible standard of care permits courts to take into account a variety of factors such as the nature and value of the property, the provisions of the parties’ agreement, the payment of consideration for the bailment, and the experience of the bailee. In addition, the bailee is required to use the property only as was agreed between the parties. For example, Jones borrows Morrow’s lawn mower to mow his lawn. If Jones uses the mower to cut the weeds on a trash-filled vacant lot and the mower is damaged, he would be liable because he was exceeding the agreed purpose of the bailment—to cut his lawn.

Bailee’s Duty to Return the Property An

essential element of a bailment is the duty of the bailee to return the property at the termination of the bailment. If

the bailed property is taken from the bailee by legal process, the bailee should notify the bailor and must take whatever action is necessary to protect the bailor’s interest. In most instances, the bailee must return the identical property that was bailed. A person who lends a 2015 Honda to a friend expects to have that particular car returned. In some cases, the bailor does not expect the return of the identical goods. For example, a farmer who stores 1,500 bushels of Grade #1 wheat at a local grain elevator expects to get back 1,500 bushels of Grade #1 wheat when the bailment is terminated, but not the identical wheat he deposited. The bailee must return the goods in an undamaged condition to the bailor or to someone designated by the bailor. If the goods have been damaged, destroyed, or lost, there is a rebuttable presumption of negligence on the part of the bailee. To overcome the presumption, the bailee must come forward with evidence showing that he exercised the relevant level of care.

Bailee’s Liability for Misdelivery The bailee is

also liable to the bailor if he misdelivers the bailed property at the termination of the bailment. The property must be returned to the bailor or to someone specified by the bailor. The bailee is in a dilemma if a third person, claiming to have rights superior to those of the bailor, demands possession of the bailed property. If the bailee refuses to deliver the bailed property to the third-party claimant and the claimant is entitled to possession, the bailee is liable to the claimant. If the bailee delivers the bailed property to the third-party claimant and the claimant is not entitled to possession, the bailee is liable to the bailor. The circumstances may be such that the conflicting claims of the bailor and the third-party claimant can be determined only by judicial decision. In some cases, the bailee may protect himself by bringing the third-party claimant into a lawsuit along with the bailor so that all the competing claims can be adjudicated by the court before the bailee releases the property. This remedy is not always available, however.

Limits on Liability Bailees may try to limit or re-

lieve themselves of liability for the bailed property. Some examples include the storage receipts purporting to limit liability to a fixed amount such as $100, signs near checkrooms such as “Not responsible for loss of or damage to checked property,” and disclaimers on claim checks such as “Goods left at owner’s risk.” The standards used to determine whether such limitations and disclaimers are enforceable are discussed in Chapter 15. Any attempt by the bailee to be relieved of liability for intentional wrongful acts is against public policy and will not be enforced. A bailee’s ability to be relieved of liability



Chapter Twenty-Three Personal Property and Bailments

for negligence is also limited. Courts look to see whether the disclaimer or limitation of liability was communicated to the bailor at the time of the bailment. When the customer handed her coat to the checkroom attendant, did the attendant point out the “not responsible for loss or damage” sign? Did the parking lot attendant call the car owner’s attention to the disclaimer on the back of the claim check? If not, the court may hold that the disclaimer was not communicated to the bailor and did not become part of the bailment contract. Even if the bailor was aware of the disclaimer, it still may not be enforced on the ground that it is contrary to public policy. If the disclaimer was offered on a take-it-or-leave-it basis and was not the subject of arm’s-length bargaining, it is less likely to be enforced than if it was negotiated and voluntarily agreed to by the parties. A bailee may be able to limit liability to a certain amount or to relieve himself of liability for certain perils. Ideally, the bailee will give the

23-15

bailor a chance to declare a higher value and to pay an additional charge in order to be protected up to the declared value of the goods. Common carriers, such as railroads and trucking companies, often take this approach. Courts do not look with favor on efforts by a person to be relieved of liability for negligence. For this reason, terms limiting the liability of a bailee stand a better chance of being enforced than do terms completely relieving the bailee of liability. An implied agreement as to the bailee’s duties may arise from a prior course of dealing between the bailor and the bailee, or from the bailor’s knowledge of the bailee’s facilities or method of doing business. The bailee may, if he wishes, assume all risks incident to the bailment and contract to return the bailed property undamaged or to pay for any damage to or loss of the property. In the case that follows, Weissman v. City of New York, the court concluded that an exculpatory clause was too vague to shield a bailor from liability for its negligence.

Weissman v. City of New York   860 N.Y.S.2d 393 (N.Y. Civ. Ct. 2009) In 2005, Ken Weissman rented storage space at the West 79th Street Boat Basin, which is owned and operated by the City of New York Parks & Recreation Department. The written agreement contained an exculpatory clause that stated: I understand that the City of New York Parks & Recreation Department will not be responsible for any damages incurred to my vessel while at the dinghy dock or while in the facility at the 79th Street Boat Basin, and that I store my vessel at my own risk. The policy and practice at the facility was that users would store their vessels in an enclosed cage-like structure that had storage bins. Each user had a key to the storage area and had unrestricted access. Within the cage, users could further secure their vessels to the bin with their own devices such as chain and lock. In 2007, Weissman had two brand-new kayaks stolen from the caged area. The lock to the caged area was intact but his kayaks and locks were missing. Weissman reported this theft to the police, staff, and management. He indicated to the Boat Basin that he was no longer going to use the facility because of the theft. The manager of the facility spoke to him and urged him to continue to use the facility because they were changing their practice and policy by adding more security measures. Only West 79th Street Boat Basin employees would have keys to the caged storage area. Users no longer had unrestricted access and would have to get an employee to escort them, open the lock, and admit them to the storage area. Security cameras were going to be installed. The Boat Basin posted a notice with the new changes, which said: Attention Kayak Owners Please see marina staff to gain access to kayak storage area. We have had a security issue and have temporarily changed the locks. We will be adding security cameras to the area shortly. We apologize for any inconvenience in the meantime. Based on the assurances by the manager that the security would be better, Weissman purchased two used kayaks and again stored them in the caged area. He and the others no longer had keys to the area and had to be admitted and escorted by an employee to access the vessels in the storage area. On or about July 23, 2007, a week after the first two kayaks were stolen, one of Weissman’s replacement kayaks, which cost $1,400, was missing from the storage area. He filed a notice of claim and then brought suit against the City of New York, seeking the value of the missing kayak and a refund of the unused portion of the storage fee.

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Part Five Property

Martino, Judge The general rule is that a marina is not liable for negligence for loss of a vessel not due to the condition of the docking facility. The privilege of keeping a vessel in a marina without an agreement to keep daily or continuous guard over the vessel or without the marina taking over or assuming custody of the vessel does not constitute a bailment. This was initially the situation under the original arrangement between Weissman and the Boat Basin. Weissman had exclusive custody of his vessels and unrestricted access because he had a key to the storage area. He had the privilege of storing his kayaks there but Boat Basin was not an insurer. However, the arrangement between the parties changed when Boat Basin took custody of the kayaks by retaining the key and controlling access to the kayaks, notifying users that this was the new temporary policy, promising better security, and urging Weissman to keep his kayaks there because of the new security measures. Under these facts, a bailment was established. A bailment gives rise to the duty of exercising ordinary care in keeping and safeguarding property. In the instant case, Weissman has made out a prima facie case of breach of that duty by establishing that Boat Basin had exclusive possession of the kayak under lock and key and that the kayak is now missing. It then becomes the obligation of the Boat Basin to come forward with evidence to rebut the presumption of negligence. Here, Boat Basin did not come forward with any evidence and argues that it had no duty of care. However, when Boat Basin took exclusive possession of Weissman’s kayak and urged him to continue using the facility because of its improved security, it created the duty of ordinary care in safeguarding the property.

Right to Compensation The express or implied

contract creating the bailment controls whether the bailee has the right to receive compensation for keeping the property or must pay for having the right to use it. If the bailment is made as a favor, then the bailee is not entitled to compensation even though the bailment is for the bailor’s sole benefit. If the bailment involves the rental of property, the bailee must pay the agreed rental rate. If the bailment is for the storage or repair of property, the bailee is entitled to the contract price for the storage or repair services. When no specific price was agreed on but compensation was contemplated by the parties, the bailee is entitled to the reasonable value of the services provided. In many instances, the bailee will have a lien (a charge against property to secure the payment of a debt) on the bailed property for the reasonable value of the services. For example, Silver takes a chair to Ace Upholstery to have it recovered. When the chair has been recovered, Ace has the right to keep

Boat Basin argues that it cannot be held liable for negligence because of the exculpatory clause in the original 2005 contract, which Weissman concedes was subsequently renewed by his yearly payments. Although exculpatory clauses are enforceable, they are strictly construed against the party seeking exemption from liability. Unless the intention of the parties to insulate one of them from liability for its own negligence is expressed in unequivocal terms, the clause will not operate to have such an effect. The exculpatory clause in this case is vague and does not suggest an intent to shield Boat Basin from its own negligence in carrying out its duty to care for Weissman’s kayak. This makes perfect sense because the City did not initially have any duty to safeguard Weissman’s vessel. There was no bailment. Weissman had the key to the storage cage and retained custody and control of his kayak. He stored the vessel at his own risk and the Boat Basin would not be responsible for any damages. This was the intent of the exculpatory clause. However, the relationship changed when Boat Basin took it upon itself to secure and take control of Weissman’s vessel. Boat Basin now had the only key and assured Weissman that his kayaks would be safer under Boat Basin’s custody because of the heightened security. The initial contract could not have been meant to cover this new arrangement. The court holds that under the facts of this case, a bailment was created and Boat Basin was negligent by breaching its duty of care. The exculpatory clause in the original contract is too vague to shield Boat Basin from liability for its own negligence. Judgment in favor of Weissman for $1,400, the value of the ­missing kayak.

it until the agreed price—or, if no price was set, the reasonable value of the work—is paid. This is an example of an artisan’s lien, which is discussed in Chapter 29.

Bailor’s Liability for Defects in the Bailed Property When personal property is rented or loaned,

the bailor makes an implied warranty that the property has no hidden defects that make it unsafe for use. If the bailment is for the bailee’s sole benefit, the bailor is liable for injuries that result from defects in the bailed property only if the bailor knew about the defects and did not tell the bailee. For example, Price lends his car, which he knows has bad brakes, to Sloan. If Price does not tell Sloan about the bad brakes and Sloan is injured in an accident because the brakes fail, Price is liable for Sloan’s injuries. If the bailment is a bailment for mutual benefit, the bailor has a greater obligation. The bailor must use reasonable care in inspecting the property and seeing that it is



Chapter Twenty-Three Personal Property and Bailments

safe for the purpose for which it is intended. The bailor is liable for injuries suffered by the bailee because of defects that the bailor either knew about or should have discovered through reasonable inspection. For example, Acme RentAll, which rents trailers, does not inspect the trailers after they are returned. A wheel has come loose on a trailer that Acme rents to Hirsch. If the wheel comes off while Hirsch is using the trailer and the goods Hirsch is carrying in it are damaged, Acme is liable to Hirsch. In addition, product liability doctrines that apply a higher standard of legal responsibility have been applied to bailors who are commercial lessors of personal property.9 Express or implied warranties of quality under either Article 2 or Article 2A of the UCC may apply. Liability under these warranties does not depend on whether the bailor knew about or should have discovered the defect. The only question is whether the property’s condition complied with the warranty. Some courts have also imposed strict liability on the commercial lessor-bailor of defective, unreasonably dangerous goods that cause personal injury or property damage to the lessee-bailee. This liability is imposed regardless of whether the lessor was negligent.

Special Bailments LO23-9

Discuss the special rules applicable for bailments to common carriers and hotelkeepers.

Common Carriers Bailees that are common car-

riers are held to a higher level of responsibility than are bailees that are private carriers. Common carriers are licensed by governmental agencies to carry the property of anyone who requests the service. Private contract carriers carry goods only for persons selected by the carrier. Both common carriers and private contract carriers are bailees. However, the law makes the common carrier a near-absolute insurer of the goods it carries. The common carrier is responsible for virtually any loss of or damage to the entrusted goods, unless the common carrier shows that the loss or damage was caused by one of the following: 1. An act of God. 2. An act of a public enemy. 3. An act or order of the government. 4. An act of the person who shipped the goods. 5. The nature of the goods themselves. Product liability doctrines are discussed in Chapter 20.

9

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Therefore, the common carrier is liable if goods entrusted to it are stolen by some unknown person, but not if the goods are destroyed when the warehouse is damaged by a hurricane. If goods are damaged because the shipper improperly packaged or crated them, the carrier is not liable. Similarly, if perishable goods are not in suitable condition to be shipped and therefore deteriorate in the course of shipment, the carrier is not liable so long as it used reasonable care in handling them. Common carriers are usually permitted to limit their liability to a stated value unless the bailor declares a higher value for the property and pays an additional fee.

Hotelkeepers Hotelkeepers are engaged in the busi-

ness of offering food and/or lodging to transient persons. They hold themselves out to serve the public and are obligated to do so. As is the common carrier, the hotelkeeper is held to a higher standard of care than that of the ordinary bailee. The hotelkeeper, however, is not a bailee in the strict sense of the word. The guest does not usually surrender the exclusive possession of his property to the hotelkeeper. Even so, the hotelkeeper is treated as the virtual insurer of the guest’s property. The hotelkeeper is not liable for loss of or damage to property if she shows that it was caused by one of the following: 1. An act of God. 2. An act of a public enemy. 3. An act of a governmental authority. 4. The fault of a member of the guest’s party. 5. The nature of the goods. Most states have passed laws that limit the hotelkeeper’s liability, however. Commonly, the law requires the hotel owner to post a notice advising guests that any valuables should be checked into the hotel vault. The hotelkeeper’s liability is then limited, usually to a fixed amount, for valuables that are not so checked.

Safe-Deposit Boxes If

a person rents a safe-­ deposit box at a local bank and places property in the box, the box and the property are in the physical possession of the bank. However, it takes both the renter’s key and the key held by the bank to open the box. In most cases, the bank does not know the nature, amount, or value of the goods in the box. Although a few courts have held that the rental of a safe-deposit box does not create a bailment, most courts have concluded that the renter of the box is a bailor and the bank is a bailee. As such, the bank is not an insurer of the contents of the box. It is obligated, however, to use due care and to come forward and explain loss of or damage to the property entrusted to it.

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Part Five Property

CONCEPT REVIEW Duties of Bailees and Bailors Type of Bailment

Duties of Bailee

Duties of Bailor

Sole Benefit of Bailee

1. Must use great care; liable for even slight negligence. 2. Must return goods to bailor or dispose of them at his direction. 3. May have duty to compensate bailor.

1. Must notify the bailee of any known defects.

Mutual Benefit

1. Must use reasonable care; liable for ­ordinary negligence. 2. Must return goods to bailor or dispose of them at his direction. 3. May have duty to compensate bailor.

1. Must notify bailee of all known defects and any defects that could be discovered on reasonable inspection.

1. Must use at least slight care; liable for gross negligence. 2. Must return goods to bailor or dispose of them at his direction.

1. Must notify bailee of all known defects and any hidden defects that are known or could be discovered on reasonable inspection. 2. May have duty to compensate bailee.

Sole Benefit of Bailor

Involuntary Bailments Suppose a person owns a

cottage on a beach. After a violent storm, a sailboat washed up on his beach. As the finder of lost or misplaced property, he may be considered the involuntary bailee or constructive bailee of the sailboat. This relationship may arise when a person finds himself in possession of someone else’s property without having agreed to accept possession. The duties of the involuntary bailee are not well defined. The involuntary bailee does not have the right to destroy or use the property. If the true owner shows up, the property must be returned to him. Under some circumstances, the involuntary bailee may be under an obligation to assume control of the property or to take some minimal steps to ascertain the owner’s identity, or both.

Documents of Title Discuss the special rules applicable to bailments covered

LO23-10 by negotiable documents of title, including warehouse

receipts and bills of lading.

Storing or shipping goods, giving a warehouse receipt or bill of lading representing the goods, and transferring such a receipt or bill of lading as representing the goods are practices

2. Commercial lessors may be subject to warranties of quality and/or strict liability in tort. 3. May have duty to compensate bailee.

of ancient origin. The warehouseman or the common carrier is a bailee of the goods who contracts to store or transport the goods and to deliver them to the owner or to act otherwise in accordance with the lawful directions of the owner. The warehouse receipt or the bill of lading may be either negotiable or nonnegotiable. To be negotiable, a warehouse receipt, bill of lading, or other document of title must provide that the goods are to be delivered to the bearer or to the order of a named person [7-104(1)]. The primary differences between the law of negotiable instruments and the law of negotiable documents of title are based on the differences between the obligation to pay money and the obligation to deliver specific goods.

Warehouse Receipts A warehouse receipt, to be

valid, need not be in any particular form, but if it does not embody within its written or printed form each of the following, the warehouseman is liable for damages caused by the omission to a person injured as a result of it: (1) the location of the warehouse where the goods are stored; (2) the date of issue; (3) the consecutive number of the receipt; (4) whether the goods are to be delivered to the bearer or to the order of a named person; (5) the rate of storage and handling charges; (6) a description of the goods or of the packages containing them; (7) the signature of the warehouseman or his agent; (8) whether the warehouseman is



Chapter Twenty-Three Personal Property and Bailments

the owner of the goods, solely, jointly, or in common with others; and (9) a statement of the amount of the advances made and of the liabilities incurred for which the warehouseman claims a lien or security interest. Other terms may be inserted [7-202]. A warehouseman is liable to a purchaser for value in good faith of a warehouse receipt for nonreceipt or misdescription of goods. The receipt may conspicuously qualify the description by a statement such as “contents, condition, and quantity unknown” [7-203]. Because a warehouseman is a bailee of the goods, he owes to the holder of the warehouse receipt the duties of a mutual benefit bailee and must exercise reasonable care [7-204]. The warehouseman may terminate the relation by notification where, for example, the goods are about to deteriorate or where they constitute a threat to other goods in the

23-19

warehouse [7-206]. Unless the warehouse receipt provides otherwise, the warehouseman must keep separate the goods covered by each receipt; however, different lots of fungible goods such as grain may be mingled [7-207]. A warehouseman has a lien against the bailor on the goods covered by his receipt for his storage and other charges incurred in handling the goods [7-209]. The Code sets out a detailed procedure for enforcing this lien [7-210].

Bills of Lading In many respects, the rights and li-

abilities of the parties to a negotiable bill of lading are the same as the rights and liabilities of the parties to a negotiable warehouse receipt. The contract of the issuer of a bill of lading is to transport goods, whereas the contract of the issuer of a warehouse receipt is to store goods. Like the issuer of a warehouse receipt, the issuer of a bill of lading

The Global Business Environment Liability of Carriers of Goods When an American firm ships goods to a foreign buyer, the goods may be shipped by ground, air, or water carrier. The duties and extent of liability of these various carriers is largely determined by domestic statutes and international law. Ground Carriers American trucking and railroad companies are regulated by the Interstate Commerce Act. American carriers are liable for any loss or damage to the goods with few exceptions—for example, damage caused by acts of God and acts of the shipper (usually the seller of the goods), such as poorly packaging the goods. An American carrier may limit its liability by contract, provided it allows the shipper to obtain full liability by paying a higher shipping charge. Most European trucking companies and railroads are covered by EU rules, which place liability on carriers for damages to goods they carry with few exceptions—for example, defective packaging by the shipper and circumstances beyond the carrier’s control. EU rules also limit a carrier’s liability unless the shipper agrees to pay for greater liability. Air Carriers The Warsaw Convention governs the liability of international air carriers. Most nations have ratified the Warsaw Convention in its original or amended form. Under the Convention, an air carrier is liable to the shipper for damages to goods with few exceptions, including that it was impossible for the carrier to prevent the loss or that the damage was caused by the negligence of the shipper. The Warsaw Convention limits a carrier’s liability to a stated amount per pound, unless the shipper pays for greater liability. Water Carriers The Hague Rules govern the liability of international water carriers. The Hague Rules were amended in Visby, Sweden, in 1968. The United States codified the Hague Rules in

the Carriage of Goods by Sea Act (COGSA) but has not ratified the Visby amendments, which do not substantially change the liability of international water carriers. The Hague–Visby Rules and the COGSA impose on international water carriers the duties to (1) furnish a seaworthy ship and (2) stow the cargo carefully to prevent it from breaking loose during storms at sea. When these duties are met, a water carrier will not usually be liable for damages to cargo. Water carriers have no liability for damages caused by circumstances beyond their control—such as poor packaging, piracy, or acts of war. Under COGSA, liability is limited to $500 per package, unless the shipper agrees to pay a higher shipping fee. Under the Hague–Visby Rules, liability will be the value of the goods declared by the shipper. Sometimes a carrier will attempt to reduce or eliminate its liability in the shipping contract. However, COGSA does not permit a carrier to eliminate its liability for loss or damages to goods resulting from the carrier’s negligence or other fault. Under COGSA or the Hague–Visby Rules, the owner of cargo will be liable for damage his cargo does to other cargo. Also, under the ancient maritime doctrine of general average, when a carrier sacrifices an owner’s cargo, such as throwing it overboard in order to save the ship and the other cargo, the other owners have liability to the owner whose cargo was sacrificed; liability is prorated to each owner according to the value of each owner’s goods in relation to the value of the voyage (the value of the ship plus the value of the other owners’ goods plus the carrier’s total shipping fees). The doctrine of general average is commonly expanded by the contract between the carrier and cargo owners in New Jason clauses. Typically, a New Jason clause provides that in all cases when goods are damaged and the carrier is not liable under COGSA, the goods owner is entitled to general average contributions from all other cargo owners. The doctrine of general average, bolstered by a New Jason clause, also requires cargo owners to pay for damages to the ship when not the result of the carrier’s fault.

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Part Five Property

is liable for nonreceipt or misdescription of the goods, but he may protect himself from liability where he does not know the contents of packages by marking the bill of lading “contents or condition of packages unknown” or similar language. Such terms are ineffective when the goods are loaded by an issuer who is a common carrier unless the goods are concealed by packages [7-301].

Duty of Care A carrier who issues a bill of lading, or

a warehouse operator who issues a warehouse receipt, must exercise the same degree of care in relation to the goods as

a reasonably careful person would exercise under similar circumstances. Liability for damages not caused by the negligence of the carrier may be imposed on him by a special law or rule of law. Under tariff rules, a common carrier may limit her liability to a shipper’s declaration of value, provided that the rates are dependent on value [7-309]. In the case that follows, Gyamfoah v. EG&G Dynatrend, a warehouseman who was unable to return goods that had been entrusted to it for safekeeping or to account for their disappearance was held liable to the bailor for the value of the goods.

Gyamfoah v. EG&G Dynatrend (now EG&G Technical Services)    51 U.C.C. Rep. 2d 805 (E.D. Pa. 2003)

On May 7, 1999, Yaa Gyamfoah, a citizen of Ghana, arrived at JFK International Airport with two suitcases containing a number of watches she had purchased in Hong Kong. The suitcases were seized by U.S. Customs because it suspected the watches were counterfeit. Gyamfoah was given a receipt for 3,520 watches. The watches were transported to a warehouse operated by EG&G Dynatrend (EG&G), now known as EG&G Technical Services, under contract with the U.S. Department of Treasury to provide seized management services for all agencies of the department. The warehouse accepted and signed for the watches on June 2, 1999. On October 13, U.S. Customs advised Gyamfoah’s agent that the nonviolative (ones that were not counterfeit) portion of the seizure (2,940 watches) would be released upon payment of $1,470. On November 18, a Customs agent, observed by EG&G’s warehouse supervisor, separated the watches into a group of 580 “violative” watches, which were placed in a carton, and 2,940 “nonviolative” watches, which were placed back in the suitcases. The carton and the suitcases were then returned to the custody of EG&G. When the Customs agent returned on November 24 to again, under the observation of the warehouse supervisor, examine the watches, there were only 1,002 watches in the carton and suitcases; some 2,518 were missing. Gyamfoah subsequently brought suit against the United States and EG&G. The claim against the United States was dismissed, and the case went to trial on the claim against EG&G. O’Neil, Jr., Judge The duties of a warehouseman that existed under New Jersey common law have now been codified in N.J.S.A. 12A: 7–101. EG&G is a warehouseman under the definition in the statute: “a person engaged in the business of storing goods for hire.” New Jersey requires that a warehouseman exercise reasonable care when storing bailed items. The statute imposes the following liability, in a provision adopted from the Uniform Commercial Code: A warehouseman is liable for damages for loss of 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 but unless otherwise agreed he is not liable for damages which could not have been avoided by the exercise of such care. N.J.S.A. 12A: 7–204(1). The warehouseman’s statute has been interpreted to involve a burden-shifting scheme that reflects that common law of bailment. The bailor must present a prima facie case of conversion by proving (1) delivery of the bailed goods to the bailee; (2) ­demand for return of the bailed goods from the bailee; and (3) failure of

the bailee to return the bailed goods. Once the bailee has proved these three points, the burden shifts to the bailee to show how the bailed goods were lost. If the bailee cannot prove how the bailed goods were lost it is liable under the New Jersey statute for conversion. Although the burden of proof regarding how the goods were lost shifts to the defendant, the burden of proving conversion rests at all times on the bailor as plaintiff. The tort of conversion that can be proved under the statute is not necessarily an intentional tort. In this instance “[a] conversion can occur even when a bailee has not stolen the merchandise but has acted negligently in permitting the loss of the merchandise from its premises.” In other words, if a bailor establishes that the bailed goods had disappeared while in the care of the bailee, there is a rebuttable presumption of conversion based either on the bailee’s negligent conduct in permitting third parties to steal the goods, or by the negligent or intentional conduct of the bailee’s employees or agents. As established earlier, I find that Gyamfoah showed by a preponderance of the evidence that: (1) 3,520 watches were delivered to EG&G’s warehouse; (2) when Gyamfoah’s agent presented the papers entitling Gyamfoah to return of the watches, 2,518 watches



Chapter Twenty-Three Personal Property and Bailments

23-21

were missing; and (3) the U.S. Customs officers who manipulated the watches did not remove the missing watches. Therefore, Gyamfoah has established delivery to EG&G and EG&G’s failure to redeliver all of the items on Gyamfoah’s demand. Under New Jersey law this creates a rebuttable presumption of conversion by EG&G. EG&G produced evidence at trial of reasonable precautions against loss. Mr. Wenzcel testified that the watches were shrinkwrapped to a pallet and stored in a secured area on a high shelf that required a forklift to be reached. Paul Hehir, the EG&G district manager who oversaw operations in the New York district of the company, also testified about security. He testified that the area in which the watches were stored was alarmed and within a gated area that only EG&G employees could enter. EG&G does not provide any evidence, however, regarding what happened to the missing watches. EG&G mentions the possibility that the missing watches were never delivered to the warehouse. This possibility is refuted, however, by evidence that U.S. Customs officers left the warehouse on November 18 thinking that there were 3,520 watches in storage. As I stated earlier, I find that Gyamfoah has proved by a preponderance of the evidence that there were 3,520 watches in the suitcases when the suitcases were delivered to EG&G’s warehouse. There is no explanation for the disappearance of the watches other than EG&G’s negligence. In fact, when asked “so it’s fair to say that sitting here

today, EG&G can offer no explanation of the loss of the majority of the contents of those two suitcases?” EG&G employee Mr. Herir testified “I cannot offer any explanation, no.” EG&G has not met its burden to rebut the presumption of negligence created by plaintiff’s case. Gyamfoah has met her burden of proving by a preponderance of the evidence that EG&G is liable to her under New Jersey’s law of bailment, as found in Section 7–204(1) and the common law. EG&G is liable for the value of the lost watches. Gyamfoah has proved by a preponderance of the evidence that EG&G is liable for the loss of 2,518 watches. For negligence, the measure of damages is the value of the lost goods. The only evidence presented at trial regarding the value of the missing watches is a receipt from Andex Trading Limited. The receipt lists ten models of watches, the quantity bought by Gyamfoah, the unit price and the amount paid for the number of watches of each model bought. Because Gyamfoah has not shown which models the 2,518 missing watches were, I will calculate damages as if the least expensive 2,518 watches are missing. The cost of the least expensive 2,518 watches is $3,781.30. That includes 300 watches at $0.90 each, 100 watches at $1.40 each, 350 watches at $1.55 each and 1,768 watches at $1.60 each.

Negotiation of Document of Title A nego-

negotiation acquires (1) title to the document, (2) title to the goods, (3) the right to the goods delivered to the bailee after the issuance of the document, and (4) the direct obligation of the issuer to hold or deliver the goods according to the terms of the document [7-502(1)]. Under the broad general principle that a person cannot transfer title to goods he does not own, a thief—or the owner of goods subject to a perfected security interest— cannot, by warehousing or shipping the goods on a negotiable document of title and then negotiating the document of title, transfer to the purchaser of the document of title a better title than he has [7-503].

tiable document of title and a negotiable instrument are negotiated in substantially the same manner. If the document of title provides for the delivery of the goods to bearer, it may be negotiated by delivery. If it provides for delivery of the goods to the order of a named person, it must be endorsed by that person and delivered. If an order document of title is endorsed in blank, it may be negotiated by delivery unless it bears a special endorsement following the blank endorsement, in which event it must be endorsed by the special endorsee and delivered [7-501]. A person taking a negotiable document of title takes as a bona fide holder if she takes in good faith and in the regular course of business. The bona fide holder of a negotiable document of title has substantially the same advantages over a holder who is not a bona fide holder or over a holder of a nonnegotiable document of title as does a holder in due course of a negotiable instrument over a holder who is not a holder in due course or over a holder of a nonnegotiable instrument.

Rights Acquired by Negotiation A

person who acquires a negotiable document of title by due

Judgment in favor of Yaa Gyamfoah and against EG&G ­Dynatrend in the amount of $3,781.30.

Warranties of Transferor of Document of Title The transferor of a negotiable document of

title warrants to his immediate transferee, in addition to any warranty of goods, only that the document is genuine, that he has no knowledge of any facts that would impair its validity or worth, and that his negotiation or transfer is rightful and fully effective with respect to the title to the document and the goods it represents [7-507].

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Part Five Property

Problems and Problem Cases 1. Jann Wenner hired Anderson Asphalt Paving to construct a driveway on his ranch. Larry Anderson, the owner of Anderson Asphalt Paving, and his employee, Gregory Corliss, were excavating soil for the driveway when they unearthed a glass jar containing paper-wrapped rolls of gold coins. Anderson and Corliss collected, cleaned, and inventoried the gold pieces dating from 1857 to 1914.  The 96 coins weighed about 4 pounds. Initially, Anderson and Corliss agreed to split the coins between themselves, with Anderson retaining possession of all the coins. Subsequently, Anderson and Corliss argued over ownership of the coins, and Anderson fired Corliss. Anderson later gave possession of the coins to Wenner in exchange for indemnification on any claim Corliss might have against him regarding the coins.  Corliss sued Anderson and Wenner for possession of some or all of the coins. Corliss contended that the coins should be considered “treasure trove” and awarded to him pursuant to the “finders-keepers” rule of treasure trove. Wenner, defending both himself and Anderson, contended that he had the better right to possession of the gold coins. Does the finder of the buried gold coins have a better right to the coins than the owner of the property on which they were found? 2. Michael Preston was shopping in a Walmart in Tumwater, Washington, when he found a diamond ring on the floor. Video surveillance footage showed him picking up the ring and pausing before walking out of the store. The next day he took the ring to a pawn shop and used the ring to secure a loan for $175. Preston said that the ring belonged to his girlfriend who lived in Texas.  The ring, which belonged to Nicole Amacker, was a wedding band with three diamonds that had a retail value of $3,200. Amacker had taken the ring off in the parking lot while assisting a man who had locked his keys in the car, but forgot to put the ring back on. She went inside the store and returned home, where she discovered the ring was missing. Amacker later viewed the store’s surveillance video, which showed that the ring had been stuck to her sweater while she was in the store and that she had been in the area where Preston found the ring. The video showed that Preston picked up the ring approximately 12 minutes after Amacker was in the area.  Amacker posted an advertisement on Craigslist offering a reward for the lost ring. Through the

advertisement, Amacker came into contact with Preston. He said that he had found the ring and had pawned it. Amacker told him that she needed him to be present to get the ring back from the pawn shop. She said that she would pay the amount needed to obtain the ring, but that the payment would come out of the reward. Preston then became uncooperative and would not assist Amacker in retrieving the ring from the pawn shop. When Preston was contacted by the police, Preston admitted he had found the ring but believed Amacker no longer owned it because he had found it.  Under State of Washington law, a person is guilty of second degree theft if he or she commits theft of property that exceeds $750 in value but does not exceed $5,000 in value. The definition of theft includes “to appropriate lost . . . property . . . of another, or the value thereof, with intent to deprive him or her of such property. . . .” The phrase “appropriate lost . . . property” is further defined as “obtaining or exerting control over the property . . . of another which the actor knows to have been lost or mislaid.”  The State charged Preston with second degree theft. On these facts, should a jury conclude that the ring was lost—rather than abandoned—property? 3. Rick Kenyon purchased a painting by a noted Western artist, Bill Gollings, valued between $8,000 and $15,000 for $25 at a Salvation Army thrift store. Claude Abel filed suit against Kenyon seeking the return of the painting, which had belonged to his late aunt. Abel claimed that the Salvation Army mistakenly took the painting from his aunt’s house when the box in which it was packed was mixed with items being donated to the thrift store. Abel’s aunt, Billie Taylor, was a friend of the artist whose works were known for their accurate portrayal of the Old West. Sometime before his death in 1932, Gollings gave a painting to Taylor depicting a Native American on a white horse in the foreground with several other Native Americans on horses in the background traveling through a traditional Western prairie landscape. The painting remained in Taylor’s possession at her home in Sheridan, Wyoming, until her death on August 31, 1999. After Taylor’s death, Abel traveled from his home in Idaho to Sheridan for the funeral and to settle the estate. Abel was the sole heir of Taylor’s estate, so he inherited all of her personal belongings, including the Gollings painting. Abel and his wife sorted through Taylor’s belongings, selecting various items they would keep



Chapter Twenty-Three Personal Property and Bailments

for themselves. Abel and his wife, with the help of a local moving company, packed those items into boxes marked for delivery to their home in Idaho. Items not being retained by Abel were either packed for donation to the Salvation Army or, if they had sufficient value, were taken by an antiques dealer for auction. The scene at the house was one of some confusion as Abel tried to vacate the residence as quickly as possible while attempting to make sure all of the items went to their designated destinations. The painting was packed by Abel’s wife in a box marked for delivery to Idaho. However, in the confusion and unbeknown to Abel, the box containing Gollings’s painting was inadvertently picked up with the donated items by the Salvation Army. It was priced at $25 in its thrift store and sold to Kenyon. After returning to Idaho, Abel discovered that the box containing the painting was not among those delivered by the moving company. He also learned that the painting had gone to the Salvation Army and had been sold to Kenyon. When Kenyon refused to acknowledge he had the painting, Abel brought suit seeking its return. Kenyon claimed that he was a good-faith purchaser of the painting that had been given to the Salvation Army. Was Abel entitled to have the painting returned to him on the grounds that not having made a gift of the painting, he was still the owner, and that its sale by the Salvation Army was a conversion of his property? 4. Charles Miller and Nicolette Chiaia met each other through work in 2007 and began a relationship. In ­October 2008, Miller moved into Chiaia’s home, where she lived with her minor children from a prior marriage. Miller had also been married and was ­recently divorced. The parties’ living arrangement was predicated on a mutual belief that they would become ­engaged and would marry. In early November 2008, the parties took a trip to Italy during which Miller proposed and presented Chiaia with a ring. She accepted the proposal and the ring. Subsequently, she asked Miller where he had purchased the ring, was disappointed with the ­answer, and gave it back to him. When they got back from Italy, Miller took the ring back to the seller and received a full refund of the amount he had paid, $5,000. Chiaia suggested the style of a different ring she would like and Miller purchased one like it from a jeweler for $12,000. Miller then “reproposed” and presented Chiaia with the second ring.  Over the next few months, Miller, who was self-­ employed, had business difficulties that caused

23-23

friction between the parties, and the relationship soured. In February 2009, Miller moved out of Chiaia’s house and the parties never reconciled. Miller asked for the ring back, but Chiaia refused. Miller then brought a lawsuit, seeking replevin of the ring. Chiaia contended that there had been a completed gift and that she owned the ring. Miller claimed that it was a conditional gift given at the time of the engagement and in contemplation of marriage. Is Miller entitled to recover the ring from Chiaia? 5. Faith Ballard’s Corvette was substantially damaged in an accident and was being stored in her garage. Her son, Tyrone Ballard, told her that he would take the vehicle and have it restored. Instead, he sold it to Lambert Auto Parts. Johnny Wetzel purchased the Corvette “hull” for $900 from Lambert, whose regular business is selling parts. Wetzel obtained a receipt documenting the purchase of the parts. He also checked the VIN numbers through the county clerk’s office to make sure the parts were not stolen. Wetzel spent approximately $5,000 and 100 hours of labor restoring the vehicle. When completed, the restoration had a market value of $7,950. George Martin, an employee of Lambert, testified that he purchased only a “hull” of a car—rather than a whole vehicle— from Tyrone Ballard. Martin also testified that he usually received a title when he bought a “whole” vehicle but had not received one in this case where he had purchased only part of one. Under Tennessee law, a certificate of title is not required to pass ownership of a motor vehicle, but any owner dismantling a registered vehicle is to send the certificate of title back to the state. Faith Ballard brought suit against Wetzel to recover possession of the Corvette. Wetzel contended that he was a good-faith purchaser for value and had become the owner of the restored auto hull by accession. Did Wetzel become the owner of the Corvette by accession? 6. R. B. Bewley and his family drove to Kansas City to attend a weeklong church convention. When they arrived at the hotel where they had reservations, they were unable to park their car and unload their luggage because of a long line of cars. They then drove to a nearby parking lot where they took a ticket, causing the gate arm to open, and drove in 15 or 20 feet. A parking attendant told them that the lot was full, that they should leave the keys with him, and that he would park the car. They told the attendant that they had reservations at a nearby hotel and that after they checked in they would come back for their luggage.

23-24

Part Five Property

Subsequently, someone broke into the Bewleys’ car and stole their personal property from the car and its trunk. Was the parking lot a bailee of the property? 7. On September 2, Deborah Jones signed a Storage Rental Agreement with Econo-Self Storage owned by Ernie Hanna. Jones needed to store her personal ­belongings and furniture because of the flooding of her apartment. The self-storage agreement was ­written as a lease and designated the parties as landlord and tenant. The warehouse space leased by Jones was 10 feet by 10 feet, on a monthly term of $45. The agreement provided in part: “All property kept, stored, or maintained within the premises by Tenant shall be at Tenant’s sole risk.”  On May 2, Jones learned that the lock to her storage unit had been cut and virtually all of her possessions were stolen. The circumstances of the theft were not known. The storage units, 180 in all, were protected by a 6-foot fence and a locked gate. The tenants placed their own locks on the units. No security dogs or watchmen were provided. Access could be made to the units between 6 A.M. and 9 P.M. daily. No inventory was made of the goods by the facility owner, and the goods were never placed in his hands, nor did he know what was stored. Jones brought suit to recover damages for the loss of her property. Was Econo-Self Storage the bailee of Jones’s goods? 8. On March 27, 2001, Felice Jasphy brought three fur coats to Illana Osinsky’s establishment trading as Cedar Lane Furs in Teaneck, New Jersey, for storage and cleaning. The three coats included a ranch mink coat, a shearling, and a blush mink. In addition to storage of the three coats, Jasphy also sought cleaning of the ranch mink. In 1997, the ranch mink had been appraised for $11,500; the shearling for $3,500; and the blush mink for $3,995. Jasphy signed a written agreement, labeled “fur storage sales receipt,” which included Jasphy’s name and address, and the price of the storage and cleaning. On the back of the receipt, the following preprinted provision limiting Cedar Lane Furs’s liability read: This receipt is a storage contract, articles listed are accepted for storage until December 31, of dated year, subject to the terms and conditions hereof, in accepting this receipt, the depositor agrees to be bound by all its terms and conditions and acknowledges that this receipt is the entire agreement with the furrier, which cannot be changed except by endorsement herein signed by the

furrier. If no value is specified, or if no separate insurance covering the garment is declared at the time of issuance of this receipt, insurance in the amount of $1.00 will be placed on the garment. Immediately above the location on the receipt for a customer’s signature, the following was printed: “I understand and agree that Cedar Lane Furs’s liability for loss or damage from any cause whatsoever, including their own negligence or that of employees and others, is limited to the declared valuation.” Jasphy did not state the value of the coats or declare whether she had separate insurance coverage when the receipt was issued. There is no identifiable room provided on the receipt to specify such information. The limitation of the furrier’s liability was not brought to Jasphy’s attention, nor was she asked to furnish the value of her coats for storage. The following day, March 28, 2001, a fire swept through Cedar Lane Furs, causing Jasphy’s furs to be completely destroyed. A hot iron, which Cedar Lane Furs’s employees apparently forgot to unplug overnight, caused the fire. Jasphy subsequently learned that her furs had not been placed in the fur vault before the fire and were destroyed in the fire. Jasphy filed a claim form with Cedar Lane Furs’s insurance company but never received any reimbursement. She then brought suit against Osinsky and Cedar Lane Furs. They contended that their liability was limited by the contract provision to $1 per garment. Should the court enforce the contractual provision limiting the furrier’s liability to $1 per garment? 9. Marie Wallinga was staying at the Commodore Hotel. She had her son take her two diamond rings to the hotel clerk for safekeeping. The rings were shown to the clerk and then placed in a “safe-deposit envelope,” which was sealed. The son received a depositor’s check stub, which had a number corresponding to the number on the envelope. He also signed his name on the safe-deposit envelope. Both the stub and his signature were necessary to get the envelope back. The envelopes were kept in a safe located in the hotel’s front office, which was 4 or 5 feet behind the reception desk. The safe was used to keep cash for use in the hotel as well as the valuables of guests. The safe was equipped with a combination lock, but for many years it had never been locked. A clerk was always on duty at the reception desk. One morning, at 3:30 A.M., the hotel was robbed by two armed men, and Wallinga’s rings were taken. She sued the hotel for the value of



Chapter Twenty-Three Personal Property and Bailments

the rings. The hotel claimed that the robbery relieved it of liability for them. Was the hotelkeeper liable for the theft of property left with it for safekeeping? 10. Griswold and Bateman Warehouse Company stored 337 cases of Chivas Regal Scotch Whiskey for Joseph H. Reinfeld Inc. in its bonded warehouse. The warehouse receipt issued to Reinfeld limited Griswold and Bateman’s liability for negligence to 250 times the monthly storage rate, a total of $1,925. When Reinfeld sent its truck to pick up the whiskey, 40 cases

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were missing. Reinfeld then brought suit seeking the wholesale market value of the whiskey, $6,417.60. Reinfeld presented evidence of the delivery of the whiskey, the demand for its return, and the failure of Griswold and Bateman to return it. Reinfeld claimed that the burden was on Griswold and Bateman to explain the disappearance of the whiskey. Griswold and Bateman admitted that it had been negligent, but sought to limit its liability to $1,925. Is Griswold and Bateman’s liability limited to $1,925?

CHAPTER 24

Real Property

J

oyce and John, a married couple with two young children, are in the process of buying a house. They made an offer on a single-family house in Greenwood, a new subdivision. The house has four bedrooms, one with custom-built bunk beds in it; four bathrooms; a swimming pool; and a large basement. There is a well-equipped kitchen and a large dining room with a vintage Tiffany lamp over the dining room table. The basement is perfect for Joyce, who plans to operate a small daycare center in the house. Joyce and John notice that the next-door neighbors, the Fieldings, have been dumping their garden refuse in a ravine at the back of the property that they have offered to buy, but they assume that they will be able to stop that practice once they move in. • Are the bunk beds and Tiffany lamp considered to be part of the real property that Joyce and John have offered to buy? • If their offer is accepted, how will Joyce and John share ownership of the property? What form of ownership will they have? • What are the steps involved in purchasing this property? • What rights might others, such as the Fieldings, have in the property? • What liability might John and Joyce have to others who are injured on their property? • What controls does the legal system place on the use of property? • Is it ethical for the Fieldings to dump their garden refuse on this property?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 24-1 Define real property and explain what is included in the concept of real property. 24-2 Provide several examples of property that would be considered to be a fixture and explain the significance of classifying an item of property as a fixture. 24-3 Explain and distinguish among the various forms of ownership of real property. 24-4 Explain the legal effects of easements and restrictive covenants as well as the duties of property owners toward third persons.

24-5 Distinguish the various ways in which ownership of real property is transferred and how title to property can be assured. 24-6 Distinguish the different types of deeds, explain the purposes of recording deeds, and describe how state law determines priorities among those who claim competing rights in a parcel of real property. 24-7 Explain governmental powers to control and purchase private land and the constitutional limits on those powers.

24-2

Part Five Property

LAND’S SPECIAL IMPORTANCE IN the law has long been recognized. In the agrarian society of previous eras, land served as the basic measure and source of wealth. In today’s society, land functions not only as a source of food, clothing, and shelter but also as an instrument of commercial and industrial development. It is not surprising, then, that a complex body of law—the law of real property—exists regarding the ownership, acquisition, and use of land. This chapter discusses the scope of real property and the various legal interests in it. In addition, the chapter examines the ways in which real property is transferred and the controls society places on an owner’s use of real property.

Scope of Real Property LO24-1

Define real property and explain what is included in the concept of real property.

Real property includes not only land, but also things firmly attached to or embedded in land. Buildings and other permanent structures thus are considered real property. The owner of a tract of real property also owns the air above it, the minerals below its surface, and any trees or other vegetation growing on the property.1 Unlike readily movable personal property, real property is immovable or attached to something immovable. Distinguishing between real and personal property is important because rules of law governing real property transactions such as sale, taxation, and inheritance are frequently different from those applied to personal property transactions.

Fixtures Provide several examples of property that would be

LO24-2 considered to be a fixture and explain the significance of

classifying an item of property as a fixture.

An item of personal property may, however, be attached to or used in conjunction with real property in such a way that it ceases being personal property and instead becomes part of the real property. This type of property is called a fixture. Fixtures belong to the owner of the real property. One who provides or attaches fixtures to real property without a request to that effect from the owner of the real property Ownership of air above one’s property is not an unlimited interest, however. Courts have held that the flight of aircraft above property does not violate the property owner’s rights, so long as it does not unduly interfere with the owner’s enjoyment of her land. 1

is normally not entitled to compensation from the owner. A conveyance (transfer of ownership) of real property also transfers the fixtures associated with that property, even if the fixtures are not specifically mentioned. People commonly install items of personal property on the real property they own or rent. Disputes may arise regarding rights to such property. Suppose that Jacobsen buys an elaborate ceiling fan and installs it in his home. When he sells the house to Orr, may Jacobsen remove the ceiling fan, or is it part of the home Orr has bought? Suppose that Luther, a commercial tenant, installs showcases and tracklights in the store she leases from Nelson. May Luther remove the showcases and the lights when her lease expires, or do the items now belong to Nelson? If the parties’ contracts are silent on these matters, courts will resolve the cases by applying the law of fixtures. As later discussion will reveal, Jacobsen probably cannot remove the ceiling fan because it is likely to be considered part of the real property purchased by Orr. Luther, on the other hand, may be entitled to remove the showcases and the lights under the special rules governing trade fixtures. Factors Indicating Whether an Item Is a Fixture There is no mechanical formula for determining whether an item has become a fixture. Courts tend to consider these factors: 1. Attachment. One factor helping to indicate whether an item is a fixture is the degree to which the item is attached or annexed to real property. If firmly attached to real property so that it cannot be removed without damaging the property, the item is likely to be considered a fixture. An item of personal property that may be removed with little or no injury to the property is less likely to be considered a fixture. Actual physical attachment to real property is not necessary, however. A close physical connection between an item of personal property and certain real property may enable a court to conclude that the item is constructively annexed. For example, heavy machinery or remote control devices for automatic garage doors may be considered fixtures even though they are not physically attached to real property. 2. Adaptation. Another factor to be considered is adaptation—the degree to which the item’s use is necessary or beneficial to the use of the real property. Adaptation is a particularly relevant factor when the item is not physically attached to the real property or is only slightly attached. When an item would be of little value except for use with certain real property, the item is likely to be considered a fixture even if it is unattached or could easily be removed. For example, keys and custom-sized window screens and storm windows have been held to be fixtures.



Chapter Twenty-Four Real Property

3. Intent. The third factor to be considered is the intent of the person who installed the item. Intent is judged not by what that person subjectively intended, but by what the circumstances indicate he intended. To a great extent, intent is indicated by the annexation and adaptation factors. An owner of real property who improves it by attaching items of personal property presumably intended those items to become part of the real estate. If the owner does not want an attached item to be considered a fixture, he must specifically reserve the right to keep the item. For instance, if a seller of a house wants to keep an antique chandelier that has been installed in the house, the seller should either replace the chandelier before the house is shown to prospective purchasers or specify in the contract of sale that the chandelier will be excluded from the sale. Express Agreement If the parties to an express agreement have clearly stated their intent about whether a particular item is to be considered a fixture, a court will generally enforce that agreement. For example, the buyer and seller of a house might agree to permit the seller to remove a fence or shrubbery that would otherwise be considered a fixture.

24-3

Trade Fixtures An exception to the usual fixture rules is recognized when a tenant attaches personal property to leased premises for the purpose of carrying on her trade or business. Such fixtures, called trade fixtures, remain the tenant’s personal property and may normally be removed at the termination of the lease. This trade fixtures exception encourages commerce and industry. It recognizes that the commercial tenant who affixed the item of personal property did not intend a permanent improvement of the leased premises. The tenant’s right to remove trade fixtures is subject to two limitations. First, the tenant cannot remove the fixtures if doing so would cause substantial damage to the landlord’s realty. Second, the tenant must remove the fixtures by the end of the lease if the lease is for a definite period. If the lease is for an indefinite period, the tenant usually has a reasonable time after the expiration of the lease to remove the fixtures. Trade fixtures not removed within the appropriate time become the landlord’s property. Leases may contain terms expressly addressing the parties’ rights in any fixtures. A lease might give the tenant the right to attach items or make other improvements and to remove them later. The reverse may also be true. The lease could state that any improvements made or fixtures

CONCEPT REVIEW Fixtures Concept

A fixture is an item of personal property attached to or used in conjunction with real property in such a way that it is treated as being part of the real property.

Significance

A transfer of the real property will also convey the fixtures on that property.

Factors Considered in Determining Whether Property Is a Fixture

1. Attachment: Is the item physically attached or closely connected to the real property? 2. Adaptation: How necessary or beneficial is the item to the use of the real property? 3. Intent: Did the person who installed the item manifest intent for the property to become part of the real property?

Express Agreement

Express agreements clearly stating intent about whether property is a fixture are generally enforceable.

Trade Fixtures (Tenants’ Fixtures)

Definition of trade fixture: personal property attached to leased real property by a tenant for the purpose of carrying on the tenant’s trade or business. Trade fixtures can be removed and retained by the tenant at the termination of the lease except when any of the following applies: 1. Removal would cause substantial damage to the landlord’s real property. 2. The tenant fails to remove the fixtures by the end of the lease (or within a reasonable time, if the lease is for an indefinite period of time). 3. An express agreement between the landlord and tenant provides otherwise.

24-4

Part Five Property

attached will become the landlord’s property at the termination of the lease. Courts generally enforce parties’ agreements on fixture ownership. In Mogilevsky v. Rubicon Technology, Inc., the court analyzes whether components of a complex electrical and cooling system are removable trade fixtures, even when

other components of it (e.g., those buried beneath the floor of the building) clearly are not. Also note how the court does not find that damage resulting from removal of the components automatically makes them permanent fixtures. Rather, that damage is handled through remedies for breach of the lease.

Mogilevsky v. Rubicon Technology, Inc.    (2014 IL App (1st) 132702-U 2014)

In 1999, Dr. Radion Mogilevsky and his wife Nanette bought an empty two-story industrial warehouse-style building in Franklin Park, Illinois. They leased the building to S & R Rubicon Inc., a company they largely controlled. S & R manufactured sapphire crystals for use in various commercial applications such as LED lighting. To make the building usable for that purpose, it purchased and installed a 2,000-amp electrical system and components of a cooling system to support the furnaces used in sapphire crystal manufacturing. The particular furnaces S & R used were of sufficiently large capacity to allow S & R to manufacture crystals of much larger size than its competitors’ crystals. The cooling system included components inside, outside, and underneath the building, including a rooftop water tower and above-ground pipe loop that ran the water to the tower. A second pipe loop ran coolant water under the concrete floor of the building. Although Dr. Mogilevsky designed the system, Christopher Moffitt loaned S & R more than half a million dollars to purchase the furnaces, electrical, and cooling systems. As a result, Moffitt eventually became a 20 percent owner of S & R. Moffitt testified that he never intended that the systems would permanently remain on the premises because S & R had funded their purchase. In contrast, the Mogilevskys expected that the systems would remain permanently affixed to the premises because they had arranged for S & R to pay for the systems only for tax reasons. In 2000, the Mogilevskys and Moffitt organized Rubicon Technology LLC (the LLC) to succeed S & R and to facilitate outside investment in anticipation of eventually converting it to a publicly held corporation. The Mogilevskys entered into a new lease with the LLC for the warehouse. Neither the sale documents nor the lease mentioned the components of the cooling system or the furnaces, but the sale document did state in the preface that S & R intended to transfer “all assets of or used in the business.” In January 2001, Rubicon Technology, Inc. (Rubicon) became the successor to the LLC. In 2005, the Mogilevskys and Rubicon entered into a five-year lease for the warehouse. The lease provided that at the conclusion of the lease, Rubicon would “at once surrender the Premises to Landlord, broom clean, in good order, condition, and repair, reasonable wear and tear excepted.” At the end of the lease term in 2010, Rubicon surrendered the premises and abandoned the underground components of the cooling system, but removed the major components. The removal left holes in the walls and floors, which required patching. Also, the 2,000-amp electrical service had been removed, leaving a 1,200-amp service only. Dr. Mogilevsky had planned to continue to use the building and the electrical and cooling systems for a new company he had created to produce high-purity densified alumina, which is used as a raw material to produce sapphire crystals. Thus, the Mogilevskys faced significant repair and replacement costs. The Mogilevskys filed a lawsuit against Rubicon, seeking $950,000 in damages for breach of the lease and conversion. A jury awarded the Mogilevskys only $22,000 on the breach of contract claim for their cost to repair the holes. It found against them on the conversion claim, essentially determining that the system components were removable trade fixtures that belonged to Rubicon. The Mogilevskys moved for a judgment notwithstanding the verdict, which the court denied. They appealed. Delort, Judge We begin with the well-recognized principle that there are essentially two kinds of fixtures attached to real estate: permanent fixtures and trade fixtures. A tenant may not remove “permanent fixtures” from leased property, as they become part of the real estate. A permanent fixture is “a former chattel which, while retaining its separate physical identity, is so connected with the reality [sic] that a disinterested observer would consider it a part thereof.” St. Louis v. Rockwell Graphic Systems, Inc., 605 N.E.2d

555 (1992). . . . To determine whether an item is a tenant’s personal property and not part of the realty, courts consider three factors: (1) the nature of its attachment to the realty; (2) its adaptation to and necessity for the purpose for which the premises are devoted; and (3) whether it was intended that the item in question be considered part of the realty. [Citations omitted.] Intent is the “preeminent factor; the other considerations are primarily evidence of intent.” A & A Market, Inc. v. Pekin Insurance Co., [306 Ill. App. 3d 485, 488 (1999)]. . . .



Chapter Twenty-Four Real Property

24-5

A “trade fixture” is also affixed to the real estate, but differs from a “permanent fixture” in two respects: (1) it must be personal property of the tenant; and (2) it is affixed to the realty for purposes of carrying on the tenant’s business. [Citation omitted.] There is a rebuttable presumption that items installed by a tenant for the purpose of carrying on a trade are trade fixtures. The test to determine whether a fixture is a trade fixture is essentially identical to the test used for permanent fixtures. [Citation omitted.] A trade fixture is the tenant’s property and may be removed by the tenant if the removal does not damage the real estate. . . . The jury did hear evidence regarding the manner in which the system was attached to the building and the necessity of the system for Rubicon’s manufacturing process. The jury also learned that the property began as an empty warehouse which, as a “white shell,” could be converted to any number of uses. Rubicon’s predecessor corporation had paid for the equipment in the first place, and the equipment was specially made for and required by manufacturers of sapphire crystals. Some key evidence, though, was clearly disputed. On the critical element of intent, Dr. Mogilevsky and Moffitt had sharply differing opinions regarding the intent of

the parties at the time of installation. That intent was never memorialized in writing, so the jury was only able to ascertain intent through the testimony of the witnesses for each party. As the trier of fact, the jury was entitled to determine which witness’s testimony was more credible, and we cannot disturb that finding. . . . The fact that the tenant paid for the installation is quite relevant to the issue of intent. [Citation omitted.] The property began as an empty warehouse and was returned to that condition, with the exceptions of $22,000 in damage caused by the removal of the system and the presence of installed underground lines which would not have affected the usability of the building for other purposes. Based on all this evidence, the jury was entitled to determine that the system was a removable trade fixture, and that Rubicon was not liable for conversion. In sum, neither the verdict on the breach of contract count nor the verdict on the conversion count was against the manifest weight of the evidence. For these reasons, we affirm the judgment of the circuit court.

Security Interests in Fixtures Special rules apply to personal property subject to a lien or security interest at the time it is attached to real property. Assume, for example, that a person buys a dishwasher on a time-payment plan from an appliance store and has it installed in the person’s kitchen. To protect itself, the appliance store takes a security interest in the dishwasher and perfects that interest by filing a financing statement in the appropriate real estate records office within the period of time specified by the Uniform Commercial Code. The appliance store then is able to remove the dishwasher if the buyer defaults. The store could be liable, however, to third parties such as prior real estate mortgagees for any damage removal of the dishwasher caused to the real estate. The rules governing security interests in personal property that will become fixtures are explained more fully in Chapter 29.

of rights subject to ownership—sometimes by different people. This discussion examines the most common forms of present possessory interests (rights to exclusive possession of real property): fee simple absolute and life estate. It also explores the ways in which two or more persons may share ownership of a possessory interest. Finally, it discusses the interests and rights one may have in another person’s real property, such as the right to use the property or restrict the way the owner uses it.

Rights and Interests in Real Property LO24-3

Explain and distinguish among the various forms of ownership of real property.

When we think of real property ownership, we normally envision one person owning all of the rights in a particular piece of land. Real property, however, involves a bundle

Affirmed.

Estates in Land The

term estate is used to describe the nature of a person’s ownership interest in real property. Estates in land are classified as either freehold estates or nonfreehold estates. Nonfreehold (or leasehold) estates are those held by persons who lease real property. They will be discussed in Chapter 25, which deals with landlord–tenant law. Freehold estates are ownership interests of uncertain duration. The most common types of freehold estates are fee simple absolute and life estates. Fee Simple Absolute The fee simple absolute is what we normally think of as “full ownership” of land. One who owns real property in fee simple absolute has the right to possess and use the property, and exclude others from using and possessing the property, for an unlimited period of time, subject only to governmental regulations or private restrictions. A fee simple absolute owner also has the unconditional power

24-6

Part Five Property

to dispose of the property during the owner’s lifetime or upon death. A person who owns land in fee simple absolute may grant many rights to others without giving up ownership. For example, the owner may grant a mortgage on the property to a party who has loaned the owner money, lease the property to a tenant, or grant rights such as those to be discussed later in this section. Life Estate The property interest known as a life estate gives a person exclusive rights to possess and use property for a time measured by that or another person’s lifetime. For example, if Haney has a life estate (measured by his life) in a tract of land known as Greenacre, he has the right to use Greenacre for the remainder of his life. At Haney’s death, the property will revert to the person who conveyed the estate to him or will pass to some other designated person. Although a life tenant has the right to use the property, he is obligated not to commit acts that would result in permanent injury to the property.

Co-ownership of Real Property Co-ownership

of real property exists when two or more persons share the same ownership interest in certain property. The co-owners do not have separate rights to any portion of the real property; each has a share in the whole property. Seven types of co-ownership are recognized in the United States. Tenancy in Common Persons who own property under a tenancy in common have undivided interests in the property and equal rights to possess it. When property is transferred to two or more persons without specification of their co-ownership form, it is presumed that they acquire the property as tenants in common. The respective ownership interests of tenants in common may be, but need not be, equal. One tenant, for example, could have a two-thirds ownership interest in the property, with the other tenant having a one-third interest. Each tenant in common has the right to possess and use the property. Individual tenants, however, cannot exclude the other tenants in common from also possessing and using the property. If the property is rented or otherwise produces income, each tenant is entitled to share in the income in proportion to that tenant’s ownership share. Similarly, each tenant must pay contribution (that is, the tenant’s proportionate share of property taxes and necessary maintenance and repair costs). If a tenant in sole possession of the property receives no rents or profits from the property, that tenant is not required to pay rent to a cotenant unless the possession is adverse or inconsistent with the cotenant’s property interests.

A tenant in common may dispose of an interest in the property during life and at death. Similarly, the tenant in common’s interest is subject to that tenant’s creditors’ claims. Upon a tenant’s death, the interest in the property passes to the tenant’s heirs or to the person or persons specified as the beneficiaries in the tenant’s will. Suppose Peterson and Sievers own Blackacre as tenants in common. Sievers dies, having executed a valid will in which he leaves his Blackacre interest to Johanns. In this situation, ­Peterson and Johanns become tenants in common. Tenants in common may sever the cotenancy by agreeing to divide the property or, if they are unable to agree, by petitioning a court for partition. The court will physically divide the property if that is feasible, so that each tenant receives his or her proportionate share. If physical division is not feasible, the court will order that the property be sold and that the proceeds be appropriately divided.   Joint Tenancy A joint tenancy is created when equal interests in real property are conveyed to two or more persons by means of a document clearly specifying that they are to own the property as joint tenants. The rights of use, possession, contribution, and partition are the same for a joint tenancy as for a tenancy in common. The Ballard case, which follows shortly, addresses partition issues in the context of a joint tenancy. The joint tenancy’s distinguishing feature is that it gives the owners the right of survivorship, which means that upon the death of a joint tenant, the deceased tenant’s interest automatically passes to the surviving joint tenant(s). The right of survivorship makes it easy for a person to transfer property at death without the need for a will. For example, ­Devaney and Osborne purchase Redacre and take title as joint tenants. At Devaney’s death, his Redacre interest will pass to Osborne even if Devaney did not have a will setting forth such an intent. Moreover, even if Devaney had a will that purported to leave his Redacre interest to someone other than Osborne, the will’s Redacre provision would be ineffective. When the document of conveyance contains ambiguous language, a court may be faced with determining whether persons acquired ownership of real property as joint tenants or, instead, as tenants in common. A joint tenant may mortgage, sell, or give away her interest in the property during her lifetime. Her interest in the property is subject to her creditors’ claims. When a joint tenant transfers her interest, the joint tenancy is severed and a tenancy in common is created as to the share affected by the transaction. For example, when a joint tenant sells her interest to a third person, the purchaser becomes a tenant in common with the remaining joint tenant(s).



Chapter Twenty-Four Real Property

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Ballard v. Dornic   140 A.3d 1147 (D.C. Ct. App. 2016) Matthew Dornic and Glenn Ballard owned, as cotenants, two properties in the District of Columbia. One was a single-family home in which Ballard resided. The other was a condominium. Their relationship apparently having deteriorated, Dornic filed a complaint for partition-by-sale of the properties. The trial court granted Dornic’s motion. Ballard appealed, arguing that Dornic had voluntarily limited his right to partition by failing to pay his fair share of the mortgages and other expenses associated with each of the properties and that the trial judge erred in holding that only tenants by the entirety are limited in their ability to seek partition. An issue on appeal was also whether partition-by-sale was appropriate, instead of dividing the properties. Thompson, Associate Judge I. Our case law recognizes that a cotenant’s unilateral “right to partition, while normally an integral part of the cotenancy form of ownership, is like most property rights subject to possible limitation by voluntary act of the parties[,]” Carter v. Carter, 516 A.2d 917, 921 (D.C. 1986), such as through the cotenants’ agreement that one of the cotenants is to have exclusive use and possession of the property for some limited time period. We therefore agree with Mr. Ballard that the fact that an estate is not a tenancy by the entireties does not negate the possibility that one of the cotenants has, by a voluntarily act, restricted his right to seek partition. But our agreement on this point does not help Mr. Ballard’s cause, because he cites no authority, and we know of none, for his novel argument that a joint tenant voluntarily restricts his right to partition by virtue of the fact—as Mr. Ballard avers is the case with Mr. Dornic—that he has paid a less-than-equal or relatively small share of the expenses related to the property. Nor does the summary judgment record reveal any evidence that either of the parties “expressed their intent not to partition.” We therefore conclude that Judge Campbell did not err in rejecting Mr. Ballard’s theory that Mr. Dornic limited his right to partition by a voluntary act. II. As his basis for granting partial summary judgment to Mr. ­Dornic, [the trial judge] determined that a partition-by-sale is appropriate because it “appears that the propert[ies] cannot be divided without loss or injury to the parties interested[.]” Mr. Ballard argues that [the judge] erred in finding, on disputed facts and on an incomplete factual record, that the property cannot be divided without loss or injury to the parties, and by concluding without analysis that a partition-by-sale is necessary. Actions for partition are governed by D.C. Code § 16-2901(a), which provides that “when it appears that the property cannot be divided without loss or injury to the parties interested, the court may decree a sale thereof and a division of the money arising from the sale among the parties, according to their respective rights.” The general test of whether a partition-in-kind—a physical division of the property according to the cotenants’ shares—would

result in loss or injury to the owners is whether the property can be divided “without materially impairing its value or the value of an owner’s interest in it.” In this case, no one contests that the properties in question— a single family home and condominium—cannot be physically divided without diminishing their value. Mr. Ballard contends, however, that a partition-in-kind does not necessarily require that a property be physically severed into separate parts. He argues that each of the properties can and should be partitioned in kind by awarding each in its totality to him. Mr. Ballard appears to be correct that if a property is subject to partition, “a fortiorari it can be awarded in part, or in its totality, to one tenant depending upon the facts, evidence, etc., in the case.” Hipp v. Hipp, 191 F. Supp. 299, 301 (D.D.C. 1960). But again, the principle on which Mr. Ballard relies does not help him, because the summary judgment record does not support an award of the properties to Mr. Ballard alone. That is so even if we take as true the factual allegations to which Mr. Ballard swore. . . . “[I]n a suit for partition, the court must first determine the respective shares which the parties hold in the property, before the property can be divided.” Sebold v. Sebold, 444 F.2d 864, 872 (D.C. Cir. 1971). “[A] presumption arises that upon dissolution of [a] joint tenancy during the lives of the cotenants, each is entitled to an equal share of the proceeds.” Id. However, that presumption “is subject to rebuttal . . . and does not prevent proof from being introduced that the respective holdings and interests of the parties are unequal.” Id. at 872. The presumption that joint tenants own an equal share of a property can be rebutted by “evidence showing the source of the actual cash outlay at the time of acquisition, the intent of the cotenant creating the joint tenancy to make a gift of the half-interest to the other cotenant, unequal contribution by way of money or services, unequal expenditures in improving the property or freeing it from encumbrances and clouds, or other evidence raising inferences contrary to the idea of equal interest in the joint estate.” Id. The foregoing case law addresses the effect the trial court may give to cotenants’ unequal contributions when determining their respective shares in a property upon partition. In addition, the partition statute prescribes the effect that may be given to cotenants’ unequal receipt of rents from a jointly owned property. Specifically, D.C. Code § 16-2901(c) addresses the situation “[i]n a case

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Part Five Property

of partition, when a tenant in common has received the rents and profits of the property to his own use[.]” It provides that such a cotenant “may be required to account to his cotenants for their respective shares of the rents and profits” and that “[a]mounts found to be due on the accounting may be charged against the share of the party owing them in the property, or its proceeds in case of sale.” Mr. Ballard’s opposition to Mr. Dornic’s motion for partial summary judgment [was based in part on] Mr. Ballard’s allegation that Mr. Dornic paid a total of only $17,225.53 toward the purchase price and mortgage service for first and second mortgages on the [property where Ballard lives], while Mr. Ballard paid a total of over $586,662. Regarding the condominum, Mr. ­Ballard [alleged] that he has made mortgage payments totaling about $147,000, while Mr. Dornic has made payments totaling about $177,000. He also averred that Mr. Dornic has collected rents of $210,000 from the [condominium] and not shared them with Mr. Ballard. As to each of the properties, Mr. Ballard contends that the amount Mr. Dornic owes him in order to equalize mortgage-payment contributions and/or to pay him his share of the rents collected is more than Mr. Dornic would realize from his half of the proceeds of a sale of the property. For that reason, Mr. Ballard contends, a sale of the property would leave Mr. Dornic with accrued liabilities to Mr. Ballard still hanging over his head, while a partition-in-kind, awarding 100% of the property to Mr. Ballard (upon Mr. Ballard’s agreement to refinance the existing mortgages so that they are solely his responsibility) would at least arguably leave Mr. Dornic better off than he is now (meaning, Mr. Ballard implies, that it is a partition-by-sale, not a partition-in-kind, that would cause “loss or injury to the parties interested”). There are, to be sure, issues of fact regarding the parties’ relative financial contributions; Mr. Dornic’s answer to Mr. Ballard’s counterclaims denies most of the relevant allegations about uneven contributions. We nonetheless are satisfied that [the trial judge] was presented with no issues of material fact that precluded partial summary judgment. Even if Mr. Ballard’s averments are taken as

true, and it also is assumed that Mr. Dornic made no non-monetary contributions and received no gifts from Mr. Ballard that entitle him to a larger share of the property, it seems clear that Mr. ­Dornic holds whatever ownership share in the [single-family home] his $17,000 investment in the property represents and whatever ownership share in the [condominium] his $177,000 investment represents. If the parties’ relative contributions are as Mr. ­Ballard avers, Mr. Ballard’s proportionately larger contributions and Mr. Dornic’s accrued liability to Mr. Ballard for [the condominium] rents collected may warrant adjustments to the parties’ otherwise presumed equal shares in the properties, and may mean that Mr. Ballard has a greater-than-50% share in each property. That is because, per the case law and the partition statute discussed above, the parties’ disproportionate contributions and accrued liabilities are to be considered in determining “the respective holdings and interests of the parties,” Sebold, 444 F.2d at 872, and, for purposes of a partition-in-kind, are to be “charged against the share of the party owing them[.]” D.C. Code § 16-2901(c). But the summary judgment record provided no basis for [the trial judge] to conclude that Mr. Dornic owns no share or interest in the properties such that Mr. Ballard is entitled to sole ownership of one or both properties as the result of a partition-in-kind.

Tenancy by the Entirety Approximately half of the states permit married couples to own real property under a tenancy by the entirety. This tenancy is essentially a joint tenancy with the added requirement that the owners be married. As does the joint tenancy, the tenancy by the entirety features the right of survivorship. Neither spouse can transfer the property by will if the other is still living. Upon the death of the husband or wife, the property passes automatically to the surviving spouse.2 

A tenancy by the entirety cannot be severed by the act of only one of the parties. Neither spouse can transfer the property unless the other also signs the deed. Thus, a creditor of one tenant cannot claim an interest in that person’s share of property held in tenancy by the entirety. Divorce, however, severs a tenancy by the entirety and transforms it into a tenancy in common. Figure 24.1 compares the features of tenancy in common, joint tenancy, and tenancy by the entirety.

In states that do not recognize the tenancy by the entirety, married  couples often own real property in joint tenancy, but they are not  required to elect that co-ownership form. 2

*** Because the record does not support a finding that Mr. Dornic voluntarily limited his right to partition; because there is no dispute that the properties cannot be physically divided without injury or loss; and because, even according to Mr. Ballard’s calculations, Mr. Dornic owns a more-than-nominal share of each of the properties, which the court may not require him to sell to Mr. Ballard, [the court below] did not err in granting partial summary judgment to Mr. Dornic on his claim for partition-by- sale. . . . Accordingly, the judgment of the Superior Court is Affirmed.

Community Property A number of western and southern states recognize the community property system of co-­ownership of property by married couples. This type of co-ownership assumes that marriage is a partnership



Chapter Twenty-Four Real Property

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Figure 24.1  Tenancy in Common, Joint Tenancy, and Tenancy by the Entirety Tenancy in Common

Joint Tenancy

Tenancy by the Entirety

Equal Possession and Use?

Yes

Yes

Yes

Share Income?

Yes

Yes

Presumably

Contribution Requirement?

Generally

Generally

Generally

Free Conveyance of Interest?

Yes; transferee becomes tenant in common

Yes, but joint tenancy is severed on conveyance and reverts to tenancy in common

Both must agree; divorce severs tenancy

Effect of Death?

Interest transferable at death by will or inheritance

Right of survivorship; ­surviving joint tenant takes decedent’s share

Right of survivorship; surviving spouse takes ­decedent’s share

in which each spouse contributes to the family’s property base. Property acquired during the marriage through a spouse’s industry or efforts is classified as community property. Each spouse has an equal interest in such property regardless of who produced or earned the property. Because each spouse has an equal share in community property, neither can convey community property without the other spouse also joining in the transaction. Various community property states permit the parties to dispose of their interests in community property at death. The details of each state’s community property system vary, depending on the specific provisions of that state’s statutes. Not all property owned by a married person is community property, however. Property a spouse owned before marriage or acquired during marriage by gift or inheritance is separate property. Neither spouse owns a legal interest in the other’s separate property. Property exchanged for separate property also remains separately owned. Tenancy in Partnership When a partnership takes title to property in the partnership’s name, the co-ownership form is called tenancy in partnership. This form of ­co-ownership is discussed in Chapter 37. Condominium Ownership Under condominium ownership, a purchaser takes title to an individual unit and becomes a tenant in common with other unit owners in shared facilities such as hallways, elevators, swimming pools, and parking areas. The condominium owner pays property taxes on the individual unit and makes a monthly payment for the maintenance of the common areas. The owner may generally mortgage or sell the unit without the other unit owners’ approval. Federal income tax laws treat the condominium owner the same as an owner of a singlefamily home, allowing deduction of property taxes and mortgage interest expenses.

Cooperative Ownership In a cooperative, a building is owned by a corporation or group of persons. One who wants to buy an apartment in the building purchases stock in the corporation and holds the apartment under a longterm, renewable lease called a proprietary lease. Frequently, the cooperative owner must obtain the other owners’ approval to sell or sublease the unit.

Interests in Real Property Owned by Others Explain the legal effects of easements and restrictive

LO24-4 covenants as well as the duties of property owners

toward third persons.

In various situations, a person may hold a legally protected interest in someone else’s real property. Such interests, to be discussed below, are not possessory because they do not give their holder the right to complete dominion over the land. Rather, they give the person the right to use another person’s property or to limit the way in which the owner uses the property.

Easements An

easement is the right to make certain uses of another person’s property (affirmative easement) or the right to prevent another person from making certain uses of the property (negative easement). The right to run a sewer line across someone else’s property would be an affirmative easement. Suppose an easement prevents Rogers from erecting, on his land, a structure that would block his neighbor McFeely’s solar collector. Such an easement would be negative in nature.

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Part Five Property

If an easement qualifies as an easement appurtenant, it will pass with the land. This means that if the owner of the land benefited by an easement appurtenant sells or otherwise conveys the property, the new owner also acquires the right contemplated by the easement. An easement appurtenant is primarily designed to benefit a certain tract of land, rather than merely giving an individual a personal right. For example, Agnew and Nixon are next-door neighbors. They share a common driveway that runs along the borderline of their respective properties. Each has an easement in the portion of the driveway that lies on the other’s property. If Agnew sells his property to Ford, Ford also obtains the easement in the driveway portion on Nixon’s land. Nixon, of course, still has an easement in the driveway portion on Ford’s land.

Creation of Easements Easements

may be

acquired in the following ways:

1. By grant. When an owner of property expressly provides an easement to another while retaining ownership of the property, the owner is said to grant an easement. For example, Monroe may sell or give Madison, who owns adjoining property, the right to go across Monroe’s land to reach an alley behind that land. 2. By reservation. When an owner transfers ownership of land but retains the right to use it for some specified purpose, the owner is said to reserve an easement in the land. For example, Smythe sells land to Jones but reserves the mineral rights to the property as well as an easement to enter the land to remove the minerals. 3. By prescription. An easement by prescription is created when one person uses another’s land openly, continuously, and in a manner adverse to the owner’s rights for a period of time specified by state statute. The necessary period of time varies from state to state. In such a situation, the property owner presumably is on notice that someone else is acting as if they possess rights to use the property. If the property owner does not take action during the statutory period to stop the other person from making use of the property, the owner may lose the right to stop that use. Suppose, for instance, that State X allows easements by prescription to be obtained through 15 years of prescriptive use. Tara, who lives in State X, uses the driveway of her next-door neighbor, Kyle. Tara does this openly, on a daily basis, and without Kyle’s permission. If this use by Tara continues for the 15-year period established by statute and Kyle takes no action to stop Tara within that time span, Tara will obtain an easement by prescription. In that event, Tara will have the right to use the driveway not only while Kyle owns the property,

but also when Kyle sells the property to another party. Easements by prescription resemble adverse possession, a concept discussed later in this chapter. 4. By implication. Sometimes, easements are implied by the nature of the transaction rather than created by express agreement of the parties. Such easements, called easements by implication, take either of two forms: easements by prior use and easements by necessity.  An easement by prior use may be created when land is subdivided and a path, road, or other apparent and beneficial use exists as of the time that a portion of the land is conveyed to another person. In this situation, the new owner of the conveyed portion of the land has an easement to continue using the path, road, or other prior use running across the nonconveyed portion of the land. Assume, for example, that a private road runs through Greenacre from north to south, linking the house located on Greenacre’s northern portion to the public highway that lies south of Greenacre. Douglas, the owner of Greenacre, sells the northern portion to Kimball. On these facts, Kimball has an easement by implication to continue using the private road even where it runs across the portion of Greenacre retained by Douglas. To prevent such an easement from arising, Douglas and Kimball would need to have specified in their contract of sale that the easement would not exist.  An easement by necessity is created when real property once held in common ownership is subdivided in such a fashion that the only reasonable way a new owner can gain access to her land is through passage over another’s land that was once part of the same tract. Such an easement is based on the necessity of obtaining access to property. Assume, for instance, that Tinker, the owner of Blackacre, sells Blackacre’s northern 25 acres to Evers and its southern 25 acres to Chance. In order to have any reasonable access to her property, Chance must use a public road that runs alongside and just beyond the northern border of the land now owned by Evers; Chance must then go across Evers’s property to reach hers. On these facts, Chance is entitled to an easement by necessity to cross Evers’s land in order to go to and from her property. In the Francini case, which follows, the Appellate Court of Connecticut had to determine whether an easement by necessity could be granted for something other than physical access to the land. Note how the court relies on the same justifications for the traditional easement by necessity to extend the doctrine to include access to utilities (namely, electricity) for a property that was landlocked from them.



Chapter Twenty-Four Real Property

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Francini v. Goodspeed Airport, LLC   134 A.3d 1278 (Conn. App. Ct. 2016) William Francini owned a parcel of land in East Haddam, Connecticut. The only access from Francini’s land to a public highway was over an abutting property owned by Goodspeed Airport, LLC. Goodspeed acquired its land in 1999 under a warranty deed subject to a right-of-way easement for Francini, as well as several of Francini’s neighbors, each of whom also owned land abutting Goodspeed’s property. In 2001, Goodspeed entered into an agreement with several of Francini’s neighbors, who also shared the right-of-way across defendant’s property, to allow them to improve the right-of-way by installing and maintaining a utility distribution system under the existing easement. As a result, a commercial utility system was constructed under the existing right-of-way, which was used to provide electricity to Francini’s neighbors. Each of the neighbors paid Goodspeed $7,500 for the addition of the utility easement to the right-of-way. Francini likewise offered to pay Goodspeed $7,500 for use of the utility easement, but Goodspeed demanded that Francini not only pay $7,500, but also that he grant it the authority to move the location of the easement at will. (It is not clear from the facts presented in the opinion why Goodspeed treated Francini differently from his neighbors or why Goodspeed would desire to retain the right to move the location of the easement, but Goodspeed did both.) Francini refused the additional terms, and he and Goodspeed never reached an agreement. Without the utility easement, Francini’s property was unable to connect to commercial electric service. Instead, a generator powered his house. The generator was insufficient, though, to run and maintain some of Francini’s basic requirements, like powering security devices and running a refrigerator. Moreover, the generator was not equipped to turn on automatically in the event of a flood. In 2011, Francini sued Goodspeed seeking an easement by necessity for access to commercial utilities across the same right-of-way that he already owned and that already provided his neighbors with commercial electric power. Goodspeed filed a motion for summary judgment, arguing that easements by necessity could not be granted for anything other than physical access to landlocked parcels. The trial court granted Goodspeed’s motion. Francini appealed. The question of whether an easement by necessity could be granted for access to utility services rather than physical access had not yet been addressed by any Connecticut appellate court. Lavery, Judge The common-law easement by necessity creates an implied servitude that burdens one piece of property, the servient estate, for the benefit of another, the dominant estate, to enable the normal “use and enjoyment of the [benefited] property.” In the classic example, “an easement by necessity will be imposed where a conveyance by the grantor leaves the grantee with a parcel inaccessible save over the lands of the grantor, or where the grantor retains an adjoining parcel which he can reach only through the lands conveyed to the grantee.” Hollywyle Assn., Inc. v. Hollister, 324 A.2d 247 (Conn. 1973). In such cases, the element of necessity lies in the grantee’s inability to use his property beneficially because he lacks physical access to it, “[f]or the law will not presume, that it was the intention of the parties, that one should convey land to the other, in such manner that the grantee could derive no benefit from the conveyance; nor that he should so convey a portion as to deprive himself of the enjoyment of the remainder.” Robinson v. Clapp, 32 A. 939 (Conn. 1895). In other words, “the necessity does not create the way, but merely furnishes evidence as to the real intention of the parties”; id.; because courts ascribe to the parties a fictitious intent— presumably, if the parties actually intended there to be an easement, they would have said so in the written grant—based on “the public policy that no land should be left inaccessible or incapable of being put to profitable use.” Thomas v. Primus, 84 A.3d 916 (Conn. App. Ct. 2014). Accordingly, the easement is based on the beliefs that parties do not intend to effectuate

a conveyance that would render the land useless . . . and that parties naturally intend to convey whatever rights are necessary for the use and enjoyment of the land conveyed. . . . Therefore, the imposition of an easement by necessity upon the burdened estate is justified by two partnering rationales, the presumed intent of the parties to the conveyance and general public policy. Today, we conclude that easements by necessity may provide not only physical access to landlocked property, but a property landlocked from commercial utilities may likewise receive an easement by necessity to access utility services. Easements by necessity are not artifacts of a more ancient era and must serve their intended purpose, to render land useful, in the present day as the beneficial use of land conforms to modern innovations and needs. This follows from the general rule that the need constituting the necessity that implies an easement by necessity may change over time. In fact, in the context of a granted right-of-way, the easement’s owner may use the easement for all purposes consistent with the reasonable use of the benefited land and is not limited to using the easement for only those purposes that existed at the time the benefited and burdened properties were created. We therefore reject the defendant’s argument that easements by necessity may be granted only for physical access to landlocked property simply because no such easement has yet been recognized. To “deny [property owners] such right would be to stop to some extent the wheels of progress, and invention, and finally make residence in the country more and more undesirable and less endurable.” Dowgiel v. Reid, 59 A.2d 115 (Pa. 1948).

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Part Five Property

In our view, the legal justifications underlying easements by necessity, intent and public policy, support extending the doctrine to include access to utilities for properties landlocked from them. Utilities are so obviously necessary for the reasonable use and enjoyment of all types of property that the law will assume that parties to a land conveyance intend to convey whatever is necessary to ensure a property’s access to utilities in the same way that the law presumes the parties intended to convey an easement for physical access. Accordingly, we conclude that access to utilities is reasonably necessary to the reasonable use and enjoyment of property, especially, as is the case here, residential property. . . . To deny a residence access to utilities would, prac­tically speaking, deny use of that property as a residence. As further support, under the approach adopted by the Restatement (Third) of Property, Servitudes, a property that is landlocked from commercial electricity enjoys an implied easement by necessity for utility services. The Restatement (Third), itself adopted eighteen years ago, explains that “the increasing dependence in recent years on electricity and telephone service, delivered through overland cables, justify the conclusion that

implied servitudes by necessity will be recognized for those purposes.” By including access to commercial electricity within the easement by necessity, the Restatement (Third) recognizes that “‘[n]ecessary’ rights are not limited to those essential to enjoyment of the property, but include those which are reasonably required to make effective use of the property.” Therefore, because electricity is essential to daily life and is reasonably required to make effective use of property, the easement by necessity includes not only physical access to landlocked property, but also access to utilities for properties landlocked from utilities. This decision honors both the principles underlying the easement by necessity and the fundamental actualities of modern life.

Easements and the Statute of Frauds As interests in land, easements are potentially within the coverage of the statute of frauds. To be enforceable, an express agreement granting or reserving an easement must be evidenced by a suitable writing signed by the party to be charged.3 An express grant of an easement normally must be executed with the same formalities observed in executing the grant of a fee simple interest. However, easements not granted expressly (such as easements by prior use, necessity, or prescription) are enforceable despite the lack of a writing.

permission for the licensee to enter the property. Because licenses are considered to be personal rights, they are not true interests in land. The licensor normally may revoke a license at will. Exceptions to this general rule of revocability arise when the license is coupled with an interest (such as the licensee’s ownership of personal property located on the licensor’s land) or when the licensee has paid money or provided something else of value either for the license or in reliance on its existence. For example, Branch pays Leif $900 for certain trees on Leif’s land. Branch is to dig up the trees and haul them to her own property for transplanting. Branch has an irrevocable license to enter Leif’s land to dig up and haul away the trees.

Profits A

profit is a right to enter another person’s land and remove some product or part of the land. Timber, gravel, minerals, and oil are among the products and parts frequently made the subject of profits. Generally governed by the same rules applicable to easements, profits are sometimes called easements with a profit.

Licenses A license is a temporary right to enter another’s land for a specific purpose. Ordinarily, licenses are more informal than easements. Licenses may be created orally or in any other manner indicating the landowner’s Chapter 16 discusses the statute of frauds and compliance with the writing requirement it imposes when it is applicable. 3

*** The judgment is reversed and the case is remanded with direction to deny the defendant’s motion for summary judgment and for further proceedings according to law. Note: In 2018, the Connecticut Supreme Court affirmed the Connecticut Appellate Court’s decision in this case. See Francini v. Goodspeed Airport, LLC, 174 A.3d 779 (Conn. 2018).

Restrictive Covenants Within

certain limitations, real estate owners may create enforceable agreements that restrict the use of real property. These private agreements are called restrictive covenants. For example, Grant owns two adjacent lots. She sells one to Foster subject to the parties’ agreement that Foster will not operate any liquor-selling business on the property. This use restriction appears in the deed Grant furnishes Foster. As another illustration, a subdivision developer sells lots in the subdivision and places a provision in each lot’s deed regarding the minimum size of house to be built on the property.



Chapter Twenty-Four Real Property

The validity and enforceability of such private restrictions on the use of real property depend on the purpose, nature, and scope of the restrictions. A restraint that violates a statute or other expression of public policy will not be enforced. For example, the federal Fair Housing Act (discussed later in this chapter) would make unlawful an attempt by a seller or lessor of residential property to refuse to sell or rent to certain persons because of an existing restrictive covenant that purports to disqualify those prospective buyers or renters on the basis of their race, color, religion, sex, disability, familial status, or national origin. Public policy generally favors the unlimited use and transfer of land. A restrictive covenant, therefore, is unenforceable if it effectively prevents the sale or transfer of the property. Similarly, ambiguous language in a restrictive covenant is construed in favor of the less restrictive interpretation. A restraint is enforceable, however, if it is clearly expressed and neither unduly restrictive of the use and transfer of the property nor otherwise violative of public policy. Restrictions usually held enforceable include those relating to minimum lot size, building design and size, and maintenance of an area as a residential community. An important and frequently arising question is whether subsequent owners of property are bound by a restrictive covenant even though they were not parties to the original agreement that established the covenant. Under certain circumstances, restrictive covenants are said to “run with the land” (or, in legal jargon, are “appurtenant”) and thus bind

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subsequent owners of the restricted property. For a covenant to run with the land, it must have been binding on the original parties to it, and those parties must have intended that the covenant bind their successors. The covenant must also “touch and concern” the restricted land. This means that the covenant must involve the use, value, or character of the land, rather than being merely a personal obligation of one of the original parties. The legal jargon for the latter is that such restrictive covenants are “in gross.” The Wykeham Rise case, which follows, involves the analysis of whether a restrictive covenant runs with the land. In addition, a covenant will typically bind a subsequent purchaser who had notice of the covenant’s existence when taking the interest. This notice would commonly be provided by the recording of the deed (a subject discussed later in this chapter) or other document containing the covenant. Restrictive covenants may be enforced by the parties to them, by persons meant to benefit from them, and—if the covenants run with the land—by successors of the original parties to them. If restrictive covenants amounting to a general building scheme are contained in a subdivision plat (recorded description of a subdivision), property owners in the subdivision may be able to enforce them against noncomplying property owners. The following Wykeham Rise case considers whether a subsequent purchaser retains the ability to enforce the benefit of restrictive covenants, along with whether the burden of the covenants runs with the land.

Wykeham Rise, LLC v. Federer   52 A.3d 702 (Conn. 2012) A parcel of land that was owned by the Wykeham Rise School abutted an adjacent property owned by Bertram Read, who was a member of the school’s board of trustees and past chairman of the board. In 1990, the school sold the property to a limited liability corporation subject to a set of restrictive covenants, one of which provides that the grantee “will not construct any buildings or other structures or any parking lots on that area of the above described premises lying within 300 feet, more or less, at all points . . . [of the] area now commonly known as ‘the Playing Field.’” The deed further provides that “[t]he foregoing covenants and agreements shall be binding upon the [g]rantee, its successors and assigns, shall inure to the benefit of the [g]rantor, its successors and assigns, and shall run with the land.” The covenant said nothing explicitly about third parties. Also in 1990, the school was administratively dissolved by the Connecticut Secretary of State. Over the next 17 years, the school property changed hands a couple of times, first to another LLC and then to Wykeham Rise, the plaintiff in this case, in 2008. The deed conveyed to Wykeham Rise expressly referenced the restrictive covenants. Around 1995, during the time that the second LLC owned the property (i.e., the one prior to the plaintiff), Read sold his land to his daughter and son-in-law, Wendy and Eric Federer. In 2005, Wendy Federer and the chairman of the now-defunct school’s board of trustees executed a document purporting to assign the school’s rights under the restrictive covenants to Wendy Federer in exchange for consideration of $500. Several years later, Wendy Federer also executed and recorded a “Declaration of Beneficial Ownership” claiming the right, along with Eric Federer and their heirs and assigns, to the benefit of the covenants as owners of the adjacent property. After purchasing the school property, Wykeham Rise sought permits to develop it in a manner inconsistent with the terms of the restrictive covenants. The Federers objected to the issuance of the permits and brought an administrative appeal after one such permit

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Part Five Property

was issued. Wykeham Rise then filed a suit seeking a declaratory judgment that the covenants “are null and void, are of no legal effect, and are accordingly unenforceable as to [Wykeham Rise], it’s successors, and assigns. . . .” The Federers counterclaimed, seeking to have the covenants declared enforceable and, thereby, to enjoin Wykeham Rise from violating them. Wykeham Rise moved for summary judgment on both its declaratory judgment action and on the Federers’ counterclaims, arguing that the restrictive covenants were invalid and regardless were neither enforceable by the Federers nor applicable to Wykeham Rise because the covenants did not run with the land. On the basis of the pleadings and affidavits submitted by both parties, the trial court ruled in favor of Wykeham Rise. The court concluded that “the restrictive covenants are null, void and of no legal effect because they were void at the time they were first conveyed in 1990.” The court further concluded that the facts did not establish that the covenants were intended to benefit the Federers’ property and that the covenants were of a personal nature that did not run with the land. The defendants’ appeal followed. Harper, Justice I The threshold question presented by this case—whether the trial court properly concluded, as a matter of law, that the covenants were not properly created—can be answered in relatively straightforward fashion. First, because the covenants were created as part of a conveyance of land, they are subject to the formal writing and recording requirements set forth in [Connecticut statutory enactments]. To be valid, covenants also must not violate the public interest. [Citations omitted.] In the present case, no formal or public policy defects in the formation of the covenants at issue have been alleged, nor are any such invalidating features apparent on the face of the covenants. It is therefore clear that summary judgment could not properly have been rendered on the ground that the covenants are inherently invalid. . . . II Having determined that summary judgment could not properly have been granted on the ground that the covenants are inherently invalid, we address the possibility that summary judgment was nonetheless appropriate on the ground that the covenants are unenforceable. More precisely, we consider whether the covenants, presumably enforceable as between the original covenanting parties, remain effective as between the parties in the present case, who are both strangers to that initial agreement. For purposes of clarity, we divide our analysis of enforceability into two parallel inquiries, outlining on the one hand the considerations governing whether the burdens of the covenants pass to [Wykeham Rise], and on the other hand whether the covenants’ benefits pass to the [Federers]. A The first question, whether the plaintiff can properly be burdened by the covenants at issue, implicates both principles of law and considerations of equity. Our inquiry begins with consideration of whether the burdens are to be characterized as “running with

the land” (appurtenant) or as personal (in gross)—that is, whether they apply to the burdened property itself or rather to the person of the initial grantee. As we later explain, in the present case the covenants may be enforced at law only if they run with the land such that the plaintiff acquired the school property subject to the covenants. Even if the covenants do not run with the land, however, we also must consider whether the plaintiff may nonetheless be subject to them as a matter of equity. We conclude that the covenant burdens in the present case are likely enforceable against the plaintiff both at law and in equity. 1 Whether the covenants’ burdens run with the land is, primarily, a question of the parties’ intent. [Citations omitted.] The presence or absence of express words of succession—such as “heirs” or “assigns”—offers strong, though not conclusive, evidence of whether the parties intended to bind future owners of the land. . . . The intent of the parties, however, is not dispositive, insofar as obligations that are inherently personal cannot be made appurtenant to the land. Thus, “[t]he use of words of succession binding the ‘heirs and assigns’ of the grantee of restricted land does not in itself cause the burden to run if the nature of the restriction is not one which could run with the land. . . . It is well settled that a covenant personal in its nature and relating to something collateral to the land cannot be made to run with the land so as to charge the assignee by the fact that the covenantor covenanted on behalf of himself and his assigns.” Pulver v. Mascolo, 155 Conn. 644, 650–51 (1967). On the other hand, “[i]f [a promise] touches the land involved to the extent that it materially affects the value of that land, it is generally to be interpreted as a covenant which runs with the land.” Carlson v. Libby, 137 Conn. 362, 367 (1950). With respect to the relative strength of these competing considerations, moreover, this court has long held that a restrictive covenant “will not be inferred to be personal when it can fairly be construed to be appurtenant to the land. . . .” Bauby v. Krasow, 107 Conn. 109, 114 (1927). In addition to these considerations, one final formal requirement also potentially bears on the question of whether



Chapter Twenty-Four Real Property

a covenant’s burdens may be said to run with the land so as to bind a stranger to the covenant. Common-law doctrine dictates that covenants may run with the land only if they are conveyed along with some other interest in land. As this court previously has held, relying on an earlier Restatement of Property, “[t]he burden of a covenant will run with land only when the transaction of which the covenant is a part includes a transfer of an interest in land which is either benefited or burdened thereby. . . .” Carlson v. Libby, 137 Conn. [at] 368. 2 Alongside the legal rules governing whether the restrictive covenants in the present case run with the land, long-standing equitable principles applicable to restrictive covenants provide an important, and independent, framework for determining whether the covenants’ burdens may be enforced as a matter of equity. This court has long recognized that “[t]he question whether [a restrictive] covenant runs with the land is material in equity only on the question of notice. If it runs with the land, it binds the owner whether he had knowledge of it or not. If it does not run with the land, the owner is bound only if he has taken the land with notice of it. . . . The question is, not whether the covenant runs with the land, but whether a party shall be permitted to use the land in a manner inconsistent with the contract entered into by his vendor, and with notice of which he purchased. The decisions proceed upon the principle of preventing one having knowledge of the just rights of another from defeating such rights, and not upon the theory that the covenants enforced create easements or are of a nature to run with the land.” Bauby v. Krasow, 107 Conn. [at] 112 [(internal citation and quotes omitted)]. Therefore, under the rules of equity, if the plaintiff took the property in question with notice that it is burdened by restrictive covenants, it may be bound in equity to those burdens, regardless of whether the burdens run with the land. 3 Turning to the summary judgment rendered in the plaintiff’s favor in the present case, we cannot say as a matter of law that the burdens of the covenants at issue in this case do not run with the land. Indeed, there is strong evidence to the contrary: the covenants were formally created as part of a transfer of land; they explicitly provide that they are “binding upon the [g]rantee, its successors and assigns, shall inure to the benefit of the [g]rantor, its successors and assigns, and shall run with the land”; and they appear on their face to relate to the land and not to impose any conceivable burden on the initial grantee independent of its ownership of the land. We recognize that circumstantial facts may emerge casting doubt on the apparent intent of the covenanting parties to create burdens appurtenant to the land; however, such determinations are for the finder of fact to make with the benefit of evidence introduced at trial.

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Even if the covenants did not meet all the requirements at law for the burden to run with the land, the issue of enforceability also turns on the possibility of an equitable remedy. In the present case, there is uncontested evidence indicating that the covenants at issue restrict [Wykeham Rise] from using the land in certain ways, rather than requiring affirmative action by [Wykeham Rise], a burden that could not be enforced in equity. There is also uncontested evidence that [it] knew of these covenants at the time of purchase. Although further facts may be uncovered that preclude [Wykeham Rise] from being burdened by the covenants, at this point it cannot be said as a matter of law that those burdens do not apply to [it], either at law or in equity. B Looking to the other side of the equation, we now outline the conditions that must be met in order for the [Federers] to potentially enforce the covenants against [Wykeham Rise], such that summary judgment could not have been rendered on this basis. The [Federers] claim the right to enforce the covenants as the successors or assigns of the covenants’ original beneficiary or beneficiaries. We must therefore consider the covenants’ benefits at two points in time: first, looking to the time of the covenants’ creation, we determine the intended beneficiary or beneficiaries and the type of benefit or benefits created; second, looking to the present time, we determine whether the [Federers] could obtain the right to those benefits by way of assignment or devolution. . . . [T]he trial court decided that it was not necessary to reach [Wykeham Rise]’s claim that the rights to enforce the covenants had not been validly assigned to the [Federers]. We conclude that the [Federers] are not precluded from enforcing the covenants as a matter of law and that material questions of fact exist regarding whether they may enforce the covenants here. As with covenant burdens, covenant benefits may be appurtenant (directly benefiting the land) or in gross (accruing to a person independent of ownership of land) and may be held by the signatory to the covenant as well as third parties that the parties to the covenant intended to so benefit. The covenant benefits in the present case, at the time of their creation, thus may conceptually be described in one or more of four ways: (1) the benefits inured to the school as the owner of a piece of land; (2) the benefits inured to the school independent of its ownership of land; (3) the benefits inured to Read, Wendy Federer’s father, a third party beneficiary, as owner of the land adjacent to the school; and (4) the benefits inured to Read independent of his ownership of land. Under the circumstances of this case, we focus on scenarios two and three, leaving the relatively implausible scenarios represented by one and four to the side. We consider each in turn along with the related question of whether the defendants properly could have obtained those benefits.

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Part Five Property

1 We consider first whether the benefits of the covenants inured to the school in a manner that is independent of its ownership of a particular parcel of land. It is clear that these benefits in gross may validly be created. [Citation omitted.] A further question potentially arises regarding whether the right to such benefits may be transferred or assigned. Although this court previously has not addressed this specific question, related case law indicates that such assignments properly can be made, if consistent with the covenanting parties’ intent. Assignability of rights is clearly favored with respect to contracts generally. [Citations omitted.] We find this approach generally appropriate to covenant rights held in gross; however, recognizing that the burdens of covenants typically endure far longer than those of contracts, we add the important caveat that covenant benefits (or burdens) in gross may not be transferred if doing so would be inconsistent with the intent of the parties. . . . Accordingly, under this rubric, if the benefits were intended to benefit the school, and the parties did not intend them to be nonassignable, the school could validly assign those benefits to the [Federers]. 2 Turning to the alternative plausible interpretation of the covenants in the present case, we next consider whether the [Federers] may enforce the covenants on the theory that Read, as the owner of the land adjacent to the school property, was the intended third party beneficiary of the covenant between the school and the initial buyer of the school property and that, by virtue of their purchasing the benefited parcel of land, the right to enforce the covenants [passed on] to the defendants. The third party beneficiary doctrine provides that “[a] third party beneficiary may enforce a contractual obligation without being in privity with the actual parties to the contract. . . . Therefore, a third party beneficiary who is not a named obligee in a given contract may sue the obligor for breach.” Wilcox v. Webster Ins., Inc., 294 Conn. 206, 217 (2009). Although the third party beneficiary doctrine was originally developed in the law of contracts, this court has recognized that third party beneficiaries may enforce covenants in land. Under the third party beneficiary doctrine, “[t]he ultimate test to be applied [in determining whether a person has a right of action as a third party beneficiary] is whether the intent of the parties to the contract was that the promisor should assume a direct obligation to the third party [beneficiary]. . . . [T]hat intent is to be determined from the terms of the contract read in the light of the circumstances attending its making, including the motives and purposes of the parties. . . . [I]t is not in all instances necessary that there be express language in the contract creating

a direct obligation to the claimed third party beneficiary. . . .” Dow & Condon, Inc. v. Brookfield Development Corp., 266 Conn. 572, 580 (2003). 3 With this framework in mind, we now look to the undisputed facts of the present case relating to covenant benefits and the intent of the covenanting parties that may be discerned from those facts. First, it is possible to conclude that the covenants at issue created a transferable benefit in gross that inured to the school independent of its ownership of land. Specifically, the deed provides that the covenant benefits “shall inure to the benefit of the [g]rantor, its successors and assigns, and shall run with the land.” This language makes clear that the parties intended to create an enduring benefit that would survive the school, but because the school retained no land following the sale, any benefits conferred on the school cannot possibly be appurtenant to the land and therefore must be construed to be in gross. The possibility that the covenants at issue created a transferable benefit in gross in the school sets up a potentially dispositive question regarding whether the school has transferred that right to Wendy Federer. It appears that the school and Wendy Federer attempted to accomplish such a transfer, but that the putative transfer occurred after the school had been dissolved by administrative order. . . . In the present case, the trial court concluded that the covenants are void and therefore made no determination whether there are material questions of fact regarding whether the school’s attempted transfer of its rights under the covenant qualified as [permissible under the Connecticut statute that allows dissolved organizations to “wind up” their affairs]. With respect to the question of whether the defendants could enforce the covenants in the present case as third party beneficiaries, the trial court concluded that “the present deed expresses a clear intent to benefit the grantor, the school, not the defendants’ property, and the surrounding circumstances do not contradict that intent.” After a review of the record, we conclude that the trial court improperly determined that there are no issues of material fact regarding whether the parties to the original contract intended that the covenants would provide an appurtenant benefit to Read as owner of the adjacent property now owned by the defendants. Although the covenants do not specifically mention the adjacent property or Read, the circumstances surrounding the transaction at the very least create an ambiguity as to whether the covenants were intended to confer such a benefit. Although the school may enjoy some personal benefits from the covenants notwithstanding the fact that it retained no land, the most obvious and direct benefits of the covenants flowed to Read as the owner of the adjacent land. The clear aesthetic—and likely



Chapter Twenty-Four Real Property

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financial—benefits conferred on Read’s property from not having the school property commercially developed, considered along with the relationship between Read and the school and the fact that, as attested to by the chairman of the school’s board of trustees, Read’s request prompted the creation of the covenants, could provide a factual basis for concluding that the original covenanting parties intended the covenants to be enforceable by the owner of the defendants’ land. Faced with uncertainty in the factual record on this issue, the trial court could not properly have rendered summary judgment on the ground that the defendants are not entitled to enforce the covenants. We thus conclude that the enforceability of the covenants in the present case cannot be foreclosed as a matter of law. Further

proceedings are necessary to determine both whether the plaintiff is bound by the covenants’ burdens, as a matter of law or equity, and whether the defendants may enforce the covenants as assignees of the school’s interest or, alternatively, as third party beneficiaries to whom Read’s third party interest [passed]. Additionally, it may be necessary to determine whether, even if valid at the time of creation and properly passed down to the parties here, the covenants continue to serve “a legal and useful purpose” and thus remain enforceable burdens on the plaintiff’s land. Gangemi v. Zoning Board of Appeals, 255 Conn. 143, 151 (2001). . . .

Termination of Restrictive Covenants Restrictive covenants may be terminated in a variety of ways, including voluntary relinquishment or waiver. They may also be terminated by their own terms (such as when the covenant specifies that it is to exist for a certain length of time) or by dramatically changed circumstances. If Oldcodger’s property is subject, for instance, to a restrictive covenant

allowing only residential use, the fact that all of the surrounding property has come to be used for industrial purposes may operate to terminate the covenant. When a restrictive covenant has been terminated or held invalid, the deed containing the restriction remains a valid instrument of transfer but is treated as if the restriction had been removed from the document.

The judgment is reversed and the case is remanded for further proceedings.

Ethics and Compliance in Action Joel Misita is a folk artist who creates and sells custom pieces of large metal sculptures from scrap. He lives on a 10-acre plot of scenic land in Adams County, Mississippi, just off of Highway 61. He originally owned seven acres, upon which he built a large three-story house in which his metalwork studio takes up the ground floor, several outbuildings, and sheds. He also stores several trailers, sculptures, and the metal raw materials for his sculptures. Kevin and Rebecca Wilson agreed to sell Misita a three-acre plot that abuts Misita’s original land and fronts Highway 61. The plot is in direct line of the scenic view of the area from the Wilson’s property. The deed to the plot includes a restrictive covenant “that no structures are to be erected on the property” because the Wilsons were otherwise concerned that Misita might clutter the land like his existing property or build another large structure on it. The Wilsons subsequently sold their land to Roy and Mitzi Conn. The restrictive covenant played a major role in the

Conn’s decision to purchase the property, as it prevented the three-acre frontage portion of Misita’s property from becoming “junked-up” like the rest of it. After the Conns moved in, though, Misita built and stored on the plot a “sign” in the shape of a triangular prism, which is intended to advertise his art. The design of the “sign” is such that its interior is big enough to serve as a showroom for his art as well. The sign/showroom has a hitch at one vertex of the prism’s base and wheels on the other two vertices. The sign/ showroom sat in the area subject to the “no-structure” restrictive plot for months without being moved. The Conns complained that the “sign” violates the restrictive covenant. Misita insisted that it is not a structure within the meaning of the covenant because it is movable. Regardless of whether Misita’s argument would withstand legal scrutiny, does he have any ethical obligation to honor the spirit of the restrictive covenant and remove the “sign”?

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Part Five Property

Acquisition of Real Property Distinguish the various ways in which ownership of real LO24-5 property is transferred and how title to property can be assured.

Title to real property may be obtained in various ways, including purchase, gift, will or inheritance, tax sale, and adverse possession. Original title to land in the United States was acquired either from the federal government or from a country that held the land prior to its acquisition by the United States. The land in the 13 original colonies had been granted by the king of England either to the colonies or to certain individuals. The states ceded the land in the Northwest Territory to the federal government, which in turn issued grants or patents of land. Original ownership of much of the land in Florida and the Southwest came by grants from Spain’s rulers.

Acquisition by Purchase Selling

one’s real property is a basic ownership right. Unreasonable restrictions on an owner’s right to sell her property are considered unenforceable because they violate public policy. Most owners of real property acquired title by purchasing the property. Each state sets the requirements for proper conveyances of real property located in that state. The various elements of selling and buying real property are discussed later in this chapter.

Acquisition by Gift Real property ownership may

be acquired by gift. For a gift of real property to be valid, the donor must deliver a properly executed deed to the donee or to some third person who is to hold it for the donee. Neither the donee nor the third person needs to take actual possession of the property. Intent to make a gift is required. The gift’s essential element is delivery of the deed. Suppose that Fields executes a deed to the family farm and leaves it in his safe-deposit box for delivery to his daughter (the intended donee) when he dies. The attempted gift will not be valid because Fields did not deliver the gift during his lifetime.

Acquisition by Will or Inheritance The owner

of real property generally has the right to dispose of the property by will. The requirements for a valid will are discussed in Chapter 26. If the owner of real property dies without a valid will, the property passes to the owner’s heirs as determined under the laws of the state in which the property is located.

Acquisition by Tax Sale If

taxes assessed on real property are not paid when due, they become a lien

on the property. This lien has priority over other claims to the land. If the taxes remain unpaid, the government may sell the land at a tax sale. Although the purchaser at the tax sale acquires title to the property, a number of states have statutes giving the original owner a limited time (such as a year) within which to buy the property from the tax sale purchaser for the price paid by the purchaser, plus interest.

Acquisition by Adverse Possession Each

state has a statute of limitations that gives an owner of land a specific number of years within which to bring suit to regain possession of her land from someone who is trespassing on it. This period varies from state to state, generally ranging from 5 to 20 years. If someone wrongfully possesses land and acts as if he were the owner, the actual owner must take steps to have the possessor ejected from the land. If the owner fails to do this within the statutory period, the owner loses the right to eject the possessor. Assume, for example, that Titus owns a vacant lot next to Holdeman’s house. Holdeman frequently uses the vacant lot for a variety of activities and appears to be the property’s only user. In addition, Holdeman regularly mows and otherwise maintains the vacant lot. He has also placed a fence around it. By continuing such actions and thus staying in possession of Titus’s property for the statutory period (and by meeting each other requirement about to be discussed), Holdeman may position himself to acquire title to the land by adverse possession. To acquire title by adverse possession, one must possess land in a manner that puts the true owner on notice of the owner’s cause of action against the possessor. The adverse possessor’s acts of possession must be (1) open and ­notorious, (2) actual, (3) continuous, (4) exclusive, and (5) hostile (or adverse) to the owner’s rights. The hostility element is not a matter of subjective intent. Rather, it means that the adverse possessor’s acts of possession must be ­inconsistent with the owner’s rights. If a person is in possession of another’s property under a lease, as a cotenant, or with the permission of the owner, that person’s possession is not hostile. In some states, the possessor of land must also pay the property taxes in order to gain title by adverse possession. It is not necessary that the same person occupy the land for the statutory period. The periods of possession of several adverse possessors may be “tacked” together when calculating the period of possession if each possessor claimed rights from another possessor. The possession must, however, be continuous for the requisite time. The following Stratford case considers a claim of adverse possession, focusing on what it means to actually, openly, and notoriously possess land.



Chapter Twenty-Four Real Property

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Stratford v. Long   430 S.W.3d 921 (Mo. Ct. App. 2014) Robert and Dora Stratford and Roger and Pamela Long own abutting parcels of land in Douglas County, Missouri. They disagreed about the ownership of a strip of land running the length of their shared boundary. It also includes a natural spring and waterfall that flows from the spring. A good portion of the disputed area of land is rugged. The Stratfords purchased their land in 1976 and moved onto the property in 1985. When they moved onto the land, there was an existing fence on the northwest corner of the property that bent west around the upper ledge of the waterfall. The Stratfords wrongly assumed that the fence marked the boundary line between the two properties. The Stratfords undertook a number of projects that reflected their mistaken belief that the disputed strip of land was within their purchased plot. Sometime after 1985—but well before 2005, when the Longs purchased the neighboring parcel—the Stratfords installed a 1,500-foot coil that ran from their home’s geothermal heat pump through the disputed land to the spring. They also constructed a berm, 374 feet in length, that separated a smaller stream from the larger spring on the property. The berm extended from the Stratfords’ property into the disputed area as well. In 1997, they constructed a fence on what they understood to be their west boundary line, beginning in the southwest corner of their property and connecting to the existing fence around the waterfall on the northwest corner. The Stratfords told Russell Doran, who was the owner of what eventually became the Longs’ property, that the fence was on the survey line. The Stratfords intended to establish a boundary line with the fence. The new fence ran through a pasture and was clearly visible. Doran used his property as a cattle pasture, allowing the cattle to graze up to the fence but not beyond it. Finally, the Stratfords mowed and cleared brush from the land in the disputed area at least once per year and allowed their bees to use the area to pollinate. The Longs purchased the neighboring property in 2005. Based on their own survey of the property boundary, they concluded that the Stratfords’ fence and other developments encroached on their land. When they could not work out a compromise, the Stratfords filed a petition with the court to quiet title, which is an action asking the court to determine the true owner of a piece of land and to remove or “quiet” any challenges or claims to title in the land. They claimed that they had acquired title to the land through adverse possession. The Longs responded with a counterclaim seeking a declaratory judgment that the legal description in their deed marked the proper boundary of their land. Following a bench trial, the judge found in favor of the Longs, concluding that the Stratfords had not proven their adverse possession claim because their possession of the disputed area had not been actual, open, and notorious. The Stratfords appealed, so they are referred to as “Appellants” in the opinion below. The Longs are referred to as “Respondents.”

Jeffrey W. Bates, Judge In Appellants’ first two points, they contend the trial court misapplied the law by concluding that Appellants failed to prove their adverse possession claim. Appellants argue that the facts found by the court were sufficient to prove that Appellants’ possession of the disputed area was actual, open and notorious. We agree. A party who seeks to establish title to real property by adverse possession must prove that he possessed the land, and that his possession was: (1) hostile and under a claim of right; (2) actual; (3) open and notorious; (4) exclusive; and (5) continuous for a period of ten years. Conduff v. Stone, 968 S.W.2d 200, 203 (Mo. App. 1998). The claimant’s failure to prove even one of the elements of adverse possession will defeat his claim. . . . The Actual Possession Element “Actual possession is the present ability to control the land and the intent to exclude others from such control.” Eime v. Bradford, 185 S.W.3d 233, 236 (Mo. App. 2006). “A mere mental enclosure of land does not constitute the requisite actual possession.” [Harris v. Lynch, 940 S.W.2d 42, 45 (Mo. App. 1997)]. “Rather,

there must be continual acts of occupying, clearing, cultivating, pasturing, erecting fences or other improvements and paying taxes on the land.” Id. The trial court cited [prior case law] for the proposition that, to prove the element of actual possession, Appellants were required to show they used the entire disputed area. The trial court concluded that: The credible evidence in this case showed, as to the entire contested area, the [Appellants] made no use of the entire contested parcel. There was no evidence that [Appellants] used the entire parcel for any use. Part of this parcel was a low-lying natural spring area, another quite small part was pasture, while much of the land was unimproved, rough and hilly timbered land. The [Appellants’] evidence was devoid of facts that would show that the “entire” area was used for anything. Accordingly, the Court finds that the [Appellants] have failed to prove actual possession of the entire parcel. We agree with Appellants that the trial court misapplied the law to its factual findings in reaching this legal conclusion. The trial court failed to account for the densely wooded and rugged nature of much of the disputed area. “The ‘actual

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Part Five Property

possession’ element of adverse possession is less strict for wild, undeveloped land than it is for developed land, because the nature, location, and possible uses for the property may restrict the type of affirmative acts of ownership that may be appropriate for the land.” [Luttrell v. Stokes, 77 S.W.3d 745, 749 (Mo. App. 2002).] The trial court’s own factual findings demonstrate that Appellants ran a long geothermal coil from their home to the spring and constructed a large 374-foot berm in part on the disputed area. Appellants also used the wooded part of the disputed area to allow their bees to pollinate. “[T]he nature of the property determines the kinds of acts which constitute possession.” Cunningham v. Hughes, 889 S.W.2d 864, 867 (Mo. App. 1994). Given the “rough and hilly” quality of most of the disputed area, these acts are sufficient to establish Appellants’ actual possession of the disputed area. Appellants also constructed a fence through the open, pasture part of the disputed area. By constructing the fence through the pasture, Appellants established a boundary and limited use of the pasture by Respondents’ predecessors’ cattle. . . . Appellants also maintained the land on their side of the fence by cutting the brush and clearing the pasture. Again, the acts of possession undertaken by Appellants, considered together, are sufficient to satisfy the actual possession element in light of the character and location of the disputed area. The Open and Notorious Possession Element In the judgment, the trial court [held] that Appellants had to prove their occupancy was “conspicuous, widely recognized and commonly known” in order to satisfy the open and notorious possession element of their adverse possession claim. The trial court concluded that Appellants failed to prove this element because they did not install “No Trespassing” signs. Appellants argue that the trial court misapplied the law in concluding that the facts it found were insufficient to prove open and notorious possession. Once again, we agree.

Transfer by Sale Steps in a Sale The major steps normally involved in the sale of real property are:

1. Contracting with a real estate broker to locate a buyer. 2. Negotiating and signing a contract of sale. 3. Arranging for the financing of the purchase and satisfying other requirements, such as having a survey conducted or acquiring title insurance.

The requirement that the occupancy be “conspicuous, widely recognized, and commonly known” exists to make sure that “the legal owner had cause to know of the adverse claim of ownership by another.” Bowles v. McKeon, 217 S.W.3d 400, 405 (Mo. App. 2007). . . . “The open and notorious requirement of adverse possession can be met by showing the defendant’s actual knowledge of a plaintiff’s claim.” Dobbs v. Knoll, 92 S.W.3d 176, 183 (Mo. App. 2002). Knowledge or notice has been held to mean “knowledge of all that would be learned by reasonable inquiry.” Id. . . . The trial court found that: (1) Doran was told by Appellants that they were constructing a boundary fence through the open pasture; and (2) once the fence was installed, Doran’s cattle used the pasture only up to Appellants’ fence line. Therefore, Doran had actual knowledge of Appellants’ possession of the disputed area and their intention to claim all of the land inside the fence as their own. Thereafter, Doran accepted the fence as the boundary line, and the cattle he pastured in the field were not able to cross the fence line to graze on the disputed area any longer. None of Respondents’ predecessors in title challenged Appellants’ use of the disputed property at any time during the statutory period. The court also found that Appellants’ 374-foot berm, which took three years to construct, was visible from the county road, despite the rugged and wooded nature of the land in that area. The foregoing factual findings were sufficient to prove that Appellants’ use of the disputed area was open and notorious. Taking into account the character of the disputed area and Doran’s actual knowledge of Appellants’ use of the land, their possession of the property was sufficiently conspicuous to satisfy the open and notorious requirement.

The trial court’s judgment in favor of Respondents is reversed. The cause is remanded for further proceedings consistent with this opinion.

4. Closing the sale, which involves payment of the purchase price and transfer of the deed, as well as other matters. 5. Recording the deed.

LOG ON For a variety of articles about practical aspects of buying, selling, or owning real estate, see Nolo Real Estate Law Center at www.nolo.com/legal-encyclopedia/buying-house/.



Chapter Twenty-Four Real Property

Contracting with a Real Estate Broker  Although engaging a real estate broker is not a legal requirement for the sale of real property, it is common for one who wishes to sell his property to “list” the property with a broker. A listing contract empowers the broker to act as the seller’s agent in procuring a ready, willing, and able buyer and in managing details of the property transfer. A number of states’ statutes of frauds require listing contracts to be evidenced by a writing and signed by the party to be charged. Real estate brokers are regulated by state and federal law. They owe fiduciary duties (duties of trust and confidence) to their clients. Chapter 35 contains additional information regarding the duties imposed on such agents.

Types of Listing Contracts Listing contracts specify such matters as the listing period’s duration, the terms on which the seller will sell, and the amount and terms of the broker’s commission. There are different types of listing contracts. 1. Open listing. Under an open listing contract, the broker receives a nonexclusive right to sell the property. This means that the seller and third parties (e.g., other brokers) also are entitled to find a buyer for the property. The broker operating under an open listing is entitled to a commission only if he was the first to find a ready, willing, and able buyer. 2. Exclusive agency listing. Under an exclusive agency listing, the broker earns a commission if he or any other agent finds a ready, willing, and able buyer during the period of time specified in the contract. Thus, the broker operating under such a listing would have the right to a commission even if another broker actually procured the buyer. Under the exclusive agency listing, however, the seller has the right to sell the property himself without being obligated to pay the broker a commission. 3. Exclusive right to sell. An exclusive right to sell contract provides the broker the exclusive right to sell the property for a specified period of time and entitles her to a commission no matter who procured the buyer. Under this type of listing, a seller must pay the broker her commission even if it was the seller or some third party who found the buyer during the duration of the listing contract.

Contract of Sale The contract formation, perfor-

mance, assignment, and remedies principles about which you read in earlier chapters apply to real estate sales contracts. Such contracts identify the parties and subject property, and set forth the purchase price, the type of deed the purchaser will receive, the items of personal property (if any) included in the sale, and other important aspects of the parties’ transaction. Real estate sales contracts often make the closing of the sale contingent on the buyer’s

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obtaining financing at a specified rate of interest, on the seller’s procurement of a survey and title insurance, and on the property’s passing various inspections. Because they are within the statute of frauds, real estate sales contracts must be evidenced by a suitable writing signed by the party to be charged in order to be enforceable. Financing the Purchase The various arrangements for financing the purchase of real property—such as mortgages, land contracts, and deeds of trust—are discussed in ­Chapter 28.

Fair Housing Act The Fair Housing Act, enacted

by Congress in 1968 and substantially revised in 1988, is designed to prevent discrimination in the housing market. Its provisions apply to real estate brokers, sellers (other than those selling their own single-family dwellings without the use of a broker), lenders, lessors, and appraisers. Originally, the act prohibited discrimination on the basis of race, color, religion, sex, and national origin. The 1988 amendments added “handicap” and “familial status” to this list. The familial status category was intended to prevent discrimination in the housing market against pregnant women and families with children.4 “Adult” or “senior citizen” communities restricting residents’ age do not violate the Fair Housing Act even though they exclude families with children, so long as the housing meets the requirements of the act’s “housing for older persons” exemption.5 The act prohibits discrimination on the above-listed bases in a wide range of matters relating to the sale or rental of housing. These matters include refusals to sell or rent, representations that housing is not available for sale or rental when in fact it is, and discriminatory actions regarding terms, conditions, or privileges of sale or rental or regarding the provision of services and facilities involved in sale or rental.6 The act also prohibits discrimination in connection with brokerage services, appraisals, and financing of dwellings. “Familial status” is defined as an individual or individuals under the age of 18 who is/are domiciled with a parent, some other person who has custody over him/her/them, or the designee of the parent or custodial individual. The familial status classification also applies to one who is pregnant or in the process of attempting to secure custody of a child or children under the age of 18. 4

The Fair Housing Act defines “housing for older persons” as housing provided under any state or federal program found by the Secretary of HUD to be specifically designed to assist elderly persons, housing intended for and solely occupied by persons 62 years old or older, or housing that meets the requirements of federal regulations and is intended for occupancy by at least one person 55 years old or older. 5 ­

Chapter 25 discusses the Fair Housing Act’s application to rentals of residential property. 6

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Part Five Property

CYBERLAW IN ACTION How does the Fair Housing Act apply to websites that permit users to post advertisements about the sale or rental of real estate? Advertisements about property for sale or lease that are posted by individuals sometimes make statements indicating a “preference, limitation, or discrimination, or an intention to make a preference, limitation, or discrimination, on the basis of race, color, national origin, disability, sex, religion, and familial status” that could violate the Fair Housing Act if the statements were made offline. For example, in Chicago Lawyers’ Committee for Civil Rights under the Law, Inc. v. Craigslist, Inc., 519 F.3d 666 (7th Cir. 2008), the plaintiff alleged that Craigslist.com posted notices in violation of the Fair Housing Act such as “Apt. too small for families with small children,” “NO MINORITIES,” and “Christian single straight female needed.” The content of advertisements on the website is created by Craigslist.com users, not by Craigslist Inc. This is a legally significant point because a federal statute, § 230 of the Communications Decency Act, states that “No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.” This statute has been interpreted in many cases to immunize websites, ISPs, and other interactive computer services for liability for thirdparty content. In the Craigslist case, the Seventh Circuit held that under § 230 of the Communications Decency Act, Craigslist could not be treated as the publisher of information provided by others and, therefore, that § 230 shielded Craigslist from liability.

In 2015, the Supreme Court clarified that the Fair Housing Act incorporates disparate impact claims of discrimination, as well as claims of disparate treatment.7 Prohibited discrimination on the basis of disability includes refusals to permit a person with a disability to make (at that person’s own expense) reasonable modifications to the property. It also includes refusals to make reasonable accommodations in property-related rules, policies, practices, or services when such modifications or accommodations are necessary to afford the person with a disability full enjoyment of the property. The act also outlaws the building of multifamily housing that is inaccessible to persons with disabilities. A violation of the Fair Housing Act may result in a civil action brought by the government or the aggrieved individual. If the aggrieved individual sues and prevails, the court may issue injunctions, award actual and punitive damages, Texas Dep’t of Hous. & Cmty. Affairs v. The Inclusive Cmtys. Project, 576 U.S. 519 (2015). Chapter 51 discusses disparate impact and disparate treatment theories of discrimination in detail in the context of employment. 7

In Fair Housing Council of San Fernando Valley v. Roommates. com, LLC, 521 F.3d 1157 (9th Cir. 2008), however, the Ninth Circuit held that § 230 of the Communications Decency Act immunized Roommates.com for some but not all of its activities. Roommates. com operates a roommate-matching website. Prior to searching or posting listings, subscribers were required to disclose their sex and sexual orientation, and to indicate whether children would live with them. Subscribers also described their preferences in roommates with regard to the same three criteria and were encouraged to provide additional comments. Roommates.com would then compile information provided in the questionnaires into a profile for each user, which would be used to match subscribers with listings and which could be viewed by other subscribers. The plaintiffs alleged that these practices constituted Fair Housing Act violations. The Ninth Circuit emphasized that § 230 provides a shield for an interactive computer service for content created by third parties, but not for content developed by the interactive computer service itself. It characterized Roommates.com’s creation and required use of the questionnaires as being “entirely its own” and the profiles created and displayed from the information provided in the questionnaire as information developed by Roommates.com. Because these practices involved content developed by Roommates.com and not a third party, they were not shielded from potential Fair Housing Act liability. However, § 230 did immunize Roommates.com liability for discriminatory content authored by subscribers in the open-ended “additional comments” section of the questionnaire.

assess attorney fees and costs, and grant other appropriate relief. Finally, the Fair Housing Act invalidates any state or municipal law requiring or permitting an action that would be a discriminatory housing practice under federal law.

Deeds Distinguish the different types of deeds, explain the purposes of recording deeds, and describe how state LO24-6 law determines priorities among those who claim competing rights in a parcel of real property.

Each state’s statutes set out the formalities necessary to accomplish a valid conveyance of land. As a general rule, a valid conveyance is brought about by the execution and delivery of a deed, a written instrument that transfers title from one person (the grantor) to another (the grantee). Three types of deeds are in general use in the United States: quitclaim deeds, warranty deeds, and deeds of bargain and sale (also called grant deeds). The precise rights contemplated by a deed depend on the type of deed the parties have used.



Chapter Twenty-Four Real Property

Quitclaim Deeds A quitclaim deed conveys whatever title the grantor has at the time he executes the deed. It does not, however, contain warranties of title. The grantor who executes a quitclaim deed does not claim to have good title—or any title, for that matter. The grantee has no action against the grantor under a quitclaim deed if the grantee does not acquire good title. Quitclaim deeds are frequently used to cure technical defects in the chain of title to property. Warranty Deeds A warranty deed, unlike a quitclaim deed, contains covenants of warranty. Besides conveying title to the property, the grantor who executes a warranty deed guarantees the title that is conveyed. There are two types of warranty deeds. 1. General warranty deed. Under a general warranty deed, the grantor warrants against (and agrees to defend against) all title defects and encumbrances (such as liens and easements), including those that arose before the grantor received title. 2. Special warranty deed. Under a special warranty deed, the grantor warrants against (and agrees to defend against) title defects and encumbrances that arose after the grantor acquired the property. If the property conveyed is subject to an encumbrance such as a mortgage, a long-term lease, or an easement, the grantor frequently provides a special warranty deed that contains a provision excepting those specific encumbrances from the warranty. Deeds of Bargain and Sale In a deed of bargain and sale (also known as a grant deed), the grantor makes no covenants. The grantor uses language such as “I grant” or “I bargain and sell” or “I convey” property. Such a deed does contain, however, the grantor’s implicit representation that he owns the land and has not previously encumbered it or conveyed it to another party.

Form and Execution of Deed Some

states’ statutes suggest a form for deeds. Although the requirements for execution of deeds are not uniform, they do follow a similar pattern. As a general rule, a deed states the name of the grantee, contains a recitation of consideration and a description of the property conveyed, and is signed by the grantor. Most states require that the deed be notarized (acknowledged by the grantor before a notary public or other authorized officer) in order to be eligible for recording in public records. No technical words of conveyance are necessary for a valid deed. Any language is sufficient if it indicates with reasonable certainty the grantor’s intent to transfer ownership

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of the property. The phrases “grant, bargain, and sell” and “convey and warrant” are commonly used. Deeds contain recitations of consideration primarily for historical reasons. The consideration recited is not necessarily the purchase price of the property. Deeds often state that the consideration for the conveyance is “one dollar and other valuable consideration.” The property conveyed must be described in such a manner that it can be identified. This usually means that the legal description of the property must be used. Several methods of legal description are used in the United States. In urban areas, descriptions are usually by lot, block, and plat. In rural areas where the land has been surveyed by the government, property is usually described by reference to the government survey. It may also be described by a metes and bounds description that specifies the boundaries of the tract of land.

Recording Deeds Delivery

of a valid deed conveys title from a grantor to a grantee. Even so, the grantee should promptly record the deed in order to prevent the interest from being defeated by third parties who may claim interests in the property. The grantee must pay a fee to have the deed recorded, a process that involves depositing and indexing the deed in the files of a government office designated by state law. A recorded deed operates to provide the public at large with notice of the grantee’s property interest. Recording Statutes Each state has a recording statute that establishes a system for the recording of all transactions affecting real property ownership. These statutes are not uniform in their provisions. In general, however, they provide for the recording of all deeds, mortgages, land contracts, and similar documents. Types of Recording Statutes State recording statutes also provide for priority among competing claimants to rights in real property, in case conflicting rights or interests in property should be deeded to (or otherwise claimed by) more than one person. (Obviously, a grantor has no right to issue two different grantees separate deeds to the same property, but if this should occur, recording statutes provide rules to decide which grantee has superior title.) These priority rules apply only to grantees who have given value for their deeds or other interest-creating documents (primarily purchasers and lenders), and not to donees. A given state’s recording law will set up one of three basic types of priority systems: race statutes, notice statutes, and race-notice statutes. Figure 24.2 explains these priority systems. Although the examples used

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Part Five Property

Figure 24.2 Three Basic Types of Priority Systems for Recording Deeds Race Statutes

Under a race statute—so named because the person who wins the race to the courthouse wins the property ownership “competition”—the first grantee who records a deed to a tract of land has superior title. For example, if Grantor deeds Blackacre to Kerr on March 1 and to Templin on April 1, Templin will have superior title to Blackacre if she records her deed before Kerr’s is recorded. Race statutes are relatively uncommon today.

Notice Statutes

Under a notice system of priority, a later grantee of property has superior title if that later grantee acquired the interest without notice of an earlier grantee’s claim to the property under an unrecorded deed. For example, Grantor deeds Greenacre to Jonson on June 1, but Jonson does not record his deed. On July 1, Marlowe purchases Greenacre without knowledge of Jonson’s competing claim. Grantor executes and delivers a deed to Marlowe. In this situation, Marlowe would have superior rights to Greenacre even if Jonson ultimately records his deed before Marlowe’s is recorded.

Race-Notice Statutes

The race-notice priority system combines elements of the systems just discussed. Under racenotice statutes, the grantee having priority is the one who both takes interest without notice of any prior unrecorded claim and records first. For example, Grantor deeds Redacre to Frazier on September 1. On October 1 (at which time Frazier has not yet recorded his deed), Grantor deeds Redacre to Gill, who is then unaware of any claim by Frazier to Redacre. If Gill records his deed before Frazier’s is recorded, Gill has superior rights to Redacre.

in Figure 24.2 deal with recorded and unrecorded deeds, recording statutes apply to other documents that create interests in real estate. Chapter 28 discusses the recording of mortgages, as well as the adverse security interest– related consequences a mortgagee may experience if its mortgage goes unrecorded.

Methods of Assuring Title In purchasing real

property, the buyer is really acquiring the seller’s ownership interests. Because the buyer does not want to pay a large sum of money for something that proves to be of little or no value, it is important for the buyer to obtain assurance that the seller has good title to the property. This is commonly done in one of three ways: 1. Title opinion. In some states, it is customary to have an attorney examine an abstract of title. An abstract of title is a history of what the public records show regarding the passage of title to, and other interests in, a parcel of real property. It is not a guarantee of good title. After examining the abstract, the attorney renders an opinion about whether the grantor has marketable title, which is title free from defects or reasonable doubt about its validity. If the grantor’s title is defective, the nature of the defects will be stated in the attorney’s title opinion. 2. Torrens system. A method of title assurance available in a few states is the Torrens system of title registration. Under this system, one who owns land in fee simple obtains a certificate of title. When the property is sold, the grantor delivers a deed and a certificate of title to the grantee. All liens and encumbrances against the title are noted on the

certificate, thus assuring the purchaser that the title is good except as to the liens and encumbrances noted on the certificate. However, some claims or encumbrances, such as those arising from adverse possession, do not appear on the records and must be discovered through an inspection of the property. In some Torrens states, encumbrances such as tax liens, short-term leases, and highway rights are valid against the purchaser even though they do not appear on the certificate. 3. Title insurance. Purchasing a policy of title insurance provides the preferred and most common means of protecting title to real property. Title insurance obligates the insurer to reimburse the insured grantee for loss if the title proves to be defective. In addition, title insurance covers litigation costs if the insured grantee must go to court in a title dispute. Lenders commonly require that a separate policy of title insurance be obtained for the lender’s protection. Title insurance may be obtained in combination with the other previously discussed methods of ensuring title.

Seller’s Responsibilities Regarding the Quality of Residential Property Buyers of real estate normally consider it important that any structures on the property be in good condition. This factor becomes especially significant if the buyer intends to use the property for residential purposes. The rule of



Chapter Twenty-Four Real Property

caveat emptor (let the buyer beware) traditionally applied to the sale of real property unless the seller committed misrepresentation or fraud or made express warranties about the property’s condition. In addition, sellers had no duty to disclose hidden defects in the property. Over the decades, however, the legal environment for sellers— especially real estate professionals such as developers and builder-vendors of residential property—has changed substantially. This section examines two important sources of liability for sellers of real property.

Implied Warranty of Habitability Historically,

sellers of residential property were not regarded as making any implied warranty that the property was habitable or suitable for the buyer’s use. The law’s attitude toward the buyer–seller relationship in residential property sales began to shift, however, as product liability law underwent rapid change in the late 1960s. Courts began to see that the same policies favoring the creation of implied warranties in the sale of goods applied with equal force to the sale of residential real estate.8 Both goods and housing are frequently mass produced. The disparity of knowledge and bargaining power often existing between a buyer of goods and a professional seller is also likely to exist between a buyer of a house and a builder-vendor (one who builds and sells houses). Moreover, many defects in houses are not readily discoverable during a buyer’s inspection. This creates the possibility of serious loss because the purchase of a home is often the largest single investment a person ever makes. For these reasons, courts in most states now hold that builders, builder-vendors, and developers make an implied warranty of habitability when they build or sell real property for residential purposes. An ordinary owner who sells her house—in other words, a seller who was neither the builder nor the developer of the residential property—does not make an implied warranty of habitability. The implied warranty of habitability amounts to a guarantee that the house is free of latent (hidden) defects that would render it unsafe or unsuitable for human habitation. A breach of this warranty subjects the defendant to liability for damages, measured by either the cost of repairs or the loss in value of the house.9 A related issue that has led to considerable litigation is whether the implied warranty of habitability extends to subsequent purchasers of the house. For example, PDQ Development Co. builds a house and sells it to Johnson, who later sells the house to McClure. May McClure

successfully sue PDQ for breach of warranty if a serious defect renders the house uninhabitable? Although some courts have rejected implied warranty actions brought by subsequent purchasers, many courts today hold that an implied warranty made by a builder-vendor or developer would extend to a subsequent purchaser. May the implied warranty of habitability be disclaimed or limited in the contract of sale? It appears at least possible to disclaim or limit the warranty through a contract provision, subject to limitations imposed by the unconscionability doctrine, public policy concerns, and contract interpretation principles.10 Courts construe attempted disclaimers very strictly against the builder-vendor or developer, and often reject disclaimers that are not specific regarding rights supposedly waived by the purchaser.

Duty to Disclose Hidden Defects Traditional

contract law provided that a seller had no duty to disclose to the buyer defects in the property being sold, even if the seller knew about the defects and the buyer could not reasonably find out about them. The seller’s failure to volunteer information, therefore, could not constitute misrepresentation or fraud. This traditional rule of nondisclosure was another expression of the prevailing caveat emptor notion. Although the nondisclosure rule was subject to certain exceptions,11 the exceptions seldom applied. Thus, there was no duty to disclose in most sales of real property. Today, courts in many jurisdictions have substantially eroded the traditional nondisclosure rule and have placed a duty on the seller to disclose any known defect that materially affects the property’s value and is not reasonably observable by the buyer. The seller’s failure to disclose such defects effectively amounts to an assertion that the defects do not exist—an assertion on which a judicial finding of misrepresentation or fraud may be based.12

Other Property Condition– Related Obligations of Real Property Owners and Possessors In recent years, the law has increasingly required real property owners and possessors to take steps to further the safety of persons on the property and to make the property The unconscionability doctrine and public policy concerns are discussed in Chapter 15. Chapter 16 addresses contract interpretation. 10

See Chapter 20 for a discussion of the development of similar doctrines in the law of product liability. 8

Measures of damages are discussed in Chapter 18.

9

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11

These exceptions are discussed in Chapter 13.

12

Misrepresentation and fraud are discussed in Chapter 13.

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more accessible to persons who are disabled. This section discusses two legal developments along these lines: the trend toward expansion of premises liability and the inclusion of property-related provisions in the Americans with Disabilities Act.

Expansion of Premises Liability Premises

liability is the name sometimes used for negligence cases in which property owners or possessors (such as business operators leasing commercial real estate) are held liable to persons injured while on the property. As explained in Chapter 7, property owners and possessors face liability when their failures to exercise reasonable care to keep their property reasonably safe result in injuries to persons lawfully on the property.13 The traditional premises liability case was one in which a property owner’s or possessor’s negligence led to the existence of a potentially hazardous condition on the property (e.g., a dangerously slick floor or similar physical condition at a business premises), and a person justifiably on the premises (e.g., a business customer) sustained personal injury upon encountering that unexpected condition (e.g., by slipping and falling). Security Precautions against Foreseeable Criminal Acts Recent years have witnessed a judicial inclination to expand premises liability to cover other situations in addition to the traditional scenario. A key component of this expansion has been many courts’ willingness to reconsider the once-customary holding that a property owner or possessor had no legal obligation to implement security measures to protect persons on the property from the wrongful acts of third parties lacking any connection with the owner or possessor. Today, courts frequently hold that a property owner’s or possessor’s duty to exercise reasonable care includes the obligation to take reasonable security precautions designed to protect persons lawfully on the premises from foreseeable wrongful (including criminal) acts by third parties. This expansion has caused hotel, apartment building, and convenience store owners and operators to be among the defendants held liable—sometimes in very large damage amounts—to guests, tenants, and customers on whom thirdparty attackers inflicted severe physical injuries. In such cases, the property owners’ or possessors’ negligent failures to take security precautions restricting such wrongdoers’ access to Chapter 7 explains the law’s traditional view that real property owners and possessors owe persons who come on the property certain duties that vary depending on those persons’ invitee, licensee, or trespasser status. It also discusses courts’ increasing tendency to merge the traditional invitee and licensee classifications and to hold that property owners and possessors owe invitees and licensees the duty to exercise reasonable care to keep the premises reasonably safe.

the premises served as at least a substantial factor leading to the plaintiffs’ injuries.14 The security lapses amounting to a lack of reasonable care in a particular case may have been, for instance, failures to install deadbolt locks, provide adequate locking devices on sliding glass doors, maintain sufficient lighting, or employ security guards. Determining Foreseeability The security precautions component of the reasonable care duty is triggered only when criminal activity on the premises is foreseeable. It therefore becomes important to determine whether the foreseeability standard has been met. In making this determination, courts look at such factors as whether previous crimes had occurred on or near the subject property (and if so, the nature and frequency of those crimes), whether the property owner or possessor knew or should have known of those prior occurrences, and whether the property was located in a high-crime area. The fact-specific nature of the foreseeability and reasonable care determinations makes the outcome of a given premises liability case difficult to predict in advance. Nevertheless, there is no doubt that the current premises liability climate gives property owners and possessors more reason than ever before to be concerned about security measures.

Americans with Disabilities Act In

1990, Congress enacted the broad-ranging Americans with ­Disabilities Act (ADA). This statute was designed to eliminate long-standing patterns of discrimination against persons who are disabled in matters such as employment, access to public services, and access to business establishments and similar facilities open to the public. The ADA’s Title III focuses on places of public accommodation.15 It imposes on certain property owners and possessors the obligation to take reasonable steps to make their property accessible to persons who are disabled (individuals with a physical or mental impairment that substantially limits one or more major life activities). Places of Public Accommodation Title III of the ADA classifies numerous businesses and nonbusiness enterprises as places of public accommodation. These include hotels, restaurants, bars, theaters, concert halls, auditoriums, stadiums, shopping centers, stores at which goods are sold or rented, service-oriented businesses (running

13

See Chapter 7’s discussion of the causation element of a negligence claim. 14

42 U.S.C. §§ 12181–12189. These sections examine only Title III of the ADA. Chapter 51 discusses the employment-related provisions set forth elsewhere in the statute. 15



Chapter Twenty-Four Real Property

the gamut from gas stations to law firm offices), museums, parks, schools, social services establishments (daycare centers, senior citizen centers, homeless shelters, and the like), places of recreation, and various other enterprises, facilities, and establishments. Private clubs and religious organizations, however, are not treated as places of public accommodation for purposes of the statute. Modifications of Property Under the ADA, the owner or operator of a place of public accommodation cannot exclude people with disabilities from the premises or otherwise discriminate against them in terms of their ability to enjoy the public accommodation. Avoiding such exclusion or other discrimination may require alteration of the business or nonbusiness enterprise’s practices, policies, and procedures. Moreover, using language contemplating the possible need for physical modifications of property serving as a place of public accommodation, the ADA includes within prohibited discrimination the property owner’s or possessor’s “failure to take such steps as may be necessary to ensure that no individual with a disability is excluded” or otherwise discriminated against in terms of access to what nondisabled persons are provided. The failure to take these steps does not violate the ADA, however, if the property owner or possessor demonstrates that implementing such steps would “fundamentally alter the nature” of the enterprise or would “result in an undue burden.” Prohibited discrimination may also include the “failure to remove architectural barriers and communication barriers that are structural in nature,” if removal is “readily achievable.” When the removal of such a barrier is not readily achievable, the property owner or possessor nonetheless engages in prohibited discrimination if he, she, or it does not adopt “alternative methods” to ensure access to the premises and what it has to offer (assuming that the alternative methods are themselves readily achievable). The ADA defines readily achievable as “easily accomplishable and able to be carried out without much difficulty or expense.” The determination of whether an action is readily achievable involves consideration of factors such as the action’s nature and cost, the nature of the enterprise conducted on the property, the financial resources of the affected property owner or possessor, and the effect the action would have on expenses and resources of the property owner or possessor. New Construction Newly constructed buildings on property used as a place of public accommodation must contain physical features making the buildings readily accessible to people with disabilities. The same is true of additions built on to previous structures. The ADA is supplemented by federal regulations setting forth property accessibility

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guidelines designed to lend substance and specificity to the broad legal standards stated in the statute. In addition, the federal government has issued technical assistance manuals and materials in an effort to educate public accommodation owners and operators regarding their obligations under the ADA. Remedies A person subjected to disability-based discrimination in any of the respects discussed above may bring a civil suit for injunctive relief. An injunction issued by a court must include “an order to alter facilities” to make the facilities “readily accessible to and usable by individuals with disabilities to the extent required” by the ADA. The court has discretion to award attorney fees to the prevailing party. The U.S. Attorney General also has the legal authority to institute a civil action alleging a violation of Title III of the ADA. In such a case, the court may choose to grant injunctive and other appropriate equitable relief, award compensatory damages to aggrieved persons (when the Attorney General so requests), and assess civil penalties (up to $75,000 for a first violation and up to $150,000 for any subsequent violation) “to vindicate the public interest.” When determining the amount of any such penalty, the court is to give consideration to any good-faith effort by the property owner or possessor to comply with the law. The court must also consider whether the owner or possessor could reasonably have anticipated the need to accommodate people with disabilities.

Land Use Control Explain governmental powers to control and purchase

LO24-7 private land and the constitutional limits on those

powers.

Although a real property owner generally has the right to use the property as the owner desires, society has placed certain limitations on this right. This section examines the property use limitations imposed by nuisance law and by zoning and subdivision ordinances. It also discusses the ultimate land use restriction—the eminent domain power— which enables the government to deprive property owners of their land.

Nuisance Law One’s enjoyment of her land depends

to a great extent on the uses her neighbors make of their land. When the uses of neighboring landowners conflict, the aggrieved party sometimes institutes litigation to resolve the conflict. A property use that unreasonably interferes with another person’s ability to use or enjoy her own property

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may lead to an action for nuisance against the landowner or possessor engaging in the objectionable use. The term nuisance has no set definition. It is often regarded, however, as encompassing any property-related use or activity that unreasonably interferes with the rights of others. Property uses potentially constituting nuisances include uses that are inappropriate to the neighborhood (such as using a vacant lot in a residential neighborhood as a garbage dump), bothersome to neighbors (such as keeping a pack of barking dogs in one’s backyard), dangerous to others (such as storing large quantities of gasoline in 50-gallon drums in one’s garage), or of questionable morality (such as operating a house of prostitution). To amount to a nuisance, a use need not be illegal. The fact that relevant zoning laws allow a given use does not mean that the use cannot be a nuisance. The use’s having been in existence before complaining neighbors acquired their property does not mean that the use cannot be a nuisance, though it does lessen the likelihood that the use would be held a nuisance. The test for determining the presence or absence of a nuisance is necessarily flexible and highly dependent on the individual case’s facts. Courts balance a number of factors, such as the social importance of the parties’ respective uses, the extent and duration of harm experienced by the aggrieved party, and the feasibility of abating (stopping) the nuisance. Nuisances may be private or public. To bring a private nuisance action, the plaintiff must be a landowner or occupier whose enjoyment of her own land is substantially lessened by the alleged nuisance. The remedies for private nuisance include damages and injunctive relief designed to stop the offending use. A public nuisance occurs when a nuisance harms members of the public, who need not be injured in their use of property. For example, if a power plant creates noise and emissions posing a health hazard to pedestrians and workers in nearby buildings, a public nuisance may exist even though the nature of the harm has nothing to do with any loss of enjoyment of property. Public nuisances involve a broader class of affected parties than do private nuisances. The action to abate a public nuisance must usually be brought by the government. Remedies generally include injunctive relief and civil penalties that resemble fines. On occasion, constitutional issues may arise in public nuisance cases brought by the government. Private parties may sue for abatement of a public nuisance or for damages caused by one only when they suffered unique harm different from that experienced by the general public.

the power to take property for public use if it pays “just compensation” to the owner of the property. This power, called the power of eminent domain, makes it possible for the government to acquire private property for highways, water control projects, municipal and civic centers, public housing, urban renewal, and other public uses. Governmental units may delegate their eminent domain power to private corporations such as railroads and utility companies. Although the eminent domain power is a useful tool of efficient government, there are problems inherent in its use. Determining when the power can be properly exercised presents an initial problem. When the governmental unit itself uses the property taken, as would be the case with property acquired for construction of a municipal building or a public highway, the exercise of the power is proper. The use of eminent domain is controversial, however, when the government acquires the property and transfers it to a private developer.16 In the Kelo case, which follows shortly, the U.S. Supreme Court grappled with this issue.17 Determining just compensation in a given case poses a second and frequently encountered eminent domain problem. The property owner is entitled to receive the “fair market value” of the property. Critics assert, however, that this measure of compensation falls short of adequately compensating the owner for the loss because fair market value does not cover such matters as the lost goodwill of a business or one’s emotional attachment to one’s home. A third problem sometimes encountered is determining when there has been a “taking” that triggers the government’s just compensation obligation. The answer is easy when the government institutes a formal legal action to exercise the eminent domain power (often called an action to condemn property). In some instances, however, the government causes or permits a serious physical invasion of a landowner’s property without having instituted formal condemnation proceedings. For example, the government’s dam-building project results in persistent flooding of a private party’s land. Courts have recognized the right of property owners in such cases to institute litigation seeking compensation from the governmental unit whose actions effectively amounted to a physical taking of their land. In these so-called inverse condemnation cases, the property owner sends the message that “you have taken my land; now pay for it.” This issue is discussed further in Chapter 3, as are other issues relating to eminent domain. 16

As you read the Kelo opinion, keep in mind that the decision was controversial. In fact, in response to the decision, a substantial majority of the states have subsequently passed legislation intended to limit the types of takings allowed by Kelo, where the justification is economic development (though some of those enactments allow such takings when the goal is to eliminate “blight”). 17

Eminent Domain The

Fifth Amendment to the Constitution provides that private property shall not be taken for public use without “just compensation.” Implicit in this provision is the principle that the government has



Chapter Twenty-Four Real Property

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Kelo v. City of New London   545 U.S. 469 (2005) The city of New London, Connecticut, had experienced decades of economic decline. In 1990, a state agency designated the city a “distressed municipality.” In 1996, the federal government closed a U.S. naval facility in the Fort Trumbull area of the city that had employed more than 1,500 people. In 1998, the city’s unemployment rate was nearly double that of the rest of the state and its population of just under 24,000 residents was at its lowest since 1920. These conditions prompted state and local officials to target New London, and particularly its Fort Trumbull area, for economic revitalization. To this end, New London Development Corporation (NLDC), a private nonprofit entity established some years earlier to assist the city in planning economic development, was reactivated. In January 1998, the state authorized a $5.35 million bond issue to support the NLDC’s planning activities. In February, the pharmaceutical company Pfizer Inc. announced that it would build a $300 million research facility on a site immediately adjacent to Fort Trumbull; local planners hoped that Pfizer would draw new business to the area, thereby serving as a catalyst to the area’s rejuvenation. In May, the city council authorized the NLDC to formally submit its plans to the relevant state agencies for review. Upon obtaining state-level approval, the NLDC finalized an integrated development plan focused on 90 acres of the Fort Trumbull area, which comprises approximately 115 privately owned properties, as well as the 32 acres of land formerly occupied by the naval facility. The development plan called for the creation of restaurants, shops, marinas for both recreational and commercial uses, a pedestrian “riverwalk,” 80 new residences, a new U.S. Coast Guard Museum, research and development office space, and parking. The NLDC intended the development plan to capitalize on the arrival of the Pfizer facility and the new commerce it was expected to attract. In addition to creating jobs, generating tax revenue, and helping to build momentum for the revitalization of downtown New London, the plan was also designed to make the city more attractive and to create leisure and recreational opportunities on the waterfront and in the park. The city council approved the plan in January 2000 and designated the NLDC as its development agent in charge of implementation. The city council also authorized the NLDC to purchase property or to acquire property by exercising eminent domain in the city’s name. The NLDC successfully negotiated the purchase of most of the real estate in the 90-acre area, but its negotiations with nine property owners, including the petitioners Susette Kelo, Wilhelmina Dery, and Charles Dery, failed. As a result, in November 2000, the NLDC initiated condemnation proceedings. Kelo had lived in the Fort Trumbull area since 1997. She had made extensive improvements to her house, which she prizes for its water view. Wilhelmina Dery was born in her Fort Trumbull house in 1918 and had lived there her entire life. Her husband, Charles, had lived in the house since they married some 60 years prior. In all, the nine petitioners owned 15 properties in Fort Trumbull. There was no allegation that any of these properties were blighted or otherwise in poor condition; rather, they were condemned only because they happened to be located in the development area. In December 2000, the petitioners brought this action claiming, among other things, that the taking of their properties would violate the “public use” restriction in the Fifth Amendment. The trial court granted a permanent restraining order prohibiting the taking of properties in one area of Fort Trumbull, but denied the order for properties in another area. Both sides appealed to the Supreme Court of Connecticut. That court held that all of the city’s proposed takings were valid. The petitioners then appealed to the U.S. Supreme Court.

Stevens, Justice Two polar propositions are perfectly clear. On the one hand, it has long been accepted that the sovereign may not take the property of A for the sole purpose of transferring it to another private party B, even though A is paid just compensation. On the other hand, it is equally clear that a State may transfer property from one private party to another if future “use by the public” is the purpose of the taking; the condemnation of land for a railroad with common-carrier duties is a familiar example. Neither of these propositions, however, determines the disposition of this case. As for the first proposition, the City would no doubt be forbidden from taking petitioners’ land for the purpose of conferring a private benefit on a particular private party. Nor would the City

be allowed to take property under the mere pretext of a public purpose, when its actual purpose was to bestow a private benefit. The takings before us, however, would be executed pursuant to a carefully considered development plan. The trial judge and all the members of the Supreme Court of Connecticut agreed that there was no evidence of an illegitimate purpose in this case. On the other hand, this is not a case in which the City is planning to open the condemned land—at least not in its entirety—to use by the general public. Nor will the private lessees of the land in any sense be required to operate like common carriers, making their services available to all comers. But although such a projected use would be sufficient to satisfy the public use requirement, this Court long ago rejected any literal requirement that condemned property be put into use for the general public. Indeed, while

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Part Five Property

many state courts in the mid-19th century endorsed “use by the public” as the proper definition of public use, that narrow view steadily eroded over time. Not only was the “use by the public” test difficult to administer (e.g., what proportion of the public need have access to the property? at what price?), but it proved to be impractical given the diverse and always evolving needs of society. Accordingly, when this Court began applying the Fifth Amendment to the States at the close of the 19th century, it embraced the broader and more natural interpretation of public use as “public purpose.” The disposition of this case therefore turns on the question whether the City’s development plan serves a “public purpose.” Without exception, our cases have defined that concept broadly, reflecting our long-standing policy of deference to legislative judgments in this field. Viewed as a whole, our jurisprudence has recognized that the needs of society have varied between different parts of the Nation, just as they have evolved over time in response to changed circumstances. For more than a century, our public use jurisprudence has wisely eschewed rigid formulas and intrusive scrutiny in favor of affording legislatures broad latitude in determining what public needs justify the use of the takings power. Those who govern the City were not confronted with the need to remove blight in the Fort Trumbull area, but their determination that the area was sufficiently distressed to justify a program of economic rejuvenation is entitled to our deference. The City has carefully formulated an economic development plan that it believes will provide appreciable benefits to the community, including—but by no means limited to—new jobs and increased tax revenue. As with other exercises in urban planning and development, the City is endeavoring to coordinate a variety of commercial, residential, and recreational uses of land, with the hope that they will form a whole greater than the sum of its parts. To effectuate this plan, the City has invoked a state statute that specifically authorizes the use of eminent domain to promote economic development. Given the comprehensive character of the plan, the thorough deliberation that preceded its adoption, and the limited scope of our review, it is appropriate for us to resolve the challenges of the individual owners, not on a piecemeal basis, but rather in light of the entire plan. Because that plan unquestionably serves a public purpose, the takings challenged here satisfy the public use requirement of the Fifth Amendment. To avoid this result, petitioners urge us to adopt a new brightline rule that economic development does not qualify as a public use. Putting aside the unpersuasive suggestion that the City’s plan will provide only purely economic benefits, neither precedent nor logic supports petitioners’ proposal. Promoting economic development is a traditional and long-accepted function of government. There is, moreover, no principled way of distinguishing

economic development from the other public purposes that we have recognized. In our cases upholding takings that facilitated agriculture and mining, for example, we emphasized the importance of those industries to the welfare of the States in question. It would be incongruous to hold that the City’s interest in the economic benefits to be derived from the development of the Fort Trumbull area has less of a public character than any of those other interests. Clearly, there is no basis for exempting economic development from our traditionally broad understanding of public purpose. Petitioners contend that using eminent domain for economic development impermissibly blurs the boundary between public and private takings. Again, our cases foreclose this objection. Quite simply, the government’s pursuit of a public purpose will often benefit individual private parties. It is further argued that without a bright-line rule nothing would stop a city from transferring citizen A’s property to citizen B for the sole reason that citizen B will put the property to a more productive use and thus pay more taxes. Such a one-to-one transfer of property, executed outside the confines of an integrated development plan, is not presented in this case. While such an unusual exercise of government power would certainly raise a suspicion that a private purpose was afoot, the hypothetical cases posited by petitioners can be confronted if and when they arise. They do not warrant the crafting of an artificial restriction on the concept of public use. Alternatively, petitioners maintain that for takings of this kind we should require a “reasonable certainty” that the expected public benefits will actually accrue. Such a rule, however, would represent an even greater departure from our precedent. The disadvantages of a heightened form of review are especially pronounced in this type of case. Orderly implementation of a comprehensive redevelopment plan obviously requires that the legal rights of all interested parties be established before new construction can be commenced. A constitutional rule that required postponement of the judicial approval of every condemnation until the likelihood of success of the plan had been assured would unquestionably impose a significant impediment to the successful consummation of many such plans. Just as we decline to second-guess the City’s considered judgments about the efficacy of its development plan, we also decline to second-guess the City’s determinations as to what lands it needs to acquire in order to effectuate the project. In affirming the City’s authority to take petitioners’ properties, we do not minimize the hardship that condemnations may entail, notwithstanding the payment of just compensation. We emphasize that nothing in our opinion precludes any State from placing further restrictions on its exercise of the takings power. Indeed, many States already impose “public use” requirements that are stricter



Chapter Twenty-Four Real Property

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than the federal baseline. Some of these requirements have been established as a matter of state constitutional law, while others are expressed in state eminent domain statutes that carefully limit the grounds upon which takings may be exercised. As the submissions of the parties make clear, the necessity and wisdom of using eminent domain to promote economic development are

certainly matters of legitimate public debate. This Court’s authority, however, extends only to determining whether the City’s proposed condemnations are for a “public use” within the meaning of the Fifth Amendment to the Federal Constitution.

Zoning and Subdivision Laws State

Nonconforming Uses A zoning ordinance has prospective effect. This means that the uses and buildings already existing when the ordinance is passed (nonconforming uses) are permitted to continue. The ordinance may provide, however, for the gradual phasing out of nonconforming uses and buildings that do not fit the general zoning plan.

legislatures commonly delegate to cities and other political subdivisions the power to impose reasonable regulations designed to promote the public health, safety, and welfare (often called the police power). Zoning ordinances, which regulate real property use, stem from the exercise of the police power. Normally, zoning ordinances divide a city or town into various districts and specify or limit the uses to which property in those districts may be put. They also contain requirements and restrictions regarding improvements built on the land. Zoning ordinances frequently contain direct restrictions on land use, such as by limiting property use in a given area to single-family or high-density residential uses, or to commercial, light industrial, or heavy industrial uses. Other sorts of use-related provisions commonly found in zoning ordinances include restrictions on building height, limitations on the portion of a lot that can be covered by a building, and specifications of the distance buildings must be from lot lines (usually called setback requirements). Zoning ordinances also commonly restrict property use by establishing population density limitations. Such restrictions specify the maximum number of persons who can be housed on property in a given area and dictate the amount of living space that must be provided for each person occupying residential property. In addition, zoning ordinances often establish restrictions designed to maintain or create a certain aesthetic character in the community. Examples of this type of restriction include specifications of buildings’ architectural style, limitations on billboard and sign use, and designations of special zones for historic buildings. Many local governments also have ordinances dealing with proposed subdivisions. These ordinances often require the subdivision developer to meet certain requirements regarding lot size, street and sidewalk layout, and sanitary facilities. They also require that the city or town approve the proposed development. Such ordinances are designed to further general community interests and to protect prospective buyers of property in the subdivision by ensuring that the developer meets minimum standards of suitability.

Affirmed in favor of the City.

Relief from Zoning Ordinances A property owner who wishes to use the property in a manner prohibited by a zoning ordinance has more than one potential avenue of relief from the ordinance. The owner may, for instance, seek to have the ordinance amended—in other words, attempt to get the law changed—on the ground that the proposed amendment is consistent with the essence of the overall zoning plan. A different approach would be to seek permission from the city or political subdivision to deviate from the zoning law. This permission is called a variance. A person seeking a variance usually claims that the ordinance works an undue hardship on her by denying her the opportunity to make reasonable use of her land. Examples of typical variance requests include a property owner’s seeking permission to make a commercial use of her property even though it is located in an area zoned for residential purposes, or permission to deviate from normal setback or building size requirements. Attempts to obtain variances and zoning ordinance amendments frequently clash with the interests of other owners of property in the same area—owners who have a vested interest in maintaining the status quo. As a result, variance and amendment requests often produce heated battles before local zoning authorities. Challenges to the Validity of the Zoning Ordinance  A disgruntled property owner might also attack the zoning ordinance’s validity on constitutional grounds. Litigation challenging zoning ordinances has become frequent in recent years, as cities and towns have used their zoning power to achieve social control. For example, assume that a city creates special zoning requirements for adult bookstores

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Part Five Property

or other uses considered moral threats to the community. Such uses of the zoning power have been challenged as unconstitutional restrictions on freedom of speech. In City of Renton v. Playtime Theatres, Inc.,18  however, the Supreme Court upheld a zoning ordinance that prohibited the operation of adult bookstores within 1,000 feet of specified uses such as residential areas and schools. The Court established that the First Amendment rights of operators of adult businesses would not be violated by such an ordinance so long as the city provided them a “reasonable opportunity to open and operate” their businesses within the city. Other litigation has stemmed from ordinances by which municipalities have attempted to “zone out” residential facilities such as group homes for developmentally disabled adults. In a leading case, the Supreme Court held that the Constitution’s Equal Protection Clause was violated by a zoning ordinance that required a special use permit for such a group home.19 The Fair Housing Act, which forbids discrimination on the basis of disability and familial status, has also been used as a basis for challenging decisions that zone out group homes. Such a challenge has a chance of success when the plaintiff demonstrates that the zoning board’s actions were a mere pretext for discrimination.20 Certain applications of zoning ordinances that establish single-family residential areas may also raise Fair Housing Act–based claims of disability discrimination. Many cities and towns have attempted to restrict singlefamily residential zones to living units of traditional families related by blood or marriage. In enacting ordinances along those lines, municipalities have sought to prevent the presence of groups of unrelated students, commune members, or religious cult adherents by specifically defining the term family in a way that excludes these groups. In Belle Terre v. Boraas,21 the Supreme Court upheld such an ordinance as applied to a group of unrelated students. The Court later held, however, that an ordinance defining family so as to prohibit a grandmother from living with her grandsons was an unconstitutional intrusion on personal freedom regarding family life.22 Restrictive definitions of family have been held unconstitutional under state constitutions in some cases but narrowly construed by courts in other cases.

475 U.S. 41 (1986).

18

19

City of Cleburne v. Cleburne Living Centers, 473 U.S. 432 (1985).

See, for example, Baxter v. City of Belleville, 720 F. Supp. 720 (S.D. Ill. 1989), which involves a challenge by a hospice for AIDS patients to a city’s denial of a special use permit.

Land Use Regulation and Taking Another

type of litigation seen with increasing frequency in recent years centers around zoning laws and other land use regulations that impose burdens or diminish properties’ values by restricting their permissible uses.23 Affected property owners have challenged the application of such regulations as unconstitutional takings of property without just compensation, even though these cases do not involve the actual physical invasions present in the inverse condemnation cases discussed earlier in this chapter. States normally have broad discretion to use their police power for the public benefit, even when that means interfering to some extent with an owner’s right to develop the property as the owner desires. Some regulations, however, may interfere with an owner’s use of the property to such an extent that they constitute a taking. For instance, in Nollan v. California Coastal Commission,24 the owners of a beachfront lot (the Nollans) wished to tear down a small house on the lot and replace that structure with a larger house. The California Coastal Commission conditioned the grant of the necessary coastal development permit on the Nollans’ agreeing to allow the public an easement across their property. This easement would have allowed the public to reach certain nearby public beaches more easily. The Nollans challenged the validity of the Coastal Commission’s action. Ultimately, the Supreme Court concluded that the Coastal Commission’s placing the easement condition on the issuance of the permit amounted to an impermissible regulatory taking of the Nollans’ property. In reaching this conclusion, the Court held that the state could not avoid paying compensation to the Nollans by choosing to do by way of the regulatory route what it would have had to pay for if it had followed the formal eminent domain route. Regulations Denying Economically Beneficial Uses  What about a land use regulation that allows the property owner no economically beneficial use of the property? Lucas v. South Carolina Coastal Commission25 was brought by a property owner, Lucas, who had paid nearly $1 million for two residential beachfront lots before South Carolina enacted a coastal protection statute. This statute’s effect was to bar Lucas from building any permanent habitable structures on the lots. The trial court held that the statute rendered Lucas’s property “valueless” and that an unconstitutional taking had occurred, but the South Carolina

20

23

416 U.S. 1 (1974).

24

Moore v. City of East Cleveland, 431 U.S. 494 (1977).

25

21

22

This issue is also discussed in Chapter 3.

483 U.S. 825 (1987). 505 U.S. 1003 (1992).



Chapter Twenty-Four Real Property

Supreme Court reversed. The U.S. Supreme Court, however, held that when a land use regulation denies “all economically beneficial use” of property, there normally has been a taking for which just compensation must be paid. The exception to this rule, according to the Court, would be when the economically productive use being prohibited by the land use regulation was already disallowed by nuisance law or other comparable property law principles. The Court therefore reversed and remanded the case for determination of whether there had been a taking under the rule crafted by the Court, or instead an instance in which the “nuisance” exception applied. On remand, the South Carolina Supreme Court concluded that a taking calling for compensation had occurred (and, necessarily, that the nuisance exception did not apply to Lucas’s intended residential use).26 The mere fact that a land use regulation deprives the owner of the highest and most profitable use of the property does not mean, however, that there has been a taking. If the regulation still allows a use that is economically beneficial in a meaningful sense—even though not the most profitable use—the Lucas analysis would seem to indicate

26

Lucas v. South Carolina Coastal Council, 424 S.E.2d 484 (S.C. 1992).

Problems and Problem Cases 1. In 2003, Hall acquired a sculpture by Anselm Kiefer, a German artist, and placed it on the lawn of his property fronting Harbor Road in the Southport Historic District, which is one of three historic districts in Fairfield, Connecticut. The sculpture is approximately 80 feet long and weighs more than six tons. It was placed on a specially prepared trench filled with more than 21 tons of gravel and stone. The Fairfield Historic District Commission regulates the use of historic property under a Connecticut statute that states, “No building or structure shall be erected or altered within an historic district until after an application for a certificate of appropriateness as to exterior architectural features has been submitted to the historic district commission and approved by said commission.” Hall initially filed an application for a “certificate of appropriateness” with the Commission, but withdrew it before the Commission acted on it and went ahead and installed the sculpture. The Commission filed an action against Hall, seeking to force Hall to remove the sculpture or file an application for a certification of appropriateness within 30

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that an unconstitutional taking probably did not occur. At the same time, Lucas offered hints that less-than-total takings (in terms of restrictions on economically beneficial uses) may sometimes trigger a right of compensation on the landowner’s part. Thus, it appears that even as to land use regulations that restrict some but not all economically beneficial uses, property owners are likely to continue arguing (as they have in recent years) that the regulations go “too far” and amount to a taking. There is no set formula for determining whether a regulation has gone too far. Courts look at the relevant facts and circumstances and weigh a variety of factors, such as the economic impact of the regulation, the degree to which the regulation interferes with the property owner’s reasonable expectations, and the character of the government’s invasion. The weighing of these factors occurs against the backdrop of a general presumption that state and local governments should have reasonably broad discretion to develop land use restrictions pursuant to the police power. As a result, the outcome of a case in which regulatory taking allegations are made is less certain than when a physical taking (either in the traditional sense or when there is a physical invasion of the sort addressed in the earlier discussion of inverse condemnation cases) appears to have occurred.

days. Hall claims that the sculpture is not a “structure” because it is not affixed to the land by direct physical attachment nor embedded in the ground, and therefore, the Commission has no jurisdiction over the placement of the sculpture. Is the sculpture likely to be considered a “structure”? 2. Chevron U.S.A. Inc. and Sheikhpour had entered into a settlement agreement that would require Sheikhpour to complete reconstruction work on his gas station. When Sheikhpour did not do the work, Chevron sued to enforce the settlement agreement. Sheikhpour requested continued access to the property for 14 days to allow him to remove his “personal property.” The parties then entered a Release and Indemnification Agreement, which allowed Sheikhpour to access the property for the sole purpose of removing his personal property. Sheikhpour informed Chevron that he intended to dig up and remove the fuel storage tanks. The tanks, which are valued at about $120,000, sit in a “tank pit area” and are covered with gravel. Are the tanks personal property or fixtures, and what difference does that make? 3. In May 1994, the Hubers rented a house to Lois Olbekson, who was the daughter of their friends, Loren and

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Part Five Property

Alice May Olbekson. Lois hoped to be able to purchase the house from the Hubers one day. The primary source of heat for the rental house was a wood furnace located in the basement. Lois was not happy with the wood furnace. In the fall of 1995, she persuaded her parents to buy an oil furnace to replace the wood furnace in the rental house. During the process of installing the new oil furnace, the old wood furnace was removed from the rental house at the Olbeksons’ direction and hauled to the landfill. Installation of the oil furnace required wiring in a thermostat and drilling a hole in the wall to accommodate the fuel line from the outside oil tank, and the Olbeksons had to widen an existing doorway into the basement in order to accommodate the new oil furnace. The Olbeksons paid $2,525 to have the new oil furnace installed. The Hubers acquiesced in the installation of the new furnace but would not have done so if they had believed that they would be required to purchase it. During the time that Lois lived in the Hubers’ rental house, the Hubers spent approximately $28,000 remodeling it, yet collected only $175 per month in rent. Lois admitted that before the remodeling was complete, the reasonable rental value of the house was probably $250 per month. In order to placate her husband about the rent, Emelia prepared an agreement that purported to tie the low rent to compensation for the cost of the furnace. The agreement, which Emelia and Lois signed, stated as follows:  uring October 1995, a fuel furnace for $2,525.00 was inD stalled at 317 W. Lincoln and paid for by Loren and Alice May Olbekson. To compensate for the expense of this heating device, rent on this residence will remain at $175.00 per month thru the duration of Nov. 1st, 1995 thru Dec. 31st 1997.

Lois continued to rent the house until September 2000. Even though the written agreement provided that Lois would enjoy reduced rent only until December 31, 1997, the Hubers did not raise the rent at any time prior to the termination of the tenancy. At the end of Lois’s tenancy, the Olbeksons removed the outside oil tank. Do they have the right to remove the oil furnace as well? 4. Janet and Frank Mandeville were married in 1975 and remained married until Janet died in 2002, after a battle with breast cancer. The Mandevilles acquired two properties during their marriage, their home in Macomb County and a parcel of property in Ogamaw County. They owned both properties as tenants by the entirety. Accordingly, by the right of survivorship inherent in a tenancy by the entirety, both properties passed to Frank upon Janet’s death.

In the last decade of their marriage, Frank was often out of the country for extended periods. Specifically, he was absent for the 18 months preceding Janet’s death. During this period, he did not try to call Janet or otherwise communicate with her, even though he knew she was seriously ill. He did not attend her funeral. In Frank’s absence, Janet maintained the properties and was responsible for paying the taxes, insurance, and mortgage. She was cared for by her sister, Susan Tkachik. In the months before she died, Janet executed a trust and will that stated her intent to disinherit her husband and leave everything to her mother. She tried to defeat the right of survivorship in the real estate by transferring her interest in them to her mother by a quitclaim deed. In November 2003, Tkachik filed suit on behalf of the estate to effectuate Janet’s intent to disinherit Frank. She claimed the Mandevilles should be considered tenants in common with regard to their real property and Frank should not obtain full ownership of the properties. Tkachik later amended her petition to seek contribution from Frank for the expenses Janet incurred in maintaining the property before her death. What is Frank’s ownership interest in the properties, if any? Is he liable for contribution? 5. Aidinoff purchased land in 1979. It is adjacent to Sterling City Road but can only be reached by crossing land formerly owned by Rand. Other routes of access are impossible because of wetlands and a brook. A gravel driveway crosses the Rand land to Aidinoff’s land. The person from whom Aidinoff purchased her land used the driveway for access to her land, and Aidinoff used the driveway from 1979 until 2003. She drove vehicles, walked, and brought animals across the driveway. She also used the power coming in over utility lines serving the property. After Aidinoff had begun using the driveway, she and Rand had had a conversation about the driveway, and Rand had told her that he owned it and he had no problem with her using it, but it was not “an open way for everybody to go through.” In 2003, Rand sold his property to the Lathrops. After buying the property, the Lathrops blocked the driveway and prevented Aidinoff from using it to access her property. Aidinoff claimed that she had the right to use the driveway because she had acquired an easement by prescription and an easement by necessity. Did she? 6. William Jefferys’s parents transferred parcels of their land to the Gardners with a deed that contained a restrictive covenant that required that a specified part of the property be kept open and free of all structures, with



Chapter Twenty-Four Real Property

certain exceptions. The deed indicated that the restrictive covenants were to be enforced by the grantors, their heirs and assigns. The Jefferys also conveyed a parcel of land above the Gardners to Souminen, who then conveyed that parcel to the Soules, who built a house on their land. The Jefferys deeded the remainder of their land to their son, William, and his wife. The Gardners wanted to build a structure on the restricted land and sought permission of William Jefferys. The Soules claimed that they were interested parties as assigns of the elder Jefferys. The Gardners began planting white pines directly in the Soules’ view. The Gardners filed a declaratory judgment action about this and the Soules counterclaimed. Do the benefits and the burdens of the restrictive covenant still affect the relationship between the landowners who were not parties to it originally? And does planting the trees violate the restrictive covenant if it is still effective? 7. Schlichtling had lived on her property since 1979 and had a friendly relationship with her then-neighbors, the Nitsos. The boundary between the two parcels had never been surveyed, and the parties had a vague understanding of where the boundary lay. Schlichtling continuously and exclusively gardened, mowed, and otherwise cared for land that she thought was hers. The Nitsos sold their property to the Cotters in 2005, and the Cotters claimed that Schlichtling was encroaching on their land. The Cotters cut down trees on the disputed parcel, removed part of a stone wall, dug up the lawn, cut up a driveway that crossed the land, erected a fence, and otherwise disturbed the property. Schlichtling applied for a temporary injunction against the Cotters to stop them from entering and altering the land and to direct them to return the property to the state in which Schlichtling had maintained it. The court’s decision, of course, depended on who was the rightful owner of the disputed parcel of land. During the legal proceedings, surveys showed that the land had originally been part of the Nitsos’ property, but they and Schlichtling had mutually mistook the proper boundary. As such, does Schlichtling have any claim to the land? 8. The Buzby Landfill was operated from 1966 to 1978. Although it was not licensed to receive liquid industrial or chemical wastes, large amounts of hazardous materials and chemicals were dumped there. Toxic wastes began to escape from the landfill because it had no liner or cap. Tests performed by a state environmental protection agency revealed ground water contamination caused by hazardous waste seepage from the landfill. The federal Environmental Protection Agency investigated the



24-35

situation and recommended that the Buzby Landfill site be considered for cleanup under the federal Superfund law, but the cleanup did not take place. During the 1980s, Canetic Corp. and Canuso Management Corp. developed a housing subdivision near the closed Buzby Landfill. Some of the homes in the subdivision were within half a mile of the old landfill. Some of the homeowners filed a class action lawsuit alleging that Canetic and Canuso had substantial information about the dangers of placing a subdivision near the landfill, but they had not disclosed to buyers the fact that the subdivision was located near a hazardous waste dump. The defendants claimed that they did not have the duty to disclose conditions that happened on someone else’s property. Will the defendants win? 9. Angel Castelan and Marvin Huezo are friends who enjoy visiting the Universal Studios theme park. They were each denied access to one of their favorite rides, The Mummy, because they did not satisfy the rider requirements in the manufacturer recommendations. In particular, Castelan was turned away because the requirements indicate that each rider must have at least “one functioning arm [and] hand.” Huezo was denied access to the ride because the rider requirements state that each rider must have at least one leg that may be placed behind the shin pad. Castelan’s forearms were amputated due to an electrical accident when he was a child. Huezo’s legs were amputated after he was hit by a car during an attempt to assist another motorist. After being turned away from The Mummy on a couple of occasions, Castelan and Huezo filed a lawsuit under Title III of the Americans with Disabilities Act for failure to design a ride that does not require rider eligibility criteria that excludes patrons with disabilities. Will their claim succeed? 10. Voyeur Dorm operates an Internet-based website that provides a 24-hour-a-day Internet transmission portraying the lives of the residents of 2312 West Farwell Drive, Tampa, Florida. Throughout its existence, Voyeur Dorm has employed 25 to 30 different women, most of whom entered into a contract that specifies, among other things, that they are “employees,” on a “stage and filming location,” with “no reasonable expectation of privacy,” for “entertainment purposes.” Subscribers to voyeurdorm.com pay a subscription fee of $34.95 a month to watch the women employed at the premises and pay an added fee of $16.00 per month to “chat” with the women. At a zoning hearing, Voyeur Dorm’s counsel conceded that five women live in the house; that there are cameras in the corners of

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Part Five Property

all the rooms of the house; that for a fee a person can join a membership to a website wherein a member can view the women 24 hours a day, seven days a week; that a member, at times, can see someone disrobed; that the women receive free room and board; and that the women are paid as part of a business enterprise. From August 1998 to June 2000, Voyeur Dorm generated subscriptions and sales totaling $3,166,551.35. Section 27-523 of Tampa’s City Code defines adult entertainment establishments as: any premises . . . on which is offered to members of the public or any person, for a consideration, entertainment featuring or in any way including specified sexual activities . . . or entertainment featuring the displaying or depicting of

specified anatomical areas . . . ; “entertainment” as used in this definition shall include, but not be limited to, books, magazines, films, newspapers, photographs, paintings, drawings, sketches or other publications or graphic media, filmed or live plays, dances or other performances either by single individuals or groups, distinguished by their display or depiction of specified anatomical areas or specified sexual activities.

The City of Tampa argues that Voyeur Dorm is an adult use business pursuant to the express and unambiguous language of section 27-523 and, as such, cannot operate in a residential neighborhood. Is the city correct?

CHAPTER 25

Landlord and Tenant

F

rank Johnson and Sonia Miller, along with several other friends, were looking to rent a house near campus for the following school year. In June, they orally agreed with a landlord on a one-year lease to begin the following August 15 with a monthly rent of $1,750 and provided a $2,000 security deposit. When they arrived at school in August, the current tenants were still in possession and did not move out until September 1, leaving the house a mess. The landlord told Frank and Sonia to move in and that he would clean it up later; however, he never did so despite repeated requests. They complained to the city housing department, which conducted an inspection and found numerous violations of the city’s housing code. The city gave the landlord 15 days to make the necessary repairs. Before any of the repairs were made, a friend who was visiting was injured when she fell through some rotten floorboards on the porch. At the end of September, Frank, Sonia and the other tenants moved out, but the landlord refused to return their security deposit. Among the legal issues raised by this scenario are: • Did the oral agreement create an enforceable lease? • Were the tenants’ rights violated when they were unable to take possession on August 15? • Does the landlord have any liability to the injured friend? • Are the tenants entitled to terminate the lease on the grounds the house is not habitable and obtain the return of their security deposit? • If the landlord never intended to clean up the house, was it ethical for him to tell the tenants he would do so?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 25-1

 ecognize that the legal principles applicable R to landlord–tenant relationships are drawn from property law, contract law, and the law of negligence and that they incorporate the common law as well as legislative enactments. 25-2 Describe and differentiate the four main types of tenancies. 25-3 Understand the importance of a carefully drafted lease that makes clear the parties’ rights and obligations and complies with any LANDLORD–TENANT LAW HAS undergone dramatic change, owing in large part to the changing nature of the relationship between landlords and tenants. In England and in early America, farms were the usual subjects of leases. The

applicable provisions of state law, including the statute of frauds. 25-4 List and discuss the primary rights, duties, and liabilities of the landlord. 25-5 List and discuss the primary rights, duties, and liabilities of the tenant. 25-6 Describe the different ways that a lease may be terminated and identify the legal principles that apply to each method of termination.

tenant sought to lease land on which to grow crops or graze cattle. Accordingly, traditional landlord–tenant law viewed the lease as primarily a conveyance of land and paid relatively little attention to its contractual aspects.

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Part Five Property

In today’s society, however, the landlord–tenant relationship is typified by the lease of property for residential or commercial purposes. A residential tenant commonly occupies only a small portion of the total property. He bargains primarily for the use of structures on the land rather than for the land itself. He is likely to have signed a landlord-provided form lease, the terms of which he may have had little or no opportunity to negotiate. In areas with a shortage of affordable housing, a residential tenant’s ability to bargain for favorable lease provisions is further hampered. Because the typical landlord– tenant relationship can no longer fairly be characterized as one in which the parties have equal knowledge and bargaining power, it is not always realistic to presume that tenants are capable of negotiating to protect their own interests. Recognize that the legal principles applicable to landlord–tenant relationships are drawn from property LO25-1 law, contract law, and the law of negligence and that they incorporate the common law as well as legislative enactments.

Although it was initially slow to recognize the changing nature of the landlord–tenant relationship, the law now places greater emphasis than it once did on the contract components of the relationship. As a result, modern contract doctrines such as unconscionability, constructive conditions, the duty to mitigate damages, and implied warranties are commonly applied to leases. Such doctrines may operate to compensate for tenants’ lack of bargaining power. In addition, state legislatures and city councils have enacted statutes and ordinances that regulate leased property and the landlord–tenant relationship. This chapter’s discussion of landlord–tenant law will focus on the nature of leasehold interests, the traditional rights and duties of landlords and tenants, and recent statutory and judicial developments affecting those rights and duties.

Leases and Tenancies Nature of Leases A

lease is a contract under which an owner of property, the landlord (also called the lessor), conveys to the tenant (also called the lessee) the exclusive right to possess property for a period of time. The property interest conveyed to the tenant is called a leasehold estate.

Types of Tenancies  LO25-2

Describe and differentiate the four main types of tenancies.

The duration of the tenant’s possessory right depends upon the type of tenancy established by or resulting from the lease. There are four main types of tenancies. 1. Tenancy for a term. In a tenancy for a term (also called a tenancy for years), the landlord and tenant have agreed on a specific duration of the lease and have fixed the date on which the tenancy will terminate. For example, if Dudley, a college student, leases an apartment for the academic year ending May 25, 2021, a tenancy for a term will have been created. The tenant’s right to possess the property ends on the date agreed upon without any further notice, unless the lease contains a provision permitting extension. 2. Periodic tenancy. A periodic tenancy is created when the parties agree that rent will be paid in regular successive intervals until notice to terminate is given, but do not agree on a specific lease duration. If the tenant pays rent monthly, the tenancy is from month to month; if the tenant pays yearly, as is sometimes done under agricultural leases, the tenancy is from year to year. (Periodic tenancies therefore are sometimes called tenancies from month to month or tenancies from year to year.) To terminate a periodic tenancy, either party must give advance notice to the other. The precise amount of notice required is often defined by state statutes. For example, to terminate a tenancy from month to month, most states require that the notice be given at least one month in advance. 3. Tenancy at will. A tenancy at will occurs when property is leased for an indefinite period of time and either party may choose to conclude the tenancy at any time. Generally, tenancies at will involve situations in which the tenant either does not pay rent or does not pay it at regular intervals. For example, Landon allows her friend Trumbull to live in the apartment over her garage. Although this tenancy’s name indicates that it is terminable “at [the] will” of either party, most states require that the landlord give reasonable advance notice to the tenant before exercising the right to terminate the tenancy. 4. Tenancy at sufferance. A tenancy at sufferance occurs when a tenant remains in possession of the property (holds over) after a lease has expired. In this situation, the landlord has two options: (a) treating the holdover tenant as a trespasser and bringing an action to eject him or (b) continuing to treat him as a tenant and collecting rent from him. Until the landlord makes her election, the tenant is a tenant at sufferance.



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CONCEPT REVIEW Types of Tenancies Type of Lease

Characteristics

Termination

Tenancy for a term

Landlord and tenant agree on a specific duration of the lease and fix the date on which the tenancy will end.

Ends automatically on the date agreed upon; no additional notice necessary.

Periodic tenancy

Landlord and tenant agree that tenant will pay rent at regular, successive intervals (e.g., month to month).

Either party may terminate by giving the amount of advance notice required by state law.

Tenancy at will

Landlord and tenant agree that tenant may possess property for an indefinite amount of time, with no agreement to pay rent at regular, successive intervals.

May be terminated “at will” by either party, but state law requires advance notice.

Tenancy at sufferance

Tenant remains in possession after the termination of one of the leaseholds described above, until landlord brings ejectment action against tenant or collects rent from him.

Landlord has choice of: 1. Treating tenant as a trespasser and bringing ejectment action against him or 2. Accepting rent from tenant, thus creating a new leasehold.

Suppose that Templeton has leased an apartment for one year from Larson. At the end of the year, Templeton holds over and does not move out. Templeton is a tenant at sufferance. Larson may have him ejected or may continue treating him as a tenant. If Larson elects the latter alternative, a new tenancy is created. The new tenancy will be either a tenancy for a term or a periodic tenancy, depending on the facts of the case and any presumptions established by state law. Thus, a tenant who holds over for even a few days runs the risk of creating a new tenancy he might not want.

Execution of a Lease  Understand the importance of a carefully drafted lease that makes clear the parties’ rights and obligations and LO25-3 complies with any applicable provisions of state law, including the statute of frauds.

As transfers of interests in land, leases may be covered by the statute of frauds. In most states, a lease for a term of more than one year from the date it is made is unenforceable unless it is evidenced by a suitable writing signed by the party to be charged. A few states, however, require leases to be evidenced by a writing only when they are for a term of more than three years.

The vignette at the start of this chapter poses a situation with an oral lease entered into in June that will run for a year beginning on August 15. This lease would not be enforceable in a state where the statute of frauds requires a lease for more than a year from the date it is made to be in writing. However, it would be enforceable in a state where an oral lease for a period of less than three years is allowed. Good business practice demands that leases be carefully drafted to make clear the parties’ respective rights and obligations. Care in drafting leases is especially important in cases of long-term and commercial leases. Lease provisions normally cover such essential matters as the term of the lease, the rent to be paid, the uses the tenant may make of the property, the circumstances under which the landlord may enter the property, the parties’ respective obligations regarding the condition of the property, and the responsibility (as between landlord and tenant) for making repairs. In addition, leases often contain provisions allowing a possible extension of the term of the lease and purporting to limit the parties’ rights to assign the lease or sublet the property. State or local law often regulates lease terms. For example, the Uniform Residential Landlord and Tenant Act (URLTA) has been enacted in a substantial minority of states. The URLTA prohibits the inclusion of certain lease provisions, such as a clause by which the tenant supposedly agrees to pay the landlord’s attorney’s

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fees in an action to enforce the lease. In states that have not enacted the URLTA, lease terms are likely to be regulated at least to a moderate degree by some combination of state statutes, common law principles, and local housing codes.

Rights, Duties, and Liabilities of the Landlord LO25-4

List and discuss the primary rights, duties, and liabilities of the landlord.

Landlord’s Rights The

landlord is entitled to receive the agreed rent for the term of the lease. Upon expiration of the lease, the landlord has the right to the return of the property in as good a condition as it was when leased, except for normal wear and tear and any destruction caused by an act of God. Security Deposits Landlords commonly require tenants to make security deposits or advance payments of rent. Such deposits operate to protect the landlord’s right to receive rent as well as her right to reversion of the property in good condition. In recent years, many cities and states have enacted statutes or ordinances designed to prevent landlord abuse of security deposits. These laws typically limit the amount a landlord may demand and require that the security deposit be refundable, except for portions withheld by the landlord because of the tenant’s nonpayment of rent or tenant-caused property damage beyond ordinary wear and tear. Some statutes or ordinances also require the landlord to place the funds in interest-bearing accounts when the lease is for more than a minimal period of time. As a general rule, these laws require landlords to provide tenants a written accounting regarding their security deposits and any portions being withheld. Such an accounting normally must be provided within a specified period of time (30 days, for example) after the termination of the lease. The landlord’s failure to comply with statutes and ordinances regarding security deposits may cause the landlord to experience adverse consequences that vary state by state.

discriminatory practices in various transactions affecting housing, including the rental of dwellings.2 Included within the act’s prohibited instances of discrimination against a protected person are refusals to rent property to such a person; discrimination against him or her in the terms, conditions, or privileges of rental; publication of any advertisement or statement indicating any preference, limitation, or discrimination operating to the disadvantage of a protected person; and representations that a dwelling is not available for rental to such a person when, in fact, it is available. The act also makes it a discriminatory practice for a landlord to refuse to permit a tenant with a disability to make—at his own expense—reasonable modifications to leased property. The landlord may, however, make this permission conditional on the tenant’s agreement to restore the property to its previous condition upon termination of the lease, reasonable wear and tear excepted. In addition, landlords are prohibited from refusing to make reasonable accommodations in rules, policies, practices, or services if such accommodations are necessary to afford a disabled tenant equal opportunity to use and enjoy the leased premises. When constructing certain types of multifamily housing for first occupancy, property owners and developers risk violating the act if they fail to make the housing accessible to persons with disabilities. Because of a perceived increase in the frequency with which landlords refused to rent to families with children, the act prohibits landlords from excluding families with children. If, however, the dwelling falls within the act’s “housing for older persons” exception, this prohibition does not apply.3 Implied Warranty of Possession Landlords have certain obligations that are imposed by law whenever property is leased. One of these obligations stems from the landlord’s implied warranty of possession. This warranty guarantees the tenant’s right to possess the property for the term of the lease. Suppose that Turner rents an apartment from Long for a term to begin on September 1, 2021, and to end on August 31, 2022. When Turner attempts to move in on September 1, 2021, she

Landlord’s Duties Fair Housing Act As explained in Chapter 24, the Fair Housing Act prohibits housing discrimination on the basis of race, color, sex, religion, national origin, disability, and familial status.1 The Fair Housing Act prohibits Familial status is defined in Chapter 24.

1

The act provides an exemption for certain persons who own and rent single-family houses. To qualify for this exemption, owners must not use a real estate broker or an illegal advertisement and cannot own more than three such houses at one time. It also exempts owners who rent rooms or units in dwellings in which they themselves reside, if those dwellings house no more than four families. 3  The “housing for older persons” exception is described in Chapter 24. 2 



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finds that Carlson, the previous tenant, is still in possession of the property. In this case, Long has breached the implied warranty of possession.

have resulted in dramatically increased legal responsibility on the part of landlords for the condition of leased residential property.

Implied Warranty of Quiet Enjoyment By leasing property, the landlord also makes an implied warranty of quiet enjoyment (or covenant of quiet enjoyment). This covenant guarantees that the tenant’s possession will not be interfered with as a result of the landlord’s act or omission. In the absence of a contrary provision in the lease, allowance by state or local law, or an emergency that threatens the property, the landlord may not enter the leased property during the term of the lease. If he does, he will be liable for trespass. In some cases, courts have held that the covenant of quiet enjoyment was violated when the landlord failed to stop third parties, such as trespassers or other tenants who make excessive noise, from interfering with the tenant’s enjoyment of the leased premises.

Implied Warranty of Habitability The legal principle that landlords made no implied warranty regarding the condition of leased property arose during an era when tenants used land primarily for agricultural purposes. Buildings existing on the property were frequently of secondary importance. They also tended to be simple structures, lacking modern conveniences such as plumbing and wiring. These buildings were fairly easily inspected and repaired by the tenant, who was generally more self-sufficient than today’s typical tenant. In view of the relative simplicity of the structures, landlord and tenant were considered to have equal knowledge of the property’s condition upon commencement of the lease. Thus, a rule requiring the tenant to make repairs seemed reasonable. The position of modern residential tenants differs greatly from that of an earlier era’s agricultural tenants. The modern residential tenant bargains not for the use of the ground itself but for the use of a building (or portion thereof) as a dwelling. The structures on land today are complex, frequently involving systems (such as plumbing and electrical systems) to which the tenant does not have physical access. Besides decreasing the likelihood of perceiving defects during inspection, this complexity compounds the difficulty of making repairs—something at which today’s tenant already tends to be less adept than his grandparents were. Moreover, placing a duty on tenants to negotiate for express warranties and duties to repair is no longer feasible. Residential leases are now routinely executed on standard forms provided by landlords. For these reasons, statutes or judicial decisions in most states now impose an implied warranty of habitability on many landlords who lease residential property. According to the vast majority of cases, this warranty is applicable only to residential property and not to property leased for commercial uses. The implied warranty of habitability’s content in lease settings is basically the same as in the sale of real estate: The property must be safe and suitable for human habitation. In lease settings, however, the landlord not only must deliver a habitable dwelling at the beginning of the lease but also must maintain the property in a habitable condition during the term of the lease. Various statutes and judicial decisions provide that the warranty includes an obligation that the leased property comply with any applicable housing codes.

Constructive Eviction The doctrine of constructive eviction may aid a tenant when property becomes unsuitable for the purposes for which it was leased because of the landlord’s act or omission, such as the breach of a duty to repair or the covenant of quiet enjoyment. Under this doctrine, which applies to both residential and commercial property, the tenant may terminate the lease because she has effectively been evicted as a result of the poor condition or the objectionable circumstances there. Constructive eviction gives a tenant the right to vacate the property without further rent obligation if she does so promptly after giving the landlord reasonable notice and an opportunity to correct the problem. Because constructive eviction requires the tenant to vacate the leased premises, it is an unattractive option, however, for tenants who cannot afford to move or do not have a suitable alternative place to live.

Landlord’s Responsibility for ­Condition of Leased Property The common law histori-

cally held that landlords made no implied warranties regarding the condition or quality of leased premises. As an adjunct to the landlord’s right to receive the leased property in good condition at the termination of the lease, the common law imposed on the tenant the duty to make repairs. Even when the lease contained a landlord’s express warranty or express promise to make repairs, a tenant was not entitled to withhold rent if the landlord failed to carry out his obligations. This was because a fundamental contract performance principle—that a party is not obligated to perform if the other party fails to perform—was considered inapplicable to leases. However, changing views of the landlord–tenant relationship

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In the scenario set out at the start of this chapter, the tenants who arrived on the date when the lease was to begin and found that the property was not in suitable condition for habitation, including violations of the city’s housing code, would have an arguable claim against the landlord for breach of implied warranty of habitability. Remedies for Breach of Implied Warranty of Habitability From a tenant’s point of view, the implied warranty of habitability is superior to constructive eviction because a tenant does not have to vacate the leased premises in order to seek a remedy for breach of the warranty. The particular remedies for breach of the implied warranty of habitability differ from state to state. Some of the remedies a tenant may pursue include: 1. Action for damages. The breach of the implied warranty of habitability violates the lease and renders the landlord liable for damages. The damages generally are measured by the diminished value of the leasehold. The landlord’s breach of the implied warranty of habitability may also be asserted by the tenant as a counterclaim and defense in the landlord’s action for eviction and/or nonpayment of rent. 2. Termination of lease. In extreme cases, the landlord’s breach of the implied warranty of habitability may justify the tenant’s termination of the lease. For this remedy to be appropriate, the landlord’s breach must have been substantial enough to constitute a material breach. 3. Rent abatement. Some states permit rent abatement, a remedy under which the tenant withholds part of the rent for the period during which the landlord was in breach of the implied warranty of habitability. Where authorized by law, this approach allows the tenant to pay a reduced rent that reflects the actual value of the leasehold in its defective condition. There are different ways of computing this value. State law determines the amount by which the rent will be reduced.

4. Repair-and-deduct. A number of states have statutes that permit the tenant to have defects repaired and to deduct the repair costs from her rent. The repairs authorized in these statutes are usually limited to essential services such as electricity and plumbing. They also require that the tenant give the landlord notice of the defect and an adequate opportunity to make the repairs himself. Housing Codes Many cities and states have enacted housing codes that impose duties on property owners with respect to the condition of leased property. Typical of these provisions is Section 14-400.3 of the District of Columbia Municipal Regulations, which provides: “No person shall rent or offer to rent any habitation, or the furnishings of a habitation, unless such habitation and its furnishings are in a clean, safe, and sanitary condition, in repair, and free from rodents or vermin.” Such codes commonly call for the provision and maintenance of necessary services such as heat, water, and electricity, as well as suitable bathroom and kitchen facilities. Housing codes also tend to require that specified minimum space-per-tenant standards be met; that windows, doors, floors, and screens be kept in repair; that the property be painted and free of lead paint; that keys and locks meet certain specifications; and that the landlord issue written receipts for rent payments. A landlord’s failure to comply with an applicable housing code may result in a fine or in liability for injuries resulting from the property’s disrepair. The noncompliance may also result in the landlord’s losing part or all of his claim to the agreed-upon rent. Some housing codes establish that tenants have the right to withhold rent until necessary repairs have been made and the right to move out in cases of particularly egregious violations of housing code requirements. In the case that follows, Brooks v. Lewin Realty III, Inc., the court held that a landlord could be liable for injuries to a child that were caused by the landlord’s failure to comply with the city’s housing code.

Brooks v. Lewin Realty III, Inc.   835 A.2d 616 (Md. Ct. App. 2003) In August 1988, Shirley Parker rented a house in Baltimore City. Fresh paint was applied to the interior of the house at the beginning of the tenancy. Sharon Parker, Shirley’s daughter, moved into the house shortly after her mother rented it. On December 6, 1989, Sharon gave birth to Sean, who then also lived there. Early in 1991, when Sean was slightly more than a year old, Lewin Realty purchased the house at an auction. Before the purchase, one of the owners of Lewin Realty walked through the house accompanied by Sharon as he inspected it. At the time of the walk-through, there was peeling, chipping, and flaking paint present in numerous areas of the interior of



Chapter Twenty-Five Landlord and Tenant

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the house, including in Sean’s bedroom. After Lewin Realty purchased the house, it entered into a new lease with Shirley but did not paint its interior at that time. In February 1992, Sean was diagnosed with an elevated blood lead level. In May 1992, the house was inspected and found to contain 56 areas of peeling, chipping, and flaking lead paint, and the Baltimore City Health Department (BCHD) issued a lead paint violation notice to Lewin Realty. Section 702(a) of the Baltimore City Housing Code requires that a dwelling be kept in “good repair” and “safe condition” and prohibits a landlord from leasing a dwelling that violates the Housing Code. The Housing Code further provides that maintaining a dwelling in good repair and safe condition includes keeping all interior walls, ceilings, woodwork, doors, and windows clean and free of any flaking, loose, or peeling paint. It also mandates the removal of loose and peeling paint from interior surfaces and requires that any new paint be free of lead. The Housing Code also grants the landlord the right of access to rental dwellings at reasonable times for purpose of making inspections and such repairs as are necessary to comply with the Code. Sharon Parker brought a lawsuit on behalf of her son, alleging, among other things, negligence. The negligence claim was founded on several grounds, including (1) Lewin Realty’s violation of the Baltimore City Code; (2) Sean’s exposure to an unreasonable risk of harm from the lead-based paint while Lewin Realty knew that its dangerous properties were not known to Sean and not discoverable in the exercise of reasonable care; (3) Lewin Realty’s failure to exercise reasonable care in properly maintaining the walls, doors, and ceilings after Lewin Realty had actual and constructive knowledge of the flaking paint condition; and (4) Lewin Realty’s failure to exercise reasonable care to inspect the dwelling’s paint when a reasonable inspection would have revealed the flaking paint condition. One of the questions in the litigation was whether the tenants were required to show that the landlord had notice of the violation in order to establish a prima facie case of negligence. Lewin Realty argued that because the tenant had control over the property and neither the common law nor any statute expressly required inspections during the tenancy, the court should not impose such a duty. Lewin Realty further argued it should not be held liable unless it had actual knowledge of the violation and that landlords who do not perform periodic inspections should not be charged with knowledge of what such inspections would reveal.

Eldridge, Justice As the parties point out, under the common law and in the absence of a statute, a landlord ordinarily has no duty to keep rental premises in repair, or to inspect the rental premises either at the inception of the lease or during the lease term. There are, however, exceptions to this general rule. Moreover, where there is an applicable statutory scheme designed to protect a class of persons which includes the plaintiff, another well-settled Maryland common law rule has long been applied by this Court in negligence actions. That rule states that the defendant’s duty ordinarily “is prescribed by the statute” or ordinance and that the violation of the statute or ordinance is itself evidence of negligence. Under this principle, in order to make out a prima facie case in a negligence action, all that a plaintiff must show is: (a) the violation of a statute or ordinance designed to protect a specific class of persons which includes the plaintiff, and (b) that the violation proximately caused the injury complained of. “Proximate cause is established by determining whether the plaintiff is within the class of persons sought to be protected, and the harm suffered is of a kind which the drafters intended the statute to prevent. . . . It is the existence of this cause and effect relationship that makes the violation of a statute prima facie evidence of negligence.”

We stress that none of the cases we cite impose upon the plaintiff the additional burden of proving that the defendant was aware that he or she was violating the statute or ordinance. Depending upon the statute and the particular sanction involved, knowledge, and the type thereof, may or may not be pertinent in establishing whether or not there was a statutory violation. Nevertheless, once it is established that there was a statutory violation, the tort defendant’s knowledge that he or she violated the statute is not part of the tort plaintiff’s burden of proof. It is the violation of the statute or ordinance alone which is evidence of negligence. This rule has been stated in the context of landlords and tenants in the Restatement (Second) of Property, Landlord and Tenant Section 17.6 (1977), and cited with approval by this Court in lead paint premises liability cases. Section 17.6 of the Restatement (Second) of Property provides (emphasis added): A landlord is subject to liability for physical harm caused to the tenant . . . by a dangerous condition existing before or arising after the tenant has taken possession, if he has failed to exercise reasonable care to repair the condition and the existence of the condition is in violation of: (1) an implied warranty of habitability; or (2) a duty created by statute or administrative regulation.

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In the instant case, the Housing Code, Baltimore City Code imposes numerous duties and obligations upon landlords who rent residential property to tenants. The plaintiffs are obviously within a class of persons which the Housing Code was designed to protect. Brown v. Dermer, 357 Md. 344, 367 (2000) (“Patently, by enacting Sections 702 and 703 of the Housing Code, the City Council sought to protect children from lead paint poisoning by putting landlords on notice of conditions which could enhance the risk of such injuries”). Under the established principles of Maryland tort law set forth in the previously cited cases, if the plaintiffs can establish a violation of the Housing Code which proximately caused Sean’s injuries, then the plaintiffs are entitled to have count one of their complaint submitted to the trier of facts. Under the above-cited cases, the plaintiffs need not prove that Lewin Realty had notice of the Housing Code violation. *** Thus, under the plain meaning of the Code’s language, it is clear that the Mayor and City Council of Baltimore mandated a continuing duty to keep the dwelling free of flaking, loose, or peeling paint, at all times “while [the dwelling is] in use,” in order for the landlord to remain in compliance with the Housing Code. The nature of the landlord’s duty is continuous. The Housing Code does not limit the landlord’s duty to keep the premises free of flaking paint to a one-time duty at the inception of the lease. The landlord must take whatever measures are necessary during the pendency of the lease to ensure the dwelling’s continued compliance with the Code. To facilitate such continuous maintenance of the leased premises, Section 909 explicitly grants a right of entry to the landlord to ensure that he or she can “make such inspections and such repairs as are necessary” to comply with the Housing Code. It states: Every occupant of a dwelling . . . shall give the owner thereof . . . access to any part of such dwelling . . . at all reasonable times for the purpose of making such inspection and such repairs or alterations as are necessary to effect compliance with the provisions of this Code. . . . Although this section may not explicitly require the landlord to perform periodic inspections, it grants such right to the landlord and shows that the City anticipated that periodic inspections might be necessary to comply with the Code. Lewin Realty urges that “during a tenancy . . . the landlord surrenders control of the property and, in doing so, surrenders the ability, at least in some respects, to prevent a violation of the housing code during the tenancy.” Lewin Realty’s principal argument is that the landlord has no ability to control the condition of the interior surfaces of the premises during the tenancy. We disagree. Contrary to Lewin Realty’s argument, Section 909 vests

the landlord with sufficient control of the leased premises during the tenancy to inspect and to rectify a condition of flaking, loose, or peeling paint. Furthermore, contrary to Lewin Realty’s statements in its brief, our holding in the instant case does not impose a strict liability regime upon landlords. Whether Lewin Realty is held liable for an injury to a child, based on lead paint poisoning, will depend on the jury’s evaluation of the reasonableness of Lewin Realty’s actions under all the circumstances. Lewin Realty also contends that “the imposition of a duty to inspect during [the] tenancy would create a minefield of difficulties.” The respondent’s concerns that a landlord will be required to “inspect the property every day, three times a week, twice a week, twice a month, once a month . . .” are without basis. The nature of the defective condition in question—a flaking, loose, or peeling paint condition—is a slow, prolonged process which is easily detected in the course of reasonable periodic inspections. As Lewin Realty concedes, “we know that paint in a property will chip—it is just a matter of time.” It does not occur overnight. In addition, Lewin Realty raises doubts about the ability to quantify the dangerousness of a lead paint condition: “Is one area in a far corner of a property a ‘dangerous condition’? . . . Is the presence of lead-based paint in the eighth layer of paint, covered by seven non-leaded layers of paint, a hazardous condition when present on a windowsill as opposed to the upper far corner of a wall?” In a negligence case, such as the case at bar, the simple answer to these questions is that it will be the duty of the trier of fact to determine whether the steps taken by the landlord to ensure continued compliance with the Code, i.e., the frequency and thoroughness of inspections, and the maintenance of the interior surfaces of the dwelling, were reasonable under all the circumstances. The test is what a reasonable and prudent landlord would have done under the same circumstances. Finally, Lewin Realty suggests that a tenant might object to the landlord’s need to inspect the premises. That concern is allayed by the fact that the Housing Code requires the tenant to give the owner access to the premises “at all reasonable times for the purpose of making such inspections . . . as are necessary to effect compliance with the provisions of this Code.” Section 909. JUDGMENT OF THE COURT OF SPECIAL APPEALS AFFIRMED. Raker, Judge, dissenting I respectfully dissent. The majority explicitly overrules Richwind v. Brunson, 335 Md. 661 (1994)—a case that, until today, had never had any doubt cast upon it by this Court or any other—and holds that by enacting the Baltimore City Housing Code, the City Council intended to abolish the element of notice in a common law negligence action for injuries resulting



Chapter Twenty-Five Landlord and Tenant

from flaking, loose or peeling paint. In the process of overruling Richwind, the majority also reads into the Code an ongoing, affirmative duty by landlords to inspect periodically each of their housing units for loose or flaking paint for as long as they retain ownership of the premises. I disagree with the majority’s conclusion that the ordinance does away with the traditional, common law notice requirement to the landlord as a precursor to liability for negligence. It is helpful to understand first what the majority’s holding actually means and its implications for landlords and tenants in Baltimore. A violation of Baltimore’s Housing Code occurs when the landlord does not comply with Section 703, which mandates, in relevant part, that “all walls, ceilings, woodwork, doors and windows shall be kept clean and free of any flaking, loose or peeling paint. . . .” The majority asserts that “if the plaintiffs can establish a violation of the Housing Code which proximately caused [their] injuries, then the plaintiffs are entitled to have . . . their complaint submitted to the trier of facts.” Read together, the result of the majority’s holding is astounding: Any flaking, loose or peeling paint in a leased premises, combined with an injury from lead paint, automatically gives rise to a cognizable action, worthy of a jury trial. The majority admits as much in summarizing its holding: In sum, the presence of flaking, loose, or peeling paint is a violation of the Housing Code. As earlier pointed out, certain provisions of the Housing Code were clearly enacted to

Americans with Disabilities Act Landlords leasing property constituting a place of public accommodation (primarily commercial property as opposed to private residential property) must pay heed to Title III of the Americans with Disabilities Act. Under Title III, own-­ ers and possessors of real property that is a place of public accommodation may be expected to make reasonable accommodations, including physical modifications of the property, in order to allow people with disabilities to have access to the property. Chapter 24 contains a detailed discussion of Title III’s provisions.

Landlord’s Tort Liability Traditional No-Liability Rule There were two major effects of the traditional rule that a landlord had no legal responsibility for the condition of the leased property. The first effect—that the uninhabitability of the premises traditionally did not give a tenant the right to withhold rent, assert a defense to nonpayment, or terminate a lease—has already been discussed. The second effect was that landlords normally could not be held liable in tort for injuries

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prevent lead poisoning in children. Therefore, the plaintiff Sean is in the class of people intended to be protected by the Housing Code, and his injury, lead poisoning, is the kind of injury intended to be prevented by the Code. This is all the plaintiffs must show to establish a prima facie case sounding in negligence. The majority’s new rule means that the landlord will be forced to defend the case in court even if the plaintiff concedes that the landlord behaved reasonably in not knowing about a Code violation. Without any express instruction, the majority reads into the statute the dramatic institution of a wholly new regulatory scheme that essentially imposes strict liability upon landlords and makes landlords the insurers of litigants for injuries sustained by a minor plaintiff due to exposure to lead-based paint. Furthermore, the majority’s new rule means that plaintiff tenants will no longer be required to notify landlords of hazards in their dwelling home, hazards that they, not the landlord, are in the best position to identify. The common law used to deal with such unfairness by providing that a landlord who had a valid excuse, such as lack of ­notice, for not remedying the violation would not be held liable, see ­Restatement (Second) of Torts Section 288A(2)(b) (1965) (excusing liability for violation of a legislative enactment or administrative regulation when defendant neither knows nor should know of the occasion for compliance). But under the majority’s new rule, no such excuse is relevant.

suffered by tenants on leased property. This state of affairs stemmed from the notion that the tenant had the ability and responsibility to inspect the property for defects before leasing it. By leasing the property, the tenant was presumed to take it as it was, with any existing defects. As to any defects that might arise during the term of the lease, the landlord’s tort immunity was seen as justified by his lack of control over the leased property once he had surrendered it to the tenant. Traditional Exceptions to No-Liability Rule Even before the current era’s protenant legal developments, however, courts created exceptions to the no-liability rule. In the following situations, landlords have traditionally owed the tenant (or an appropriate third party) a duty the breach of which could constitute a tort: 1. Duty to maintain common areas. Landlords have a duty to use reasonable care to maintain the common areas (such as stairways, parking lots, and elevators) over which they retain control. If a tenant or a tenant’s guest sustains injury as a result of the landlord’s negligent maintenance of a common area, the landlord is liable.

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Part Five Property

2. Duty to disclose hidden defects. Landlords have the duty to disclose hidden defects about which they know, if the defects are not reasonably discoverable by the tenant. The landlord is liable if a tenant or appropriate third party suffers injury because of a hidden danger that was known to the landlord but went undisclosed. 3. Duty to use reasonable care in performing repairs. If a landlord repairs leased property, he must exercise reasonable care in making the repairs. The landlord may be liable for the consequences stemming from negligently performed repairs, even if he was not obligated to perform them. 4. Duty to maintain property leased for admission to the public. The landlord has a duty to suitably maintain property that is leased for admission to the public. A theater would be an example. 5. Duty to maintain furnished dwellings. The landlord who rents a fully furnished dwelling for a short time impliedly warrants that the premises are safe and habitable. Except for the above circumstances, the landlord traditionally was not liable for injuries suffered by the tenant on leased property. Note that none of these exceptions would apply to one of the most common injury ­scenarios—when the tenant was injured by a defect in her own apartment and the defect resulted from the landlord’s failure to repair, rather than from negligently performed repairs. Current Trends in Landlord’s Tort Liability Today, the traditional rule of landlord tort immunity has largely been abolished. The proliferation of housing codes and the development of the implied warranty of habitability have persuaded a majority of courts to impose on landlords the duty to use reasonable care in their maintenance of the leased property. As discussed earlier, a landlord’s duty to keep the property in repair may be based on an express clause in the lease, the implied warranty of

habitability, or provisions of a housing code or statute. The landlord now may be liable if injury results from her negligent failure to carry out her duty to make repairs. As a general rule, a landlord will not be liable unless she had notice of the defect and a reasonable opportunity to make repairs. Applying these principles to the vignette at the beginning of this chapter, a landlord who was on notice of a significant defect in property he had leased, namely rotten floorboards in a porch, and who failed to make repairs in a timely fashion probably would be liable for injuries sustained by an invitee of the tenants. The duty of care landlords owe tenants has been held to include the duty to take reasonable steps to protect tenants from substantial risks of harm created by other tenants. Courts have held landlords liable for tenants’ injuries resulting from dangerous conditions (such as vicious animals) maintained by other tenants when the landlord knew or had reason to know of the danger. It is not unusual for landlords to attempt to insulate themselves from negligence liability to tenants by including an exculpatory clause in the standard form leases they expect tenants to sign. An exculpatory clause purports to relieve the landlord from legal responsibility that the landlord could otherwise face (on negligence or other grounds) in certain instances of premises-related injuries suffered by tenants. In recent years, a number of state legislatures and courts have frowned upon exculpatory clauses when they are included in leases of residential property. There has been an increasing judicial tendency to limit the effect of exculpatory clauses or declare them unenforceable on public policy grounds when they appear in residential leases. In the case that follows, Wendzel v. Feldstein, the Court of Appeals of Michigan considers what sorts of lease terms might act as a disfavored exculpatory clause. A Michigan statute prohibits such clauses; however, as the court notes, that does not mean the landlord will inevitably bear the risk of actually paying the damages caused by its own negligence.

Wendzel v. Feldstein   2015 WL 7288057 (Mich. Ct. App. Nov. 17, 2015) Susan Feldstein leased an apartment at Whethersfield Apartments in Bloomfield Hills, Michigan. Though the lease prohibited dogs “in the Apartment or common areas,” Feldstein adopted and brought home to her apartment an eight- or nine-year-old German Shepherd named Dreidel. Due to the developments addressed below, DeAnna Bruzos, Whethersfield’s manager, learned that Feldstein was keeping Dreidel in her apartment. Bruzos delivered to Feldstein Whethersfield’s standard “dog pet addendum” to the lease. The addendum permitted the lessee to keep one dog in her apartment as long as the lessee agreed to the terms of the addendum and paid a refundable $200 pet deposit. The addendum included the following language in paragraph 6: “Resident



Chapter Twenty-Five Landlord and Tenant

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agrees to indemnify and hold Landlord harmless from any and all claims arising out of the presence of said pet. Resident also affirms that renters insurance will be in force for the duration of the lease.” Feldstein signed the addendum and paid the deposit. She and Whethersfield agree that the terms of the addendum applied retroactively to the date she signed her lease. She never secured renters insurance. Prior to moving to Whethersfield and adopting Dreidel, Feldstein had fostered the dog. Dreidel’s previous owner kept him in the basement most of the time. As a result, Dreidel had serious problems with socialization. During the seven months that Dreidel lived with Feldstein at Whethersfield, he bit three people in the apartment complex’s common areas. Dreidel’s first victim was a drunken neighbor who allegedly ignored Feldstein’s order to stay back while she walked Dreidel on a leash. No one notified Whethersfield of this incident. The second victim was Peter Lee, a young boy who was riding his bicycle near the edge of Feldstein’s back patio in the complex’s courtyard. Dreidel broke free from a 12-foot steel cable attached to a stake just outside Feldstein’s door and bit Peter’s ankle. Peter’s parent told Bruzos about this episode, which was what prompted her to deliver the addendum to Feldstein. Bruzos and Feldstein also discussed plans for keeping Dreidel leashed and muzzled in any of the common areas. Nonetheless, a little over a month later, Feldstein’s neighbor, Carold Wendzel, was walking on a path through the middle of the courtyard when Dreidel emerged from behind the patio privacy wall of Feldstein’s apartment and bit her leg, knocking her to the ground and breaking her ankle. Dreidel apparently broke free once again from a 12-foot tether with a reinforced collar. Animal control seized Dreidel, and after a 10-day quarantine period, Feldstein had Dreidel euthanized. Wendzel filed suit against Feldstein and Whethersfield, claiming strict liability and negligence against Feldstein and negligence against Whethersfield. Whethersfield filed a cross-complaint against Feldstein seeking indemnification under the pet addendum. Wendzel and Whethersfield settled for $30,000, after which the court granted Whethersfield’s motion for summary judgment against Feldstein, reasoning that the language of paragraph 6 of the pet addendum clearly and unambiguously obligated Feldstein to indemnify Whethersfield for losses related to Wendzel’s injury, which were due to the presence of Feldstein’s dog. Feldstein appealed. Per Curiam Feldstein first contends that the indemnification clause in paragraph 6 of the pet addendum violates public policy because it conflicts with . . . Michigan’s Truth in Renting Act, [which] provides in relevant part: A rental agreement shall not include a provision that does 1 or more of the following: . . . (e) Exculpates the lessor from liability for the lessor’s failure to perform, or negligent performance of, a duty imposed by law. . . . Feldstein argues that the indemnification requirement illegally exculpated Whethersfield from liability for Whethersfield’s breach of its nondelegable duty to maintain the common areas “fit for the use intended by the parties,” thereby free from Dreidel’s attacks. . . . The language of the indemnification agreement is plain, unambiguous, and broad in scope. It requires Feldstein to indemnify Whethersfield from “any and all claims arising out of the presence of” Dreidel in the apartment complex. Feldstein does not dispute the meaning of this provision. Landlords have “a duty of care to keep the premises within their control reasonably safe from physical hazard,” and to generally keep common areas “reasonably safe.” Bailey v. Schaaf, 835 N.W.2d 413 (Mich. 2013). According to Feldstein, this includes protecting tenants “from foreseeable activities in the common areas where for example the presence of a ‘vicious’

dog might be found.” By transferring this duty to Feldstein through the indemnification clause in the pet addendum, Feldstein contends, Whethersfield “effectively exculpated itself from liability arising from violation of the duty imposed by law.” We [disagree], as the indemnification agreement did not “exculpate” Whethersfield. Exculpatory clauses in residential leases that negate a landlord’s statutory duties are unenforceable because they violate public policy[; however, w]e are unpersuaded that the indemnification provision in Feldstein’s lease amounts to an illegal exculpation clause. First, nothing in paragraph 6 (or the balance of the lease) absolves Whethersfield of its own liability for breaches of its standard of care. Assuming that Whethersfield bore a statutory duty to keep the common areas safe from “vicious dogs,” the indemnification agreement simply did not delegate that duty to Feldstein. . . . [N]othing in the lease or the addendum released Whethersfield from the obligation to keep the premises safe from physical or other hazards. As stated by the Supreme Court of Colorado in a somewhat analogous case: An agreement to indemnify against liability for the breach of a duty is clearly not the equivalent of delegating that duty to another. An agreement to indemnify in no way purports to relieve the indemnitee of a duty owed to someone else, whether that duty is considered delegable or not. As in this case, an indemnitee remains liable to another for injury resulting from its breach of a duty owed to the injured party, and its indemnitor merely agrees to hold the indemnitee

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Part Five Property

harmless from such loss or damage as may be specified in their contract. Significantly, an agreement to indemnify, by definition, does not (and could not, without becoming something more than an agreement to indemnify) purport to substitute an indemnitor for an indemnitee, or in any way diminish the indemnitee’s obligation to a party it has injured, whether the indemnitor ultimately fulfills its agreement or not. [Constable v. Northglenn, LLC, 248 P.3d 714, 718 (Colo. 2011).] Rather than immunizing Whethersfield from its statutory duties, paragraph 6 identified the tenant as the party bearing ultimate financial responsibility when a tenant’s dog causes injuries or damage on the premises. As articulated in Constable, “It is often the case that such an allocation of the risk of injury, without regard to fault, serves as a constituent component of the consideration demanded for entering into a lease agreement.” Id. Unlike [a true exculpatory] provision . . . , the language of paragraph 6 merely allocates financial responsibility for loss incurred by the landlord that was occasioned by an act or omission of the tenant. Nor do we find objectionable the fact that the provision serves in part to reimburse Whethersfield for its own failure to take more

aggressive actions against Feldstein and Dreidel after the Peter Lee incident. This Court has held that an indemnification agreement may be upheld despite that it indemnifies an indemnitee for its own negligence: Michigan courts have discarded the additional rule of construction that indemnity contracts will not be construed to provide indemnification for the indemnitee’s own negligence unless such an intent is expressed clearly and unequivocally in the contract. Instead, broad indemnity language may be interpreted to protect the indemnitee against its own negligence if this intent can be ascertained from “other language in the contract, surrounding circumstances, or from the purpose sought to be accomplished by the parties.” [Sherman v. DeMaria Bldg Co, Inc., 513 N.W.2d 187 (Mich. Ct. App. 1994).] Thus, the clear and unequivocal language of the agreement does not collide with any public policy considerations. *** We affirm.

Ethics and Compliance in Action Disclosing Possible Hazards to Tenants Suppose you own an older home that in the past was painted with lead-based paint. You rent it to a family with three small children. A state law forbids using lead-based paint

Landlord’s Liability for Injuries Resulting from Others’ Criminal Conduct Another aspect of the trend toward increasing landlords’ legal accountability is that many courts have imposed on landlords the duty to take reasonable steps to protect tenants and others on their property from foreseeable criminal conduct.4 Although landlords are not insurers of the safety of persons on their property, an increasing number of courts have found them liable for injuries sustained by individuals who were criminally attacked on the landlord’s property if the attack was facilitated by the landlord’s failure to comply with housing codes or maintain reasonable security. This liability has been imposed on Chapter 24 contains a more extensive discussion of courts’ recent inclination to impose this duty on owners and possessors of property.

on residential property after the effective date of the statute, but it does not require owners of property with residues of leadbased paint to remove it. Should you disclose the presence of the lead-based paint to your tenants? What legal liability might you incur if you do not do so?

residential and commercial landlords (such as shopping mall owners). Some courts have held that the implied warranty of habitability includes the obligation to provide reasonable security. In most states that have imposed this type of liability, however, principles of negligence or negligence per se furnish the controlling rationale.5 In the case that follows, Tan v. Arnel Management Company, a California court applied negligence principles in holding that a landlord violated its duty of care to a tenant who was rendered a quadriplegic when shot in the course of an attempted carjacking on a common area of an apartment complex.

4

The law of negligence is covered in detail in Chapter 7.

5



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Tan v. Arnel Management Company   170 Cal. App. 4th 1087 (2009) Arnel Management Company manages the Pheasant Ridge Apartments, a 620-unit, multibuilding apartment complex with more than 1,000 residents situated on 20.59 acres in Rowland Heights, California. The entrance road bisects the property. The beginning of the entrance road has a grassy median and is bordered on both sides by tennis courts. A little farther up the road lie two open parking lots. One is a visitor lot, located on one side of the entrance road, and the other is the parking lot for the leasing office, located on the other side of the road. Just before the two parking lots, in the middle of the entrance road, sits a “guard shack.” Continuing past the two parking lots to the back of the property, the entrance road fans out into a circle by which vehicles can turn left or right through two security gates. The apartments are located beyond the security gates. The gates are remotecontrol operated. Most of the property’s parking spaces lie behind these gates by the apartments. Yu Fang Tan, his wife Chun Kuei Chang, and their son moved into Pheasant Ridge in July 2002 and received one assigned parking space. Tenants could pay an additional fee for a garage, but Tan and his family chose not to rent one. At the time they leased the apartment, they learned that if they had a second car, they could park it in unassigned parking spaces throughout the complex or in one of the two lots for visitors and the leasing office, as long as the car was removed from the leasing office lot before 7:00 A.M. At around 11:30 P.M. on December 28, 2002, Tan arrived home and drove around the property looking for an open parking space because his wife had parked the family’s other car in their assigned space. Unable to locate an available space, Tan parked in the leasing office parking lot outside the gated area. As Tan was parking his car, an unidentified man approached him and asked for help. When Tan opened his window, the man pointed a gun at Tan and told him to get out of the car because the man wanted it. Tan responded, “Okay. Let me park my car first.” But the car rolled a little, at which point the assailant shot the plaintiff in the neck. The incident rendered Tan a quadriplegic. Tan and his wife brought suit against Arnel Management alleging, among other things, negligence and loss of consortium. Arnel Management sought and obtained a pretrial hearing to ascertain whether Tan’s proposed evidence of prior similar criminal conduct was sufficiently similar to make the assault on Tan foreseeable. Tan’s expert, a UCLA sociology professor, looked at police reports, complaints to the police, property management reports, and records of Pheasant Ridge’s security services. After excluding from his analysis those prior incidents involving attacks by acquaintances, he found 10 incidents he viewed as being “particularly significant warning signs,” of which three involved “prior violent incidents.” All of the incidents involved a sudden attack without warning late at night by a stranger who was on the ungated portion of the premises. Tan also presented nearly 80 examples of thefts from garages or cars or thefts of cars occurring on the Pheasant Ridge property, but the trial court excluded the evidence because the incidents did not involve robberies or violent attacks on people. In response to a question from the court as to what additional security measures Tan was contending fell within the apartment manager’s duty to have in place in order to prevent the harm he sustained, Tan’s counsel indicated they wanted gates installed on the entrance roadway before the leasing office and visitor parking lots, rather than at the back of the entrance road. The purpose would be to effectively deter escape and to reduce the probability of a carjack occurring. He also indicated that Tan was not asking that any measure be undertaken that would require ongoing surveillance or monitoring or necessitate the expenditure of funds. The expert presented evidence that when gates were installed in crime areas, the rate of violence went down as potential offenders want to anticipate an easy escape. Moreover, gates deter strangers who must explain their presence on the property. The trial court ruled that Tan had failed to demonstrate that enclosing the entire complex, moving the gates, and installing some system or a guard that would let invited guests enter the complex at night, as Tan proposed, would be any less burdensome than providing full-time security guards at night. Therefore, the court observed that in order to impose a duty on the apartment manager, Tan would have to demonstrate a high degree of foreseeability of the crime committed against Tan based upon prior similar incidents of violent crime at Pheasant Ridge. However, the court ruled that none of the prior incidents referenced by Tan’s expert involved a prior attempted carjacking, or of an attempted murder, or of anyone being shot, or shot at. Therefore, the trial court held that Arnel Management had no duty to take the additional security measures proposed by Tan to enhance the security in the common areas, including the leasing office parking lot where the crime occurred. Tan appealed.

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Aldrich, Judge b. The duty of landlords to prevent third-party criminal acts on their premises To succeed in a negligence action, the plaintiff must show that (1) the defendant owed the plaintiff a legal duty, (2) the defendant breached the duty, and (3) the breach proximately or legally caused (4) the plaintiff’s damages or injuries. Our Supreme Court has clearly articulated the scope of a landowner’s duty to provide protection from foreseeable third-party criminal acts. It is determined in part by balancing the foreseeability of the harm against the burden of the duty to be imposed. In cases where the burden of preventing future harm is great, a high degree of foreseeability may be required. On the other hand, in cases where there are strong policy reasons for preventing the harm, or the harm can be prevented by simple means, a lesser degree of foreseeability may be required. Duty in such circumstances is determined by a balancing of foreseeability of the criminal acts against the burdensomeness, vagueness and efficacy of the proposed security measures. The higher the burden to be imposed on the landowner, the higher the degree of foreseeability is required. The appropriate analytical approach was confirmed by the Supreme Court in Castaneda v. Olsher, 41 Cal. 4th 1205 (2007). First, the court must determine the specific measures the defendant should have taken to prevent the harm. This frames the issue for the court’s determination by defining the scope of the duty under consideration. Second, the court must analyze how financially and socially burdensome these proposed measures would be to a landlord, which measures could range from minimally burdensome to significantly burdensome under the facts of the case. Third, the court must identify the nature of the third-party conduct that the plaintiff claims could have been prevented had the landlord taken the proposed measures and assess how foreseeable (on a continuum from a mere possibility to a reasonable probability) it was that this conduct would occur. Once the burden and foreseeability have been independently assessed, they can be compared in determining the scope of the duty the court imposes on a given defendant. The more certain the likelihood of harm, the higher the burden a court will impose on a landlord; the less foreseeable the harm, the lower the burden a court will impose on a landlord. c. The trial court erred in finding defendants owed no duty. Referring to the first step of the analysis, i.e., the specific security measures that plaintiffs proposed defendants should have taken, the record shows that plaintiff requested minimal changes. Professor Katz recommended (1) moving the existing security gates from the back of the access road, or (2) installing very similar gates before the visitor and leasing office parking lots. Any gate could remain open during the day to allow business in the leasing office. Plaintiffs clearly stated they were not asking for the hiring of a guard or for any form of ongoing surveillance or monitoring.

Furthermore, existing fencing extends around almost the entire perimeter of the property, only a “very minor” extension over a “very small area” would be necessary to close the fencing gap. The second issue requires the court to analyze how financially and socially onerous the proposed measures would be to the landlord. The evidence adduced at the hearing was that the cost to defendants to install the two security gates barricading the two roads at the back of the property was about $13,500. And plaintiffs suggested using the same gates for the front of the property. Although plaintiffs presented no evidence about the cost of extending the fence, notably Professor Katz testified that would necessitate only a “minor extension” because the property is already almost completely surrounded by walls and could even involve merely mounding dirt. As plaintiffs observed, their proposed security measures involved a one-time expenditure and did not require ongoing surveillance of any kind, or the expenditure of significant funds. We disagree with the trial court that the proposed security measures were onerous. Turning to the heart of the case, the third element of foreseeability, the plaintiffs demonstrated three prior incidents of sudden, unprovoked, increasingly violent assaults on people in ungated parking areas on the Pheasant [R]idge premises by a stranger in the middle of the night, causing great bodily injury. We conclude that plaintiffs presented substantial evidence of prior similar incidents or other indications of a reasonably foreseeable risk of violent criminal assaults on the property so as to impose on defendants a duty to provide the comparatively minimal security measures plaintiffs described. The court here required a heightened showing of foreseeability necessitating nearly identical prior crimes, in part, because the court perceived the proposed security to be onerous. We have already concluded that the actual measures sought were not especially burdensome under the facts of this case. Thus, the court’s ruling is erroneous that where none of these incidents involved guns, shootings, attempted carjacking, or attempted murder, the incidents were not sufficiently similar to meet the heightened standard of foreseeability. Perfect identity of prior crimes to the attack on plaintiff is not necessary. Under the Supreme Court’s “sliding scale balancing formula,” heightened foreseeability is required to impose a high burden whereas some showing of a lesser degree of foreseeability is sufficient where a minimum burden is sought to be imposed on defendants. Because plaintiffs have only asked for relatively minimal security measures—ones already taken by defendants in another portion of the property—the degree of foreseeability here is not especially high. As a matter of law, therefore, the three prior incidents cited are sufficiently similar to make the assault on plaintiff foreseeable and to place a duty of care on defendants. Accordingly, the trial court erred in ruling defendants had no duty of care in this case. Judgment in favor of Arnel Management Company reversed.



Chapter Twenty-Five Landlord and Tenant

Rights, Duties, and Liabilities of the Tenant LO25-5

List and discuss the primary rights, duties, and liabilities of the tenant.

Rights of the Tenant The tenant has the right to

exclusive possession and quiet enjoyment of the property during the term of the lease. The landlord is not entitled to enter the leased property without the tenant’s consent, unless an emergency threatens the property or the landlord is acting under an express lease provision or a state or local law giving her the right to enter. The tenant may use the leased premises for any lawful purpose that is reasonable and appropriate, unless the purpose for which it may be used is expressly limited in the lease. Furthermore, the tenant has both the right to receive leased residential property in a habitable condition at the beginning of the lease and the right to have the property maintained in a habitable condition for the duration of the lease. The Miller case that appears at the end of the chapter discusses the tenant’s rights of exclusive possession and quiet enjoyment.

Duty to Pay Rent The tenant, of course, has the duty

to pay rent in the agreed amount and at the agreed times. If two or more persons are cotenants on the same lease, their liability under the lease is generally joint and several. This means that each cotenant has complete responsibility—not just partial responsibility—for performing the tenants’ duties under the lease. For example, Alberts and Baker rent an apartment from Caldwell, with both Alberts and Baker signing a one-year lease. If Alberts moves out after three months, Caldwell may hold Baker responsible for the entire rent, not just half of it. Naturally, Alberts remains liable on the lease—as well as to Baker under any rent-sharing agreement the two of them had—but Caldwell is free to proceed against Baker solely if Caldwell so chooses.

Duty Not to Commit Waste The tenant also has

the duty not to commit waste on the property. This means that the tenant is responsible for the routine care and upkeep of the property and that he has the duty not to commit any act that would harm the property. In the past, fulfillment of this duty required that the tenant perform necessary repairs. Today, the duty to make repairs has generally been shifted to the landlord by court ruling, statute, or lease provision. The tenant now has no duty to make major repairs unless the relevant damage was caused by his own negligence. When damage exists through no fault of the tenant and the tenant

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therefore is not obligated to make the actual repairs, the tenant nonetheless has the duty to take reasonable interim steps to prevent further damage from the elements. This duty would include, but not necessarily be limited to, informing the landlord of the problem. The duty would be triggered, for instance, when a window breaks or the roof leaks.

Assignment and Subleasing As

with rights and duties under most other types of contracts, the rights and duties under a lease may generally be assigned and delegated to third parties. Assignment occurs when the landlord or the tenant transfers all of her remaining rights under the lease to another person. For example, a landlord may sell an apartment building and assign the relevant leases to the buyer, who will then become the new landlord. A tenant may assign the remainder of her lease to someone else, who then acquires whatever rights the original tenant had under the lease (including, of course, the right to exclusive possession of the leased premises). Subleasing occurs when the tenant transfers to another person some, but not all, of his remaining right to possess the property. The relationship of tenant to sublessee then becomes one of landlord and tenant. For example, Dorfman, a college student whose 18-month lease on an apartment is to terminate on December 31, 2021, sublets his apartment to Wembley for the summer months of 2021. This is a sublease rather than an assignment because Dorfman has not transferred all of his remaining rights under the lease. The significance of the assignment–sublease distinction is that an assignee acquires rights and duties under the lease between the landlord and the original tenant, but a sublessee does not. An assignee steps into the shoes of the original tenant and acquires any rights she had under the lease.6 For example, if the lease contained an option to renew, the assignee would have the right to exercise this option. The assignee, of course, becomes personally liable to the landlord for the payment of rent. Unless otherwise stated in the original lease, under both an assignment and a sublease, the original tenant remains liable to the landlord for the commitments made in the lease. If the assignee or sublessee fails to pay rent, for example, the tenant has the legal obligation to pay it. The Concept Review box compares the characteristics of assignments and subleases. Lease Provisions Limiting Assignment Leases commonly contain limitations on assignment and subleasing. This is especially true of commercial leases. Such provisions typically require the landlord’s consent to any assignment or sublease, or purport to prohibit such a transfer of the tenant’s interests. Assignment is discussed in detail in Chapter 17.

6

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CONCEPT REVIEW Comparison of Assignment and Sublease

Sublease

Assignment

Does the tenant transfer to the third party all his remaining rights under the lease?

No

Yes

Does the tenant remain liable on the lease?

Yes

Yes

Does the third party (assignee or sublessee) acquire rights and duties under the tenant’s  lease with the landlord?

No

Yes

Provisions requiring the landlord’s consent are upheld by the courts, although some courts hold that the landlord cannot withhold consent unreasonably. Total prohibitions against subleasing or assignment may be enforced as well, but they are disfavored in the law. Courts usually construe them narrowly, resolving ambiguities against the landlord. Additionally, in recent years, many state and local laws invalidate lease terms prohibiting subleasing or assignment.

Tenant’s Liability for Injuries to Third Persons The tenant is normally liable to persons who suffer harm while on the portion of the property over which the tenant has control, if the injuries resulted from the tenant’s negligence.

Termination of the Leasehold Describe the different ways that a lease may be

LO25-6 terminated and identify the legal principles that apply to

each method of termination.

A leasehold typically terminates because the lease term has expired. Sometimes, however, the lease is terminated early because of a party’s material breach of the lease or because of mutual agreement.

Eviction If a tenant breaches the lease (most com-

monly, by nonpayment of rent), the landlord may take action to evict the tenant. State statutes usually establish a relatively speedy eviction procedure. The landlord who desires to evict a tenant must be careful to comply with any applicable state or city regulations governing evictions. These regulations usually forbid self-help measures on the landlord’s part, such as forcible entry to change locks. At common law, a landlord had a lien on the tenant’s personal property. The landlord therefore could remove and hold such property as security for the rent obligation. This lien has been abolished in many states. Where the lien still exists, it is subject to

constitutional limitations requiring that the tenant be given notice of the lien, as well as an opportunity to defend and protect his belongings before they can be sold to satisfy the rent obligation.

Agreement to Surrender A lease may terminate

prematurely by mutual agreement between landlord and tenant to surrender the lease (i.e., return the property to the landlord prior to the end of the lease). A valid surrender discharges the tenant from further liability under the lease.

Abandonment Abandonment occurs when the tenant

unjustifiably and permanently vacates the leased premises before the end of the lease term, and defaults in the payment of rent. If a tenant abandons the leased property, he is making an offer to surrender the leasehold. As shown in the Concept Review box, the landlord must make a decision at this point. If the landlord’s conduct shows acceptance of the tenant’s offer of surrender, the tenant is relieved of the obligation to pay rent for the remaining period of the lease. If the landlord does not accept the surrender, she may sue the tenant for the rent due until such time as she rents the property to someone else, or, if she cannot find a new tenant, for the rent due for the remainder of the term. At common law, the landlord had no obligation to mitigate (decrease) the damages caused by the abandonment by attempting to rent the leased property to a new tenant. In fact, taking possession of the property for the purpose of trying to rent it to someone else was a risky move for the landlord—her retaking of possession might be construed as acceptance of the surrender. Historically, a nonbreaching landlord had no duty to mitigate damages in most jurisdictions. Today, however, all but six of the states impose a duty on landlords to mitigate damages, usually by making a reasonable effort to rerent the property. Most of these states also hold that the landlord’s retaking of possession for the purpose of rerenting does not constitute a waiver of her right to pursue an action to collect unpaid rent. The following Miller case explores the notion of abandonment and the landlord’s duty to mitigate damages.



Chapter Twenty-Five Landlord and Tenant

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Miller v. Burnett   397 P.3d 448 (Kan. Ct. App. 2017) William Burnett rented 35 acres of pastureland to Linda Miller, pursuant to an oral lease agreement under which Miller agreed to pay $1,000 per year for a period of roughly six years. Miller and her husband used the land to grow and harvest brome grass for grazing their cattle. Burnett claimed that Miller failed to pay the $1,000 rent for 2015. Because of that, he permitted his neighbor’s four horses to graze on the rented pastureland in late summer and then denied Miller access to the pastureland from December 2015 through February 2016. At that point, Miller sued Burnett in small-claims court for violation of the lease and sought half the cost of fertilizing the pastureland, half the rent, the cost of feeding their cattle instead of grazing them, and an unspecified amount for being denied access to the property. Burnett filed a counterclaim against Miller for the unpaid rent as well as other alleged wrongdoing by Miller not relevant to the issue presented here. The small-claims court denied Miller’s claims and granted Burnett’s claim for rent. Miller appealed that decision to the district court. The district court also denied Miller’s claims and ordered her to pay Burnett $1,000 for the unpaid rent. The district court reasoned that Burnett had not breached the lease by allowing the horses to graze and cutting off Miller’s access to the land because he was “obligated upon [Miller]’s breach to mitigate his damages.” Miller appealed. Leben, Judge In a landlord-tenant context, only a minority of states recognize a duty to mitigate damages. The majority rule is that if a tenant abandons the lease, the landlord doesn’t have to try to find a new tenant; the landlord can just sue the abandoning tenant for the full amount of rent owed under the lease. But Kansas follows the minority rule: If a tenant abandons a lease, the landlord has a duty to try to find a new tenant rather than just suing the original tenant for any remaining rent. But the duty to mitigate damages doesn’t arise until a tenant abandons the lease. And there’s no suggestion before us that Miller abandoned the lease. Even so, the district court concluded that Burnett had to mitigate his damages without considering whether Miller had abandoned the lease—its conclusion was based solely on Miller’s nonpayment of rent. We can find no caselaw suggesting that the duty to mitigate damages arises or applies in cases that don’t involve either abandonment or termination of the lease. On the contrary, the Kansas ­Supreme Court has described it this way: “Kansas follows the minority position, imposing upon a landlord the duty to make reasonable effort to secure a new tenant if a tenant surrenders possession of leased property.” (Emphasis added.)  In re Estate of Sauder, 156 P.3d 1204, 1205 (Kan. 2007). And though the Restatement (Second) of Property follows the majority, no-duty rule, it nonetheless phrases the duty to mitigate as one that could arise only when a tenant abandons the property: “[I] f the tenant abandons the leased property, the landlord is under no duty to attempt to relet the leased property for the balance of the term of the lease to mitigate the tenant’s liability under the lease.” (Emphasis added.) Restatement (Second) of Property, Landlord and Tenant § 12.1(3). In sum, the district court wrongly concluded that Burnett had a duty to mitigate damages based solely on a nonpayment of rent and without any consideration of whether Miller had abandoned the lease. Nothing in the record available to us suggests that Miller had abandoned the lease.

An additional problem with the district court’s conclusion is that it would allow a landlord to interfere with the tenant’s possession of the rented property. When a landlord leases property to a tenant, the tenant has exclusive right of possession. The tenant’s right to exclusive possession is encapsulated in what lawyers call the “implied covenant of quiet enjoyment,” which exists in every Kansas lease, including oral farm leases. . . . If a landlord were required to mitigate damages caused by the nonpayment of rent when a tenant has not abandoned the property, then the landlord would be required to violate the implied covenant of quiet enjoyment and the tenant’s right to exclusive possession without the landlord’s interference. . . . The duty to mitigate damages has its limits. It isn’t a license for landlords to interfere with a current tenant’s use of the rented property. Saying that a landlord can’t interfere with the tenant’s exclusive use of the property merely due to nonpayment of rent doesn’t leave the landlord without recourse: The landlord has other remedies available when a tenant fails to pay rent but doesn’t abandon the leased property. For example, if a tenant fails to pay rent when it’s due, the landlord can give the tenant notice that the lease will be terminated if rent isn’t paid within 10 days. And specifically related to farm leases, a landlord can enforce a lien (a legal interest in someone else’s property) on the crops growing on the farmland. . . . Either of these options protects the landlord’s right to receive rent without interfering with the tenant’s possessory rights. [I]t’s clear to us that the district court’s judgment was based in part on a legal error—its conclusion that Burnett’s duty to mitigate damages authorized him to allow others to graze their horses on the rented pastureland. Because the district court’s judgment is based in part on a legal error, we reverse it. We remand the case for the district court to reconsider application of the law to the facts as it found them in a manner consistent with this opinion. The district court’s judgment is reversed, and this case is ­remanded for further proceedings consistent with this opinion.

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Part Five Property

CONCEPT REVIEW Termination of a Leasehold by Abandonment

Tenant abandons property before termination of lease.

Tenant’s conduct constitutes an offer to surrender leasehold.

Landlord expressly or impliedly accepts offer.

Landlord rejects offer.

Tenant is discharged from obligations under lease (has no duty to pay remaining rent).

Tenant is not discharged from lease (has duty to pay rent as agreed in lease).

Depending upon state law, landlord may have duty to mitigate damages by taking reasonable steps to rerent property.

Problems and Problem Cases 1. A tenant rented an apartment from the landlord pursuant to a lease that required her to surrender the premises in “as good a state and condition as reasonable use and wear and tear will permit,” and also required her to make a refundable security deposit. After the lease was executed, the landlord notified the tenants in the building

that no tenant was to shampoo the wall-to-wall carpet on surrender of the lease because the landlord had retained a professional carpet cleaner to do it. The cost of the carpet cleaner’s services was to be automatically deducted from the security deposit. When the tenant left the building, a portion of her security deposit was withheld to cover carpet cleaning, and she sued for a refund of the full deposit. Is the tenant entitled to a refund?



Chapter Twenty-Five Landlord and Tenant

2. Mary Ajayi and Wemi Alakija were tenants in an apartment complex managed for the landlord by Lloyd Management. Neighboring tenants complained on various occasions to Lloyd about repeated disturbances that continued late into the night and included yelling and loud noises coming from the apartment shared by Ajayi and Alakija. The sound of running could also be heard during those disturbances. Neighbors whose apartment walls adjoined those of the Ajayi–Alakija apartment also complained that items were knocked off their walls as a result of banging and jarring coming from that apartment. Do Lloyd and the landlord have any obligations to take responsive action? If so, why? What course(s) of action might they pursue? 3. On August 2, Dan Maltbie and John Burke, students at Indiana University, entered into a one-year written lease with Breezewood Management Company for the rental of an apartment in an older house in Bloomington, Indiana. When they moved in, they discovered numerous defects: rotting porch floorboards, broken and loose windows, an inoperable front door lock, leaks in the plumbing, a back door that would not close, a missing bathroom door, inadequate water pressure, falling plaster, exposed wiring, and a malfunctioning toilet. Later they discovered a leaking roof, cockroach infestation, the absence of heat and hot water, more leaks in the plumbing, and pigeons in the attic. The City of Bloomington had a minimum housing code in effect at that time. Code enforcement officers inspected the apartment and found more than 50 violations, 11 of which were “life safety” violations, defined as conditions that might be severely “hazardous to the health of the occupant.” These conditions remained largely uncorrected after notice by the code officers and further complaints by Maltbie and Burke. On May 3 of the following year, Maltbie vacated the apartment, notified Breezewood, and refused to pay any further rent. Breezewood agreed to let Burke remain and pay half the rate of the originally agreed-upon rent. Breezewood then filed suit against Maltbie and Burke for the balance due under the original rental contract plus a number of additional charges. Maltbie and Burke each filed counterclaims against Breezewood, claiming damages and abatement of the rent for breach of the implied warranty of habitability. Was there an implied warranty of habitability in the lease of the property that was breached? 4. On February 14, Don Weingarden entered into a written rental agreement with Eagle Ridge Condominiums for an apartment in Maumee, Ohio. Weingarden paid

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$150 as a security deposit with a monthly rental rate of $750 payable on the first of each month; the month of March was rent free. The parties also agreed that the landlord would replace the bedroom door, repair the electrical outlet in the bedroom, and replace the boards in the basement. Weingarden took possession on March 1. On March 23, he notified the apartment manager in writing that the basement of the apartment would leak when snow melted and also after a rain. The leak would saturate the carpeting in the basement and render the basement useless. When wet, the carpet would become mildewed and odorous. Weingarden also indicated that the stairway in the unit was not in compliance with the Ohio Basic Building Code and that he had fallen as a result and, further, that the door in the bedroom had not been repaired and/or replaced and that the frame on the master bedroom door was cracked. Weingarden indicated that as a result he would vacate the premises on or before July 1. The landlord attempted to remedy the basement leak by applying cement to the interior basement walls; however, the basement continued to leak and soak the carpet. On April 1, the landlord replied to Weingarden that it would not release him from his obligations under the lease agreement. On June 16, Weingarden surrendered his keys to the apartment and indicated in writing that his deposit should be forwarded to the address in Michigan that was on the application he had submitted for the lease. The landlord did not return any security deposit to Weingarden and did not send any itemization of disbursements to him. The landlord spent the security deposit on a water bill of $27.11 and for the cost of carpet cleaning, with the balance being applied to unpaid rent pursuant to the terms of the lease. Weingarden brought suit against the landlord to recover the balance of his security deposit and damages of $250 per month for the diminution of value of the rental unit because of the inability to utilize the basement, which constituted one-third of the apartment. The landlord counterclaimed for the unpaid rent due for the balance of the lease term. One of the issues in the case was whether the conditions in the basement amounted to a constructive eviction of Weingarden. Did the wet conditions in the basement substantially affect the habitability of the apartment and amount to a constructive eviction of the tenant? 5. Linda Schiernbeck rented a house from Clark and Rosa Davis. Approximately one month after she moved in,

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Part Five Property

Schiernbeck noticed a discolored area on one of the walls. There was a screw in the middle of this area. Schiernbeck determined that a smoke detector had been attached to the wall, but no smoke detector was present during the time she lived there. Schiernbeck later contended that she had notified the Davises about the missing smoke detector, but the Davises denied this. About 15 months after Schiernbeck’s occupancy began, a fire broke out in the house. Schiernbeck and her daughter were severely injured. Contending that the Davises should have installed a smoke detector, Schiernbeck sued them for negligence and breach of contract. Did the Davises owe Schiernbeck a duty to install a smoke detector? 6. DeEtte Junker leased an apartment from F. L. Cappaert in the Pecan Ridge Apartment Complex, which consisted of six buildings, each with 12 apartments. Junker’s apartment was upstairs, and she and the tenants in two other apartments used a common stairway for access to their apartments. Junker slipped on the stairway and was injured. She sued Cappaert for damages on the grounds that he had been negligent in maintaining the stairway. Junker’s lease contained an exculpatory clause in which Cappaert disclaimed any liability for injury due to his negligence. Did the exculpatory clause immunize the landlord against damages caused by his own negligence in maintaining a common area in leased residential property? 7. Kevin Allen was the owner and manager of an apartment building in Chicago, Illinois. Marybeth Duncavage, a second-year medical student, entered into an agreement with Allen for the rental of Apartment 1-W. She moved into the apartment on August 1. About 3 A.M. on August 4, Tommy Lee Jackson came into the rear yard adjacent to Apartment 1-W and concealed himself in an unlighted area and in the tall weeds. Using a ladder that Allen had stored adjacent to Duncavage’s apartment, Jackson climbed the building wall and entered Apartment 1-W through a window that was incapable of being locked. Once inside the apartment, Jackson tied up Duncavage, repeatedly raped and sodomized her, and then strangled her to death. Allen was aware that the ladder had been used on an earlier occasion to burglarize the same apartment through the same unlockable window and that it was still accessible to unauthorized persons on the property. Marybeth Duncavage’s father, as the

administrator of her estate, brought an action for negligence against Allen. Under the circumstances, did Allen owe Duncavage a duty to protect her against the criminal conduct that resulted in her death? 8. On March 1, Sharon Fitzgerald entered into an oral lease of a house owned by Parkin. The lease was on a month-to-month basis, and the rent was set at $290 per month. Parkin also agreed to make certain repairs to the house. On July 1, Fitzgerald notified Parkin by mail of the repairs that needed to be made. These included repairs of leaky pipes, the kitchen ceiling, and the back porch. Fitzgerald also said she would withhold the rent if the repairs were not made within 30 days. On July 13, Fitzgerald had the premises inspected by a city housing inspector, who found eight violations of the city code. Parkin was given notice of these violations. On July 29, Parkin served Fitzgerald with a formally correct notice to vacate the premises within 30 days. In September, he brought a lawsuit to have Fitzgerald evicted. A Minnesota statute gives a tenant a defense to an eviction action if the eviction is in retaliation for the reporting of a housing violation in good faith to city officials. Could the landlord evict the tenant from the house under these circumstances? 9. Kridel entered into a lease with Sommer, owner of the Pierre Apartments, to lease apartment 6-L for two years. Kridel, who was to be married in June, planned to move into the apartment in May. His parents and future parents-in-law had agreed to assume responsibility for the rent because Kridel was a full-time student who had no funds of his own. Shortly before Kridel was to have moved in, his engagement was broken. He wrote Sommer a letter explaining his situation and stating that he could not take the apartment. Sommer did not answer the letter. When another party inquired about renting apartment 6-L, the person in charge told her that the apartment was already rented to Kridel. Sommer did not enter the apartment or show it to anyone until he rented apartment 6-L to someone else when there were approximately eight months left on Kridel’s lease. He sued Kridel for the full rent for the period of approximately 16 months before the new tenant’s lease took effect. Kridel argued that Sommer should not be able to collect rent for the first 16 months of the lease because he did not take reasonable steps to rerent the apartment. Was Sommer entitled to collect the rent he sought?

CHAPTER 26

Estates and Trusts

G

eorge, an elderly widower, has no children of his own but enjoys a very close relationship with his two stepdaughters, his late wife’s children by her first marriage. George’s only living blood relative is his brother, from whom he has been estranged for many years. George has a substantial amount of property—his home, two cars, stocks and bonds, rental property, bank accounts, and a valuable collection of baseball cards. Though retired, George is an active volunteer for, and supporter of, several community charities and organizations. Presently, George does not have a will, but he is considering writing one. • What will happen to George’s property upon his death if he does not have a will at that time? • What are the requirements for executing a valid will? • What can cause a will to be invalid? • After George’s death, how would his estate be probated? • If George decided to create a trust to benefit his stepdaughters, what is required to create a trust, and what are the legal duties of a trustee? What are the ethical duties of a trustee?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 26-1 L  ist and explain the requirements for a valid will. 26-2 Explain how wills can be changed and revoked. 26-3 Identify and explain the legal tools (“advance directives”) available for planning for possible future incapacity. 26-4 Explain and provide examples of how property is disposed of when a person dies without leaving a will.

ONE OF THE BASIC features of the ownership of property is the right to dispose of the property during life and at death. You have already learned about the ways in which property is transferred during the owner’s life. The owner’s death is another major event for the transfer of property. Most people want to be able to choose who will get their property when they die. There are a variety of ways to control the ultimate disposition of one’s property, including taking title to the property in a form of joint ownership that gives co-­owners a right of survivorship; creating a trust

26-5 I dentify the steps in the process of administering an estate and explain the responsibilities of the personal representative for the estate. 26-6 Explain the concept of trust, identify various types of trusts, and explain the powers and responsibilities of a trustee. 26-7 List the requirements for the formation of a trust  and describe how trusts can be revoked or modified.

and transfering property to it to be used for the benefit of a spouse, child, elderly parent, or other beneficiary; or executing a will that directs real and personal property be distributed to persons named in the will. If, however, a person makes no provision for the disposition of property at death, the property will be distributed to the person’s heirs as defined by state law. This chapter focuses on the transfer of property at death and on the use of trusts for the transfer and management of property, both during life and at death.

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Part Five Property

The Law of Estates and Trusts Each state has its own statutes and common law regulating the distribution of property upon death. Legal requirements and procedures may vary from state to state, but many general principles can be stated. The Uniform Probate Code (UPC) is a comprehensive, uniform law that has been enacted in 19 states. In the remaining states, the law has been profoundly influenced by the UPC and many have adopted portions of it. Several relevant UPC provisions will be discussed in this chapter.

goes to others through other planning devices (such as life insurance policies) or by operation of law (such as by right of survivorship). For example, property held in joint tenancy or tenancy by the entirety is not controlled by a will because the property passes automatically to the surviving cotenant by right of survivorship. In addition, life insurance proceeds are controlled by the insured’s designation of beneficiaries, not by any provision of a will. (Because joint tenancy and life insurance are ways of directing the disposition of property, they are sometimes referred to as “will substitutes.”)

Estate Planning A

Common Will Terminology Some legal terms

person’s estate is all of the property owned by that person. Estate planning is the popular name for the complicated process of planning for the transfer of a person’s estate in later life and at death. Estate planning also concerns planning for the possibility of prolonged illness or disability. An attorney who is creating an estate plan will take an inventory of the client’s assets, learn the client’s objectives, and draft the instruments necessary to carry out the plan. This plan is normally guided by the desire to provide for the orderly disposition of the estate, minimize lawsuits, and decrease tax liability.

Wills Right of Disposition by Will The right to con-

trol the disposition of property at death has not always existed. In the English feudal system, the king owned all land. The lords and knights had only the right to use land for their lifetime. A landholder’s rights in land terminated upon death, and no rights descended to heirs. In 1215, the king granted the nobility the right to pass their interest in the land they held to their heirs. Later, that right was extended to all property owners. In the United States, each state has enacted statutes that establish the requirements for a valid will, including the formalities that must be met to pass property by will. LO26-1 List and explain the requirements for a valid will.

Nature of a Will A will is a document executed with

specific legal formalities by a testator (person making a will) that contains her instructions about the way her property will be disposed of at her death. A will can dispose only of property belonging to the testator at the time of her death. Furthermore, wills do not control property that

commonly used in wills include the following:

1. Bequest. A bequest (also called legacy) is a gift of personal property or money. For example, a will might provide for a bequest of a special piece of jewelry to the testator’s daughter. 2. Devise. A devise is a gift of real property. For example, the testator might devise his family farm to his grandson. However, the terms devise and bequest are often used interchangeably. 3. Residuary. The residuary estate is the balance of the estate that is left after specific devises and bequests are made by the will. After providing for the disposition of specific personal and real property, a testator might provide that the residuary estate is to go to his spouse or be divided among his descendants. 4. Issue. A person’s issue are his lineal descendants (children, grandchildren, great-grandchildren, and so forth). This category of persons includes adopted children. 5. Representation. When one of several children has died before the decedent, leaving descendants, all states provide for the dead child’s descendants to represent him or her and divide that child’s share. 6. Per stirpes. The oldest system of representation is per stirpes. When a gift is given to the testator’s issue or descendants per stirpes each surviving descendant divides the share that his or her parent would have taken if the parent had survived. For example, Grandmother dies, leaving a will providing that her residuary estate is to go to her issue or descendants per stirpes. Grandmother had two children, Terese and Marshawn. Terese had two children, Tyrone and Sue. Marshawn had one child, Aneesa. Terese and Marshawn die before Grandmother (in legal terms, predecease her), but all three of Grandmother’s grandchildren are living at the time of her death. In this case, Aneesa would take one-half of the residuary estate,



Chapter Twenty-Six Estates and Trusts

while Tyrone and Sue would take one-quarter each (that is, they would divide the share that would have gone to their mother). 7. Per capita. The more modern system of representation is per capita, which means that each of the group of persons share in the gift equally. In the preceding example, if Grandmother’s will had stated that the residuary estate is to go to her issue or descendants per capita, Tyrone, Sue, and Aneesa would each take one-third of the residuary.

Testamentary Capacity The capacity to make a

valid will is called testamentary capacity. To have testamentary capacity, a person must be of sound mind and of legal age, which is 18 in most states. A person does not have to be in perfect mental health to have testamentary capacity. Because

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people often delay executing wills until they are weak and in ill health, the standard for mental capacity to make a will is fairly low. To be of “sound mind,” a person need only be sufficiently rational to be capable of understanding the nature and character of her property, of realizing that she is making a will, and of knowing the persons who would normally be the beneficiaries of her affection. A person could move in and out of periods of lucidity and still have testamentary capacity if she executed her will during a lucid period. Lack of testamentary capacity and undue influence are the most common grounds upon which wills are challenged by persons who were excluded from a will. Fraud, duress, and tortious interference with an expectancy are also grounds for challenging the validity of a will.1 Fraud and undue influence are discussed in detail in Chapter 13.

1

Hutchison v. Kaforey   67 N.E.3d 121 (Ohio Ct. App. 2016) Michael Hutchison died in 2012 from a heroin overdose. He was not married and did not have any children. His estate consisted of substantial sums of money received from the settlement of a lawsuit alleging sexual abuse by a priest to which Michael was subjected as a child. Prior to his death, Michael was under guardianship because he was incapable of managing his own finances, health care, and living arrangements. He suffered from schizophrenia and post-traumatic stress disorder. He had a low IQ and no more than a seventh-grade education. Michael was a frequent drug user, particularly of cocaine and heroin. He was hospitalized on multiple occasions and had run-ins with the criminal justice system. Mary Hutchison Barnes, Michael’s mother, had served as Michael’s guardian prior to 2005, when she moved out of state to pursue a relationship and relinquished her guardianship. At that point, Ellen Kaforey was named Michael’s guardian. Kaforey was a public health nurse for a number of years before devoting herself to the full-time practice of law. As a nurse, she gained experience caring for patients with mental illnesses and substance abuse problems, which she applied in her work as guardian for hundreds of wards over the years, including Michael. Kaforey drafted wills for Michael in 2006, 2007, and 2008. The 2008 will was similar to the others, except that it added beneficiaries including the “Altoona Childrens’ Services Board” of Pennsylvania and “St. Jude’s Children’s Cancer Hospital,” as well as Michael’s father, three of his brothers, his nephew, and his girlfriend (who had passed away between the time Michael executed the 2008 will and his own death). As with his prior wills, Barnes was not named in the will, nor was Michael’s sister. Upon Michael’s death, his 2008 will was admitted to probate. Barnes contested the will. She claimed it was invalid because Michael lacked testamentary capacity and was subject to undue influence by Kaforey, who was appointed executrix of Michael’s estate in the will. Barnes claimed that Kaforey had admitted to Michael’s brother Mark that Michael was not competent to draft or execute a will and that she only helped him because she was scared of him. The trial court granted summary judgment against Barnes, and she appealed. Whitmore, Judge I. Barnes claims that the trial court erroneously concluded that the evidence does not give rise to a genuine issue of material fact regarding Michael’s testamentary capacity. We agree. The parties that moved for summary judgment included Kaforey as executrix of the 2008 will and multiple other beneficiaries

of the 2008 will who were named as defendants in the will contest. The movants claimed that there was no triable issue of fact regarding whether Michael lacked testamentary capacity and whether he was unduly influenced. The law recognizes that a testator whose mind is impaired “by disease or otherwise” can still have capacity to make a will. Testamentary capacity exists when the testator has sufficient mind to: (1) understand the nature of the business in which he is engaged;

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Part Five Property

(2) comprehend generally the nature and extent of the property which constitutes his estate; (3) hold in his mind the names and identity of those who have natural claims on his bounty; and (4) appreciate his relation to the members of his family. The general rule is that “[t]he mental condition of the testator at the time of making a will determines the testamentary capacity of the testator.” Oehlke v. Marks, 207 N.E.2d 676 (Ohio Ct. App. 1964), quoting Kennedy v. Walcutt, 161 N.E. 336 (Ohio 1928). Evidence of the testator’s condition “within a reasonable time before and after the making of the will is admissible as throwing light on his mental condition at the time of the execution of the will in question.” Id. What constitutes a “reasonable time” depends on the circumstances of the particular case. The burden of proof in determining testamentary capacity is on the party contesting the will. A rebuttable presumption exists that a person under guardianship lacks the testamentary capacity to write a valid will. The degree of proof necessary to rebut this presumption is not high. Instead, the degrees of proof necessary to both rebut the presumption of incompetency and establish capacity are [the same.] Kaforey testified in her capacity as a nurse and lawyer that Michael possessed testamentary capacity to make the 2008 will. She had been Michael’s guardian for about three years when she drafted the 2008 will. Kaforey stated that Michael was compliant with his medications and was not under the influence of drugs when he executed the 2008 will. She testified that she was familiar with signs that Michael was not compliant with his medications for schizophrenia or on drugs. When Michael was not taking his medications properly he suffered from, and would react to, auditory hallucinations. He would also be dirty or unkempt and agitated. Kaforey testified that there were times during her guardianship of Michael when he was not competent to execute a will because he was not taking his medications or was using drugs. However, she testified that Michael did not exhibit any of the signs of noncompliance with his medications or of being under the influence of drugs when he made the 2008 will. Kaforey also testified that Michael wanted to make the will. She explained that she met with Michael on multiple occasions and discussed with him at length who the beneficiaries of the will would be. Michael specifically requested to add his girlfriend as a beneficiary of the 2008 will. He also requested to add St. Jude’s Hospital as a beneficiary because he wanted to contribute to the hospital’s care for children. Kaforey testified that she discussed with Michael that he did not want Barnes to take under the will because Barnes was already financially stable. Kaforey further testified that she specifically assessed Michael’s capacity to make the 2008 will on the day he executed the will. She had no doubt that he possessed testamentary capacity. She testified that Michael was of sufficient mind and memory to understand the nature of what he was doing and the nature or extent of his property. According to Kaforey, Michael knew the identities of those he wanted to name as beneficiaries, and also

understood and appreciated his relationship to family members. Having concluded that Michael possessed testamentary capacity to make the 2008 will, Kaforey permitted Michael to execute the will in the presence of two witnesses. Based upon Kaforey’s testimony, we conclude that the movants successfully rebutted the presumption that Michael lacked testamentary capacity because he was under guardianship. . . . In response to the motions for summary judgment, Barnes argues that a question of fact exists as to whether Michael lacked capacity to execute the 2008 will (and the 2007 and 2006 wills). She argues . . . that Michael’s extensive medical records show that Michael could not have possessed testamentary capacity at the time he made the will. However, the medical records to which Barnes refers apparently were never placed in the record. Moreover, Barnes does not discuss the contents of the medical records with any particularity, nor did she testify regarding any specific facts in those records that would show that Michael lacked testamentary capacity at the time he made the 2008 will. Accordingly, there is no basis to conclude that the medical records created an issue of fact sufficient to overcome summary judgment. Barnes also points to evaluations of Michael by his psychiatrist to establish that Michael lacked testamentary capacity. However, while the psychiatrist opined that Michael should remain under guardianship because he had chronic mental illness and poor insight and judgment, the psychiatrist did not address any of the criteria necessary to determine testamentary capacity. . . . Accordingly, the psychiatric evaluations upon which Barnes relies do not create a triable issue of fact regarding Michael’s testamentary capacity. Barnes further argues that the fact that Michael remained under guardianship is evidence sufficient to overcome summary judgment. Her reliance on Michael’s status as a ward under guardianship is misplaced, however. The presumption that a person under guardianship lacks testamentary capacity is a rebuttable one. . . . Once evidence is produced sufficient to rebut the presumption, the presumption disappears. . . . As already discussed, we conclude that the movants presented sufficient evidence to rebut the presumption that Michael lacked testamentary capacity because he was under guardianship. Barnes also relies on her roles as Michael’s mother and former guardian to support her contention that Michael could not have had testamentary capacity to make a will. Barnes is required to present evidence of Michael’s condition “within a reasonable time before and after the making of the will” in order to create an issue of fact regarding Michael’s testamentary capacity at the time he executed the 2008 will. However, Barnes testified in her deposition that she could not ­recall the last time that she had either seen Michael or spent significant time with him before he executed the 2008 will, or when she next saw him after he signed the will. Barnes admitted in her ­deposition that Kaforey was in a better position than she was to evaluate ­Michael’s testamentary capacity when he signed the 2008 will. Neither Barnes nor [Michael’s brother] Mark observed



Chapter Twenty-Six Estates and Trusts

Michael’s condition at the time he signed the 2008 will. Accordingly, Barnes has not pointed to any evidence that anyone other than Kaforey had personal knowledge of Michael’s condition “within a reasonable time before or after the making of the will” that would give rise to an issue of fact as to Michael’s testamentary capacity when he signed the 2008 will. Barnes further argues that summary judgment is inappropriate because Kaforey admitted to her and to Mark that Michael was incompetent to write a will. Barnes and Mark both testified that Kaforey specifically discussed with them Michael’s testamentary capacity and told them that Michael could never make a will. Barnes testified that Kaforey told her before Michael’s death that the 2007 will was invalid. Mark testified that he and his mother met with Kaforey after Michael’s death and Kaforey informed them that Michael’s 2008 will was invalid “[b]ecause Michael was incompetent. . . .” Kaforey allegedly told them that a court would not uphold any will that Michael executed and that Michael’s entire estate would revert to the family. According to Mark, Kaforey told them that submitting the will to the probate court was “a matter of process that she had to go through.” He testified that Kaforey advised them to file a will contest and referred them to legal counsel. Kaforey denied ever stating that Michael lacked testamentary capacity when he executed the 2008 will. She also denied telling Barnes and Mark that Michael’s entire estate would revert to the family. Despite the testimony of Barnes and Mark that Kaforey told them that Michael lacked testamentary capacity, the trial court found that “the only evidence as to [Michael’s] testamentary capacity in the relevant time period is the testimony of Kaforey that [Michael] had sufficient testamentary capacity when he signed the [2008 will].” In so holding, the court emphasized that “Kaforey is an experienced probate attorney with a medical background who has repeatedly dealt with clients with mental health and/or substance abuse issues.” The court did not address the assertions that Kaforey told Michael’s family members that he was not competent to make a will, but rather disregarded that testimony. We find that the trial court improperly weighed the credibility of testimony in disregarding the assertions of Barnes and Mark that Kaforey told them that Michael was incompetent. [I]f Kaforey did tell Barnes and Mark that she believed that Michael lacked testamentary capacity, her statement was an admission that would support Barnes’ claim that Michael was not competent to make the 2008 will. Thus, it would constitute evidence that Michael lacked testamentary capacity. The trial court was not entitled to ignore such evidence, even if the court felt that it was contrived or that Kaforey’s testimony was more credible. . . . Barnes’ first assignment of error is sustained. . . .

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II. In her second assignment of error, Barnes argues that the trial court improperly granted summary judgment on her claim that Michael’s 2008 will was the product of undue influence. We disagree. A will that has been admitted to probate is presumed to have been made free from restraint. The contestants have the burden to prove undue influence. To invalidate a will, undue influence “must so overpower and subjugate the mind of the testator as to destroy his free agency and make him express the will of another rather than his own, and the mere presence of influence is not sufficient.” West v. Henry, 184 N.E.2d 200 (Ohio 1962). In addition, the “[u]ndue influence must be present or operative at the time of the execution of the will resulting in dispositions which the testator would not otherwise have made.” Id. Proof of undue influence requires: (1) a susceptible testator; (2) another’s opportunity to exert influence on the testator; (3) the fact of improper influence exerted or attempted; and (4) a result showing the effect of such influence. Id. Barnes . . . asserts that Kaforey unduly influenced Michael with respect to the making of his will. On appeal, Barnes argues that a presumption of undue influence arises because “Kaforey was a guardian and acted as the ward’s attorney while naming herself [e]xecutrix in the contested will.” Barnes contends that a presumption of undue influence arises because Kaforey and Michael had a confidential relationship, and Kaforey will benefit from her position as executrix of the will. We are not persuaded by Barnes’ argument. In the cases that Barnes cites where a confidential relationship gave rise to a presumption of undue influence, the confidential relationship existed between the decedent and a beneficiary of the will. . . . Here, Kaforey was not a beneficiary of Michael’s will. The mere fact that Kaforey is executrix of the will does not, by itself, give rise to a presumption of undue influence. . . . In response, Barnes fails to point to any fact that could give rise to a reasonable inference that Kaforey exerted or attempted improper influence in relation to Michael’s 2008 will. In fact, Barnes argues that Kaforey was frightened of Michael, and that she drafted the 2008 will without regard for Michael’s testamentary capacity because she was intimidated by him. Rather than demonstrate that Michael was either unduly influenced or the target of undue influence by Kaforey, these alleged facts, if true, would tend to show that Kaforey drafted the 2008 will under some degree of duress from Michael. We find that the probate court properly granted summary judgment to the movants on Barnes’ claim that Michael suffered undue influence in making the 2008 will. On this basis, Barnes’ second assignment of error is overruled. *** III. Judgment affirmed in part and reversed in part.

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Part Five Property

In Hutchison v. Kaforey, which follows, the Ohio Court of Appeals considers whether someone with serious enough mental illness and addiction issues to be under legal guardianship had testamentary capacity. Moreover, because the testator’s guardian was also his attorney and the executor of his estate, the court explores whether the will was invalid because of undue influence.

Execution of a Will Except in states that allow for

harmless error, a will is not valid unless it is executed with the formalities required by state law. The courts are strict in interpreting statutes concerning the execution of wills. If a will is declared invalid, the property of the deceased person will be distributed according to the provisions of state laws that will be discussed later. The formalities required for a valid will differ from state to state. For that reason, it is vital to consult state law before making a will. If an individual has executed a will and then moves to another state, that individual should consult with a lawyer to determine whether a new will needs to be executed in order to meet the requirements of the state where the person now lives. Despite that state-by-state variability, there are three core formalities: 1. All states require that a will be in writing. 2. State laws also require that a formal will be witnessed, generally by two or three disinterested witnesses (in other words, persons who do not stand to inherit any property under the will).

3. Most states require that the testator sign the will in the presence and the sight of the witnesses and that the witnesses sign in the presence and the sight of each other. As a general rule, an attestation clause, which states the formalities that have been followed in the execution of the will, is written following the testator’s signature. Sometimes a testator is also required to publish the will—that is, declare or indicate at the time of signing that the instrument is, in fact, the testator’s will. These detailed formalities are designed to prevent fraud. Section 2-502 of the UPC requires that a will must be in writing, signed by the testator (or in the testator’s name by some other individual in the testator’s conscious presence and by the testator’s direction), and signed by at least two individuals, each of whom signed within a reasonable time after he witnessed either the signing of the will or the testator’s acknowledgment of that signature or will. Also, under the UPC, any individual who is generally competent to be a witness may witness a will, and the fact that the witness is an interested party does not invalidate the will [2-505]. In lieu of signature by two witnesses, the UPC also allows for a will to be witnessed by a notary. Finally, the UPC incorporates the “harmless error” rule. When a testator has made a technical error in executing a will, the UPC permits the document to be treated as if it had been executed properly if it can be proven by clear and convincing evidence that the testator intended the document to constitute a will [2-503]. The following Zimmerman case provides an example of how courts deal with situations in which it is unclear if a document is, in fact, a will.

Zimmerman v. Allen   250 P.3d 558 (Ariz. Ct. App. 2011) Gloria Waterloo belonged to a congregation of which Jack Zimmerman is the senior rabbi. In April 2008, Zimmerman and his wife, Sandie, visited Waterloo in a hospice facility. Because handwriting was difficult for Waterloo, she dictated to Sandie a document that stated: To Whom It Concerns: April 11, 08 My name is Gloria Anne Waterloo. I live at [address]. The reason for this letter is so that my wishes are carried out by Jack Howard Zimmerman Also known as Rabbi Jack. He lives at [address]. 1. I want Him Jack Zimmerman to have full guardianship of My Health Decisions along with Myself. 2. Also as far as my finances, and realestate transaction I want Jack Zimmerman to have full guardianship along with Myself. 3. Properties are in CCA As of 2003, I have properties in many countries in CCA. 4. After I am deceased Jack has full instructions frome me. Attached is a list of final instructions I want to leave Jack Howard Zimmerman A sum of $3,000,000 or more Three Million dollars, or More. He has full & final guardianship of my finances & realestate properties. 5. As far as a Memorial Service I want Rabbi Jack to organize All of it. I am to be buryed next to my husband Dale Bec Waterloo at Sunny Slope Memorial in Sunny Slope, Phoenix. In the presence of the Zimmermans, Waterloo reviewed the one-page document, initialed each of the five numbered paragraphs, and dated and signed the document at the bottom. Notwithstanding the document’s reference to an “attached list of final instructions,” Waterloo dictated no such list and no such list ever was attached to the instrument. About an hour after Waterloo dictated



Chapter Twenty-Six Estates and Trusts

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the document, another couple from the congregation arrived to visit her. One of them read the document aloud to Waterloo and confirmed with her that it represented her wishes. Waterloo died less than a month later. After first petitioning for a declaration that Waterloo died intestate (i.e., without a valid will), Zimmerman petitioned the court to probate the document as a will. Waterloo’s heirs then moved for partial summary judgment, arguing that the document could not be admitted to probate because it was incomplete. They contended that because it referenced a “list of final instructions” that did not exist, the document failed as a will because it did not represent Waterloo’s full testamentary intent. The court granted the heirs’ motion, ruling it could not ascertain Waterloo’s “complete intent . . . without knowing what was to be contained in the list of instructions.” Zimmerman appealed. Johnsen, Judge A will is a “legal declaration of one’s intentions, which he wills to be performed after death. It is not necessary that the testator use the word ‘will’ in his last testament. No particular words need be used, it being sufficient if it appears that the maker intended to dispose of his property after his death. . . . A letter written and signed by the author may serve as his last will where it contains testamentary language indicating that it was so intended.” In re Miller’s Estate, 92 P.2d 335 (Ariz. 1939). To be treated as a will, an instrument that satisfies the requirement of testamentary intent must be properly executed. A nonholographic will must be signed by the testator or in the testator’s name by some other individual in the testator’s conscious presence and by the testator’s direction, and must be signed by two witnesses. An instrument that demonstrates testamentary ­intent and complies with the statutory execution requisites should be admitted to probate as a will even though all of its terms are not ­capable of being enforced. The only issue in a will contest is whether the will is valid. There is no question that Waterloo signed the document at issue (she even initialed each of the five numbered paragraphs that make up the substance of the document). As for the statutory witness requirement, Waterloo’s heirs did not cross-appeal from the superior court’s decision accepting the affidavits of the Zimmermans and the other couple for that purpose. Thus, the only issue before the court in the contested will proceeding was whether the letter Waterloo dictated contained her testamentary intent. The heirs correctly do not dispute that the document Waterloo dictated contains testamentary language indicating it was intended to constitute a will. Waterloo gave burial instructions in the letter and made provisions for what was to happen “[a] fter I am deceased.” The use of certain formal phrases and the care that Waterloo took to initial the sections of substance and to sign and date the instrument also demonstrate testamentary intent. The superior court, however, refused to admit the will to probate based on its conclusion that the absence of the “list of final instructions” referenced in Waterloo’s letter made it impossible to determine her “complete intent.” On appeal, the heirs argue that we should affirm because the absence of the “list of final instructions” means that, as a matter of law, Waterloo lacked testamentary intent when she signed the letter.

In considering this argument, we are mindful that, as a general matter, an instrument will be admitted to probate even if it is vague or incomplete in some respects, as long as “there is a single portion of the instrument which is certain in its character.” In re Harris’ Estate, 296 P. 267 (Ariz. 1931). Therefore, if some of an instrument’s testamentary terms are clear, a court may not decline to admit the will to probate simply because other terms are indefinite. Although this rule normally will doom the argument that an instrument that demonstrates testamentary intent is too ambiguous to admit to probate, we understand the heirs to argue not that the instrument is fatally ambiguous but that the omission of the “list of final instructions” necessarily means that Waterloo lacked testamentary intent when she created the letter. For the reasons set forth below, however, we conclude that the absence of the list does not disprove the presumption we are required to apply in favor of testacy. Significantly, Waterloo executed the instrument knowing that she had not created the list. Waterloo placed the date and her signature at the bottom of the single page that contained what she had dictated. From that we conclude she was satisfied with what she had dictated and that she believed that the instrument she executed adequately expressed her testamentary intent even though it lacked the “list” that she apparently had once intended to create. The heirs argue, however, that public policy requires us to affirm the order denying probate. They argue that a contrary ruling would encourage the filing of partial wills for probate, with petitioners submitting “only pages of a will that are advantageous to them, while withholding pages that are not in their favor.” But the heirs do not allege any fraud on Zimmerman’s part, and the situation the heirs posit is not present here, when the evidence is undisputed that the “missing” document never existed. Zimmerman asks that beyond ordering that the letter be admitted to probate, we construe the instrument to contain a bequest to him of “$3,000,000 or more.” The heirs argue that, at most, the letter is a direction that Zimmerman be appointed “guardian” of Waterloo’s estate. We decline both sides’ suggestions to construe the will and instead remand the matter to the superior court to conduct all further proceedings that may be required to determine the meaning of the instrument’s various terms. Vacated and remanded with instructions to admit Waterloo’s will to probate.

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Part Five Property

Incorporation by Reference In

some situations, a testator might want her will to refer to and incorporate an existing writing. For example, the testator may have created a list of specific gifts of personal property that she wants to incorporate in the will. A writing such as this is called an extrinsic document—that is, a writing apart from the will. In most states, the contents of extrinsic documents can be essentially incorporated into the will when the circumstances satisfy rules that have been designed to ensure that the document is genuine and that it was intended by the testator to be incorporated in the will. This is called incorporation by reference. For an extrinsic document to be incorporated by reference, it must have been in existence at the time the will was executed. In addition, the writing and the will must refer to each other so that the extrinsic document can be identified and so that it is clear that the testator intended the extrinsic document to be incorporated in the will. Under the UPC, incorporation by reference is allowed when the extrinsic document was in existence when the will was executed, the language of the will manifests the intent to incorporate the writing, and the will describes the writing sufficiently to identify it [2-510].

Informal Wills Some states recognize certain types of wills that are not executed with these formalities. These are:

1. Nuncupative wills. A nuncupative will is an oral will. Such wills are recognized as valid in some states, but only under limited circumstances and to a limited extent. In a number of states, for example, nuncupative wills are valid only when made by soldiers in military service and sailors at sea, and even then they will be effective only to dispose of personal property that was in the actual possession of the person at the time the oral will was made. Other states place low dollar limits on the amount of property that can be passed by a nuncupative will. 2. Holographic wills. Holographic wills are wills that are written and signed in the testator’s handwriting; therefore, they do not need to be attested by witnesses. They are recognized in about half of the states and by Section 2-502(b) of the UPC, even though they are not executed with the formalities usually required of valid wills. For a holographic will to be valid in the states that recognize them, it must evidence testamentary intent and must actually be handwritten by the testator. A typed holographic will would be invalid. Some states require that the holographic will be entirely handwritten, and some also require that the will be dated. The UPC, however, only requires that the signature and the material portions of the will be handwritten by the testator [2-502(b)].

Joint and Mutual Wills In some circumstances,

two or more people—a married couple, for example— decide together on a plan for the disposition of their property at death. To carry out this plan, they may execute a joint will (a single instrument that constitutes the will of both or all of the testators and is executed by both or all) or they may execute mutual wills (joint or separate, individual wills that reflect the common plan of distribution). Underlying a joint or mutual will is an agreement on a common plan. This common plan often includes an express or implied contract (a contract to make a will or not to revoke the will). One issue that sometimes arises is whether a testator who has made a joint or mutual will can later change the will. Whether joint and mutual wills are revocable depends on the language of the will, on state law, and on the timing of the revocation. For example, a testator who made a joint will with his spouse may be able to revoke his will during the life of his spouse because the spouse still has a chance to change her own will, but he may be unable to revoke or change the will after the death of his spouse. The UPC provides that the mere fact that a joint or mutual will has been executed does not create the presumption of a contract not to revoke the will or wills [2-514]. Because of these problems, attorneys generally advise against joint and mutual wills.

Construction of Wills Even in carefully drafted wills, questions sometimes arise as to the meaning or legal effect of a term or provision. Disputes about the meaning of the will are even more likely to occur in wills drafted by the testator himself, such as holographic wills. To interpret a will, a court will examine the entire instrument in an attempt to determine the testator’s intent. Limitations on Disposition by Will A per-

son who takes property by will takes it subject to all outstanding claims against the property. For example, if real property is subject to a mortgage or other lien, the beneficiary who takes the property gets it subject to the mortgage or lien. In addition, the rights of the testator’s creditors are superior to the rights of beneficiaries under her will. Thus, if the testator was insolvent (her debts exceeded her assets), persons named as beneficiaries do not receive any property by virtue of the will. Under the laws of most states, the surviving spouse of the testator has statutory rights in property owned solely by the testator that cannot be defeated by a contrary will provision. This means that one spouse cannot effectively disinherit the other. Even if the will provides for the surviving spouse, the survivor can elect to take the elective share



Chapter Twenty-Six Estates and Trusts

of the decedent’s estate that would be provided by state law rather than the amount specified in the will. In some states, personal property, such as furniture, passes automatically to the surviving spouse. At common law, a widow had the right to a life estate in one-third of the lands owned by her husband during their marriage. This was known as a widow’s dower right. A similar right for a widower was known as curtesy. A number of states have changed the right by statute to give a surviving spouse a one-half to one-third interest in fee simple in the real and personal property owned by the deceased spouse at the time of death. (Naturally, a testator can leave the spouse more, if desired.) Under UPC 2-201, the surviving spouse’s elective share varies depending on the length of the surviving spouse’s marriage to the testator—the elective share increases with the length of marriage. As a general rule, a surviving spouse is given the right to use the family home for a stated period as well as a portion of the deceased spouse’s estate. In community property states, each spouse has a one-half interest in community property that cannot be defeated by a contrary will provision. (Note that the surviving spouse will obtain full ownership of any property owned by the testator and the surviving spouse as joint tenants or tenants by the entirety.) While not technically a limitation on disposition, the law does provide for pretermitted children—that is, children of the testator who were born or adopted after the will was executed. There is a presumption that the testator intended to provide for such a child, unless there is evidence to the contrary. State law gives pretermitted children the right to a share of the testator’s estate. For example, under Section 2-302 of the Uniform Probate Code, a pretermitted child has the right to receive the share he would have received under the state intestacy statute unless it appears that the omission of this child was intentional, the testator gave

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substantially all of his estate to the child’s other parent, or the testator provided for the child outside of the will.

Revocation of Wills LO26-2 Explain how wills can be changed and revoked.

One important feature of a will is that it is revocable until the moment of the testator’s death. For this reason, a will confers no present interest in the testator’s property. A person is free to revoke a prior will and to make a new will. Wills can be revoked in a variety of ways. Physical destruction and mutilation done with intent to revoke a will constitute revocation, as do other acts such as crossing out the will or creating a writing that expressly cancels the will. In addition, a will is revoked if the testator later executes a valid will that expressly revokes the earlier will. A later will that does not expressly revoke an earlier will operates to revoke only those portions of the earlier will that are inconsistent with the later will. Under the UPC, a later will that does not expressly revoke a prior will operates to revoke it by inconsistency if the testator intended the subsequent will to replace rather than supplement the prior will [2-507(b)]. Furthermore, the UPC presumes that the testator intended the subsequent will to replace rather than supplement the prior will if the subsequent one makes a complete disposition of her estate, but it presumes that the testator intended merely to supplement and not replace the prior will if the subsequent will disposes of only part of her estate [2-507(c), (d)]. In some states, a will is presumed to have been revoked if it cannot be located after the testator’s death, although this presumption can be rebutted with contrary evidence. Wills can also be revoked by operation of law without any act on the part of the testator signifying revocation. State

Ethics and Compliance in Action Dr. Coggins died in 1963. In his last will, Dr. Coggins gave the residue of his estate to the Mercantile–Safe Deposit & Trust Company, to be held by it as trustee under the will. The trust provided for monthly payments to four income beneficiaries until the death of the last of them. The last of these annuitants was Dr. Coggins’s widow, who died in 1998. A provision of the will stated that, upon the death of the survivor of the four annuitants, the trust would terminate and the assets and all unpaid income shall be paid over “free of trust unto the Keswick Home, formerly Home for Incurables of Baltimore City, with the request that said Home use the estate and property thus passing to it for the acquisition or

construction of a new building to provide additional housing accommodations to be known as the ‘Coggins Building,’ to house white patients who need physical rehabilitation. If not acceptable to the Keswick Home, then this bequest shall go to the University of Maryland Hospital to be used for physical rehabilitation.” What are the major ethical considerations involved in determining whether this will provision should be enforced? In addition or in parallel to those ethical considerations, what are the related compliance responsibilities of the trustee? Consider a situation in which Coggins’s widow died but her cousin, who had cared for her in her last days, was still cashing the checks from the trust.

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Part Five Property

statutes provide that certain changes in relationships operate as revocations of a will. In some states, marriage will operate to revoke a will that was made when the testator was single. Similarly, a divorce may revoke provisions in a will made during marriage that leave property to the divorced spouse. Under the laws of a few states, the birth of a child after the execution of a will may operate as a partial revocation of the will.

Codicils A codicil is an amendment of a will. A person

who wants to change a provision of a will without making an entirely new will, may amend the will by executing a codicil. One may not amend a will by merely striking out objectionable provisions and inserting new provisions. The same formalities are required for the creation of a valid codicil as for the creation of a valid will. Similarly, where the harmless error rule applies to wills, it will also apply to codicils.

Advance Directives: Planning for Incapacity Identify and explain the legal tools (“advance directives”) LO26-3 available for planning for possible future incapacity.

Advances in medical technology have increased life expectancy. A person can be kept alive by artificial means, even in many cases in which there is no hope of the person being able to function without life support. Many people are opposed to their lives being prolonged with no chance of recovery. In response to these concerns, almost all states have enacted statutes permitting individuals to manage their property and to state their choices about the medical procedures that should be administered or withheld if they should become incapacitated in the future and cannot recover. Collectively, the written medical instructions are called advance directives. An advance directive is a written document (such as a living will or durable power of attorney for health care) that directs others how future health care decisions should be made in the event that the individual becomes incapacitated. Increasingly, these matters are handled by attorneys specializing in elder law.

Durable Power of Attorney A durable power

of attorney allows for incapacitated individuals to have their property managed by a trusted person or professional. A power of attorney is an express statement in which one person (the principal) gives another person (the attorney in fact) the authority to do an act or series of acts on the principal’s behalf. For example, Andrews enters into a contract to sell his house to Willis, but he must be out of state on the date of the real estate closing. He gives Paulsen a power of

attorney to attend the closing and execute the deed on his behalf. Ordinary powers of attorney terminate upon the principal’s incapacity. By contrast, the durable power of attorney is not affected if the principal becomes incompetent. A durable power of attorney permits a person to give someone else extremely broad powers to make decisions and enter transactions such as those involving real and personal property, bank accounts, and health care, and to specify that those powers will not terminate upon incapacity. The durable power of attorney is an extremely important planning device. For example, a durable power of attorney executed by an elderly parent to an adult child at a time in which the parent is competent would permit the child to take care of matters such as investments, property, bank accounts, and hospital admission. Without the durable power of attorney, the child would be forced to apply to a court for a guardianship, which is a more expensive and often less efficient manner in which to handle personal and business affairs.

Living Wills Living wills are documents in which a per-

son states in advance an intention to forgo or obtain certain life-prolonging medical procedures. Almost all states have enacted statutes recognizing living wills. These statutes also establish the elements and formalities required to create a valid living will and describe the legal effect of living wills. Currently, the law concerning living wills is primarily a matter of state law and differs from state to state. Living wills are typically included with a patient’s medical records. Many states require physicians and other health care providers to follow the provisions of a valid living will. Because living wills are created by statute, it is important that all terms and conditions of one’s state statute be followed. Figure 26.1 shows an example of a living will form.

Durable Power of Attorney for Health Care The majority of states have enacted statutes specifi-

cally providing for durable powers of attorney for health care (sometimes called health care representatives). This is a type of advance directive in which the principal specifically gives the attorney in fact the authority to make certain health care decisions for him if the principal should become incompetent. Depending on state law and the instructions given by the principal to the attorney in fact, this could include decisions such as consenting or withholding consent to surgery, admitting the principal to a nursing home, and possibly withdrawing or prolonging life support. Note that the durable power of attorney becomes relevant only in the event that the principal becomes incompetent. So long as the principal is competent, he retains the ability to make health care decisions. This power of attorney is also revocable at the will of the principal. The precise requirements for creation of the



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Figure 26.1 Living Will LIVING WILL DECLARATION* Declaration made this _____ day of _____ (month, year). I, _____, being at least eighteen (18) years of age and of sound mind, willfully and voluntarily make known my desires that my dying shall not be artificially prolonged under the circumstances set forth below, and I declare:  If at any time my attending physician certifies in writing that: (1) I have an incurable injury, disease, or illness; (2) my death will occur within a short time; and (3) the use of life prolonging procedures would serve only to artificially prolong the dying process, I direct that such procedures be withheld or withdrawn, and that I be permitted to die naturally with only the performance or provision of any medical procedure or medication necessary to provide me with comfort care or to alleviate pain, and, if I have so indicated below, the provision of artificially supplied nutrition and hydration. (Indicate your choice by initialing or making your mark before signing this declaration): __ I wish to receive artificially supplied nutrition and hydration, even if the effort to sustain life is futile or excessively burdensome to me. __ I do not wish to receive artificially supplied nutrition and hydration, if the effort to sustain life is futile or excessively burdensome to me. __ I intentionally make no decision concerning artificially supplied nutrition and hydration, leaving the decision to my health care representative appointed under IC 16-36-1-7 or my attorney in fact with health care powers under IC 30-5-5.  In the absence of my ability to give directions regarding the use of life prolonging procedures, it is my intention that this declaration be honored by my family and physician as the final expression of my legal right to refuse medical or surgical treatment and accept the consequences of the refusal.  I understand the full import of this declaration.  Signed: _______________________________________________  City, County, and State of Residence ________________________  The declarant has been personally known to me, and I believe (him/her) to be of sound mind. I did not sign the declarant’s signature above for or at the direction of the declarant. I am not a parent, spouse, or child of the declarant. I am not entitled to any part of the declarant’s estate or directly financially responsible for the declarant’s medical care. I am competent and at least eighteen (18) years of age. Witness ____________________________________   Date ______________________________________ Witness ____________________________________   Date ______________________________________ From Ind. Code § 16-36-4-10 (2017).

*

durable power of attorney differ from state to state, but all states require a written and signed document executed with specified formalities, such as witnessing by disinterested witnesses.

Federal Law and Advance Directives A

federal statute, the Patient Self-Determination Act,2 requires health care providers to take active steps to educate people about the opportunity to make advance decisions about medical care and the prolonging of life and to record the choices that they make. This statute, which became effective in 1991, requires health care providers such 42 U.S.C. § 1395cc (1990).

2

as hospitals, nursing homes, hospices, and home health agencies to provide written information to adults receiving medical care about their rights concerning the ability to accept or refuse medical or surgical treatment, the health care provider’s policies concerning those rights, and their right to formulate advance directives. The act also requires the provider to document in the patient’s medical record whether the patient has executed an advance directive, and it forbids discrimination against the patient based on the individual’s choice regarding an advance directive. In addition, the provider is required to ensure compliance with the requirements of state law concerning advance directives and to educate its staff and the community on issues concerning advance directives.

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Part Five Property

Intestacy LO26-4

Explain and provide examples of how property is disposed of when a person dies without leaving a will.

If a person dies without making a will, or makes a will that is declared invalid, that person has died intestate. When that occurs, that person’s property will be distributed to the persons designated as the intestate’s heirs under the appropriate state’s intestacy or intestate succession statute. The intestate’s real property will be distributed according to the intestacy statute of the state in which the property is located. Personal property will be distributed according to the intestacy statute of the state of domicile at the time of death. A domicile is a person’s permanent home. A person can have only one domicile at a time. Determinations of a person’s domicile turn on facts that tend to show that person’s intent to make a specific state a permanent home. Partial intestacy is possible when only a portion of a will is declared invalid or when a valid will does not dispose of the entire estate.

Characteristics of Intestacy Statutes The

provisions of intestacy statutes are not uniform. Their purpose, however, is to distribute property in a way that reflects the presumed intent of the deceased—that is, to carry out the probable intent of the typical testator. Most people prefer that their property is given to their closest relatives. In general, such statutes first provide for the distribution

of most or all of a person’s estate to her surviving spouse, children, or grandchildren. If no such survivors exist, the statutes typically provide for the distribution of the estate to parents, siblings, or nieces and nephews. If no relatives at this level are living, the property may be distributed to surviving grandparents, uncles, aunts, or cousins. Generally, persons with the same degree of relationship to the deceased person take equal shares. If the deceased had no surviving relatives, the property escheats (goes) to the state. Figure 26.2 shows an example of a distribution scheme under an intestacy statute.

Special Rules Under

intestacy statutes, a person must have a relationship to the deceased person through blood or marriage in order to inherit any part of the deceased person’s property. State law includes adopted children within the definition of “children” and treats adopted children in the same way as it treats biological children. Normally adopted children inherit from their adoptive families and not from their biological families, although some states’ laws may allow them to inherit from both. The following Hill v. Nakai case illustrates how, in the interest of efficiency and predictability, intestacy rules in probate codes have displaced many older common law rules and doctrines that once governed the distribution of a decedent’s estate. In Hill, the doctrine of equitable adoption is found to be preempted by the state probate code, which the court interprets strictly to allow inheritance only by biological and legally adopted children.

Figure 26.2 Example of a Distribution Scheme under an Intestacy Statute Person Dying Intestate Is Survived By

Result

1. Spouse* and child or issue of a deceased child

Spouse ½, Child ½

2. Spouse and parent(s) but no issue

Spouse ¾, Parent ¼

3. Spouse but no parent or issue

All of the estate to spouse

4. Issue but no spouse

Estate is divided among issue

5. Parent(s), brothers, sisters, and/or issue of deceased brothers and sisters but no spouse or issue

Estate is divided among parent(s), brothers, sisters, and issue of  deceased brothers and sisters

6. Issue of brothers and sisters but no spouse, issue,  parents, brothers, and sisters

Estate is divided among issue of deceased brothers and sisters

7. Grandparents, but no spouse, issue, parents, brothers, All of the estate goes to grandparents sisters, or issue of deceased brothers and sisters 8. None of the above

Estate goes to the state

Note, however, second and subsequent spouses who had no children by the decedent may be assigned a smaller share.

*



Chapter Twenty-Six Estates and Trusts

26-13

Hill v. Nakai (In re Estate of Hannifin)   311 P.3d 1016 (Utah 2013) In the summer of 1958, Father William J. Hannifin, an Episcopal priest, visited the Navajo Reservation near Aneth, Utah, where Willis Nakai and his biological family were living. Following a conversation with Nakai’s mother and maternal grandparents, Hannifin agreed to raise Nakai as his own child, even though they were neither biologically nor legally related. From that point forward, Hannifin provided Nakai an allowance, food, clothing, medical care, transportation, and emotional support. He monitored Nakai’s schoolwork and generally provided for Nakai’s health and welfare. Nakai visited his biological family yearly during his childhood, but his biological parents did not assert parental control over him and did not support him financially. Even into adulthood Nakai referred to Hannifin as his father, and Hannifin referred to Nakai as his son. Hannifin also treated Nakai’s children and grandchildren as his own grandchildren and great-grandchildren. Upon Hannifin’s death, he had arranged for many of his assets, including his life insurance policy, bank accounts, and investment accounts to be transferred to Nakai. However, Hannifin did not execute a valid will and, therefore, died intestate. He had no spouse and no biological heirs. Nakai sought to be appointed Personal Representative of Hannifin’s estate, alleging that he and his family were Hannifin’s only known heirs and devisees. The court granted the petition. Max Hill, acting on behalf of himself and 19 other collateral relatives of Hannifin, petitioned the court to be appointed Special Administrator of Hannifin’s estate for the limited purpose of contesting Nakai’s claim to the estate. The court granted Hill’s petition and, following a bench trial, held that under the doctrine of equitable adoption, Nakai was entitled “to inherit from Father Hannifin’s estate as though he were his legally adopted son.” Hill appealed, arguing that Utah’s enactment of the Probate Code preempted the common law doctrine of equitable adoption.

Justice Lee, opinion of the Court We have long recognized the axiom that our precedent must yield when it conflicts with a validly enacted statute. Statutes may preempt the common law either by governing an area in so pervasive a manner that it displaces the common law (field preemption) or by directly conflicting with the common law (conflict preemption). Preemption may be indicated expressly, by a stated intent to preempt the common law. More often, however, explicit preemption language does not appear, or does not directly answer the question. In that event, courts must consider whether the . . . statute’s structure and purpose or nonspecific statutory language nonetheless reveal a clear, but implicit, preemptive intent. [Citations and quotation marks omitted throughout paragraph.] [F]ield preemption occurs when the scope of a statute indicates that the legislature intended a statute to occupy a field in such a way as to make reasonable the inference that the legislature left no room for the common law to supplement it. Conflict preemption, on the other hand, occurs where it is impossible . . . to comply with both the common law and a statute, or where the common law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of the legislature. [Citations and quotation marks omitted throughout paragraph.] This notion of conflict preemption is reiterated in the Probate Code. Though the Code provides that “principles of . . . equity supplement its provisions,” Utah Code § 75-1-103, it also contains an express caveat that principles of equity may not be invoked where they are “displaced by the particular provisions of th[e]

code.” Id. A judge-made doctrine that conflicts with a statute is certainly “displaced” by it. We find the Code to displace the doctrine of equitable adoption recognized in Williams’ Estates. In that case, a couple took a child into their home, agreeing with the birth mother that they would adopt the child and “raise, care for and treat [her] in all respects as their own child.” In re Williams’ Estates, 348 P.2d 683, 685 (Utah 1960). Though they never formally adopted the child, they did raise her as their own. Id. at 684. And when the couple died intestate, the child claimed that “she should be awarded the same share of the Williamses[’] estate as she would have been entitled to had they . . . fulfilled their agreement to adopt.” Id. We agreed that a child in that situation could possibly inherit through intestacy. . . . Though we have not had occasion to opine on this doctrine since it was recognized, most other jurisdictions employing the doctrine have followed the same path, requiring claimants to prove the existence of an agreement to adopt. Most also limit use of the doctrine to situations that benefit the equitably adopted child, meaning, for example, that the doctrine does not prevent the equitably adopted child from inheriting from natural parents, and typically cannot be used by an adoptive parent to inherit from the equitably adopted child. Courts deem these and other similar restrictions proper since equitable adoption is only an equitable remedy to enforce a contract right, is not intended or applied to create the legal relationship of parent and child, with all the legal consequences of such relationship, [and] is [not] meant to create a legal adoption. [Citations and quotation marks omitted.]

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Part Five Property

The Probate Code, enacted fifteen years after we embraced equitable adoption in Williams’ Estates, is in direct conflict with the doctrine in three principal respects: (A) Equitable adoption allows children who cannot satisfy the Probate Code’s definition of “Child” to nonetheless participate in intestate succession as if they had. (B) Equitably adopted children can take by succession from both natural and adoptive parents—despite the Code’s clear mandate to the contrary. (C) The doctrine adds confusion and complexity to our law’s intestate succession scheme, in contravention of the Code’s stated purpose of streamlining and clarifying the distribution of a decedent’s estate. In light of these conflicts, the equitable adoption doctrine cannot be squared with the Probate Code; it is impossible to satisfy both the requirements of the Probate Code and the elements of equitable adoption. This is a doctrine in conflict with the Code, which we therefore repudiate as preempted by statute. A At the time of our decision in Williams’ Estates, our intestate succession statutes did not define the terms “child” or “parent.” See UTAH CODE § 74-4-1 to -24 (1953). They did not distinguish classes of children that could take by succession (such as natural and adopted children) from those that could not (like foster children, stepchildren, and grandchildren). The Probate Code changed the landscape by providing precise definitions of parties legally entitled to take by intestate succession. These provisions displaced the open-ended system within which Williams’ Estates was situated. The Probate Code provides that “[a]ny part of a decedent’s estate not effectively disposed of by will passes by intestate succession to the decedent’s heirs as provided in” the Code. Utah Code § 75-2-101(1). Thus, the Code establishes a detailed scheme that governs the priority by which certain classes of heirs are entitled to succeed to the decedent’s estate. Under the Code, “[a]ny part of the intestate estate” that does not pass to the decedent’s spouse (because, for example, the decedent’s spouse did not survive him) passes “to the decedent’s descendants per capita at each generation,” . . . and if no surviving descendants exist, then to the decedent’s parent(s). . . . And if neither parent survived the decedent, the estate goes to the parents’ descendants, if any, and then, if none exist, to the decedent’s grandparents or the grandparents’ descendants. . . . The second group of takers, “the decedent’s descendants,” generally includes a decedent’s children, “with the relationship of parent and child . . . being determined by the definition of child and parent contained in [the Probate Code].” Id. § 75-1201(9). And according to the Code, a “Child” is “any individual entitled to take as a child under this code by intestate succession from the parent whose relationship is involved and excludes any person who is only a stepchild, a foster child, a grandchild, or any

more remote descendant.” Id. § 75-1-201(5). “Parent” similarly “includes any person entitled to take, or who would be entitled to take if the child died without a will, as a parent under this code by intestate succession from the child whose relationship is in question and excludes any person who is only a stepparent, foster parent, or grandparent.” Id. § 75-1-201(33). And “for purposes of intestate succession by, through, or from a person, an individual is the child of the individual’s natural parents” and “[a]n adopted individual is the child of the adopting parent or parents and not of the natural parents.” Id. § 75-2-114(1), (2). By enacting a Probate Code with a specific definition of “child” that excludes those “equitably” adopted, the legislature preempted common law doctrines that are in conflict with the results those definitions require. . . . Under this scheme and according to these definitions, the only methods of determining who is a child for intestate succession purposes are legal adoption and natural parentage. And Nakai is neither Hannifin’s legally adopted nor his natural child. The closest Nakai comes to any of the relations delineated in the Probate Code is to a foster child, which is a category specifically excluded from taking intestate. Yet he falls short even there. A foster child/parent relationship is one marked by legal rights and responsibilities, neither of which existed in this case. Nakai thus can have no claim under the Probate Code to a distribution through intestate succession. It is thus impossible to comply with both the Probate Code and with the principles of equitable adoption. Because Hannifin had neither a spouse nor children, the Probate Code requires that his estate pass to his parents or, if neither survived him, to his parents’ descendants. Utah Code § 75-2-103(1)(a)–(c). If no takers exist in those categories, then his estate must past to his grandparents or, if none survived him, to their descendants. The statutory scheme makes this chain of distribution both clear and mandatory. And Hill and his fellow relatives qualify as takers in that chain. In contrast, equitable adoption requires that the estate pass to Nakai, a legal stranger to Hannifin, leaving nothing for Hill and the others. There is no way to reconcile the two different sets of requirements. B Another intractable conflict between the Probate Code and equitable adoption stems from section 75-2-114(1)–(2), which states that “for purposes of intestate succession . . . [a]n adopted individual is the child of the adopting parent . . . and not of the natural parents.” This section operates to prohibit adopted children from taking by intestacy from both their natural parents and their adoptive parents. This is in direct contravention of the doctrine of equitable adoption, which is purely beneficial to the child and in no way alters the legal relationship between the claimant and the decedent or between the claimant and the biological parents. . . .



Chapter Twenty-Six Estates and Trusts

[W]hen our legislature enacted the Probate Code . . . , it expressly foreclosed [the] possibility [of dual succession]. It did so by enacting section 114, which prevents a child from inheriting from two sets of parents. See Utah Code § 75-2-114(1)–(2) (“[F]or purposes of intestate succession . . . [a]n adopted individual is the child of the adopting parent . . . and not of the natural parents.”). That is a signifi­cant legislative development in our law in the Probate Code and one that is in direct conflict with equitable adoption. . . . Dual succession is an inherent element of equitable adoption. Yet dual succession is expressly foreclosed by statute. The conflict is palpable and explicit. Again, it is impossible to comply with both the Probate Code and with the judge-made doctrine of equitable adoption, as the former prohibits what the latter requires. And in light of this conflict, our only option is to abandon the doctrine of equitable adoption. Such abandonment is the only way to maintain fidelity to the objectives expressly detailed in the Probate Code. As the Code indicates, its detailed intestate succession scheme is designed: (a) To simplify and clarify the law concerning the affairs of decedents, missing persons . . . ; (b) To discover and make effective the intent of a decedent in distribution of his property; (c) To promote a speedy and efficient system for administering the estate of the decedent and making distribution to his successors; (d)  To facilitate use and enforcement of certain trusts; and (e) To make uniform the law among the various jurisdictions. Id. § 75-1-102(2). The doctrine of equitable adoption undermines these objectives by introducing uncertainty, complexity, and inefficiency—the very evils the Probate Code was designed to avoid. Though the equitable adoption doctrine has been on the books for more than fifty years, neither we nor any other Utah

Half brothers and half sisters are usually treated in the same way as brothers and sisters related by whole blood. An illegitimate child may inherit from his mother, but as a general rule, illegitimate children do not inherit from their fathers unless paternity has been either acknowledged or established in a legal proceeding. A person must be alive at the time the decedent dies to claim a share of the decedent’s estate. An exception may be made for children or other descendants who are born after the decedent’s death. If a person who is entitled to a share of the decedent’s estate survives the decedent but dies before receiving that share, it becomes part of the person’s own estate.

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court has given it any dimension. This boundary-less quality is another point of incompatibility with the Probate Code, which values predictability and stability. Were we to retain the doctrine, we would have to provide predictable definition to the otherwise vague standard announced in Williams’ Estates. For instance, in future cases we would surely be called on to decide questions along the following lines: Must both biological parents be party to the agreement to adopt? What kind of evidence is required to prove the existence of an agreement to adopt? How long must the adoptive parents treat the child as their own before the child qualifies for intestate succession? Just how limited must the child’s relationship with his biological family be? How completely must the natural parents relinquish all their rights to the child? In working to populate these fields, we would only compound the problem we identify today. With each new contour added to the standard, we would inevitably substitute our own policy choice for that expressed by the legislature when it enacted the Probate Code. We cannot condone such substitution. In the Code the legislature decided, as a policy matter, that efficiency and predictability are best served by distributing the estates of those that die intestate in accordance with a prediction as to the preference of the average intestate decedent. And that prediction follows biological and legal relationship lines. . . . We accordingly jettison the doctrine of equitable adoption as a vestige of a common-law friendly intestacy regime that has been overtaken by statute. Thus, we hold that the administration of Hannifin’s estate is subject to the express terms of the Probate Code, including terms governing matters of distribution and representation. We reverse and remand for further proceedings consistent with this opinion.

Simultaneous Death Prior

to the advent of automobiles and airplanes, the prospect of spouses dying in a common accident or tragedy was rare enough that there was typically not a special legal rule to determine how estates would be distributed in such instances. If one spouse survived the other, even for just a short time, the predeceased spouse’s estate passed to the surviving spouse. Particularly as automobile accidents made it marginally more likely that spouses could die simultaneously (or at least under circumstances where it was very difficult to determine which of the two died first), a need arose to craft a legal doctrine to deal with the uncertainty that created. Moreover, modern courts were less willing to allow a decedent’s estate to pass to a spouse who

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Part Five Property

died shortly thereafter without getting the benefit of the estate’s distribution, particularly because that situation could result in disinheriting the predeceased spouse’s heirs on a mere formality. As a result, a statute known as the Uniform Simultaneous Death Act provides that where two persons who would inherit from each other (such as husband and wife) die under circumstances that make it difficult or impossible to determine who died first, each person’s property is to be distributed as though he or she survived. This means, for example, that the husband’s property will go to his relatives and the wife’s property to her relatives. Jointly owned property is typically distributed in equal shares to the heirs of each of the husband and wife. Many states that have enacted the Uniform Simultaneous Death Act treat deaths that are within 120 hours (or five days) of one another as simultaneous. Most of those states also allow for a testator’s will to opt out of the simultaneous death provisions either by explicit reference or by creating contingencies and bequests that are inconsistent with the provisions of the Simultaneous Death Act.

children, the policy would be included in his taxable estate, but not in his probate estate.

Administration of Estates

other early step in the administration of an estate is the selection of a personal representative to administer the estate. If the deceased left a will, it is likely that he designated his personal representative in the will. The personal representative under a will is also known as the executor. Almost anyone could serve as an executor. The testator may have chosen, for example, his spouse, a grown child, a close friend, an attorney, or the trust department of a bank. If the decedent died intestate, or if the personal representative named in a will is unable to serve, the probate court will name a personal representative to administer the estate. In the case of an intestate estate, the personal representative is called an administrator. A preference is usually accorded to a surviving spouse, child, or other close relative. If no relative is available and qualified to serve, a creditor, bank, or other person may be appointed by the court. Most states require that the personal representative post a bond in an amount in excess of the estimated value of the estate to ensure that her duties will be properly and faithfully performed. A person making a will often directs that the executor may serve without posting a bond, and this exemption may be accepted by the court.

Identify the steps in the process of administering an

LO26-5 estate and explain the responsibilities of the personal

representative for the estate.

When a person dies, an orderly procedure is needed to collect property, settle debts, and distribute any remaining property to those who will inherit it under the will or by intestate succession. This process occurs under the supervision of a probate court and is known as the administration process or the probate process. Summary (simple) procedures are sometimes available when an estate is relatively small—for example, when it has assets of less than $7,500.

The Probate Estate The probate process operates

only on the decedent’s property that is considered to be part of the probate estate. The probate estate is that property that passes under the decedent’s will or by intestacy. Assets that pass by operation of law and assets that are transferred by other devices such as trusts or life insurance policies do not pass through probate. Note that the decedent’s probate estate and taxable estate for purposes of federal estate tax are two different concepts. The taxable estate is broader and includes all property owned or controlled by the decedent at the time of death. For example, if a person purchased a $1 million life insurance policy made payable to his spouse or

Determining the Existence of a Will The

first step in the probate process is to determine whether the deceased left a will. This may require a search of the deceased person’s personal papers and safe-deposit box. If a will is found, it must be proved to be admitted to probate. This involves the testimony of the persons who witnessed the will, if they are still alive. If the witnesses are no longer alive, the signatures of the witnesses and the testator will have to be established in some other way. In the vast majority of states and under UPC Section 2-504, a will may be proved by an affidavit (declaration under oath) sworn to and signed by the testator and the witnesses at the time the will was executed. This is called a self-proving affidavit. If a will is located and proved, it will be admitted to probate and govern many of the decisions that must be made in the administration of the estate.

Selecting a Personal Representative An-

Responsibilities of the Personal Representative The personal representative has a number of

important tasks in the administration of the estate, including ensuring that an inventory is taken of the estate’s assets and that the assets are appraised. Notice must then be given to creditors or potential claimants against the estate so that they can file and prove their claims within a specified time,



Chapter Twenty-Six Estates and Trusts

normally two to six months. As a general rule, the surviving spouse of the deceased person is entitled to be paid an allowance during the time the estate is being settled. This allowance has priority over other debts of the estate. The personal representative must see that any properly payable funeral or burial expenses are paid and that the creditors’ claims are satisfied. Both federal and some state governments impose estate or inheritance taxes on estates of a certain size. The personal representative is responsible for filing estate tax returns. The federal tax is a tax on the deceased’s estate, with provisions for deducting items such as debts, expenses of administration, and charitable gifts. In addition, an amount equal to the amount left to the surviving spouse may be deducted from the gross estate before the tax is computed. State inheritance taxes are imposed on the person who receives a gift or statutory share from an estate. It is common, however, for wills to provide that the estate will pay all taxes, including inheritance taxes, so that the beneficiaries will not have to do so. The personal representative must also make provisions for filing an income tax return and for paying any income tax due for the partial year prior to the decedent’s death. When the debts, expenses, and taxes have been taken care of, the remaining assets of the estate are distributed to the decedent’s heirs (if there was no will) or to the beneficiaries of the decedent’s will. Special rules apply when the estate is too small to satisfy all of the bequests made in a will or when some or all of the designated beneficiaries are no longer living. When the personal representative has completed all of these duties, the probate court will close the estate and discharge the personal representative.

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for her daughter. A trust may also arise by operation of law. For example, when a lawyer representing a client injured in an automobile accident receives a settlement payment from an insurance company, the lawyer holds the settlement payment as trustee for the client. Most commonly, however, trusts are created through express instruments or deed of trust whereby an owner of property transfers title to the property to a trustee who is to hold, manage, and invest the property for the benefit of either the original owner or a third person. For example, Long transfers certain stock to First Trust Bank with instructions to pay the income to his daughter during her lifetime and to distribute the stock to her children after her death.

Trust Terminology A

person who creates a trust is known as a settlor, grantor, or trustor. The person who holds the property for the benefit of another person is called the trustee. The person for whose benefit the property is held in trust is the beneficiary. Figure 26.3 illustrates the relationship among these parties. A single person may occupy more than one of these positions; however, if there is only one beneficiary, he cannot be the sole trustee. The property held in trust is called the corpus or res. A distinction is made between the property in trust, which is the principal, and the income that is produced by the principal. A trust that is established and effective during the settlor’s lifetime is known as an inter vivos trust. A trust can also be established in a person’s will. Such trusts take effect only at the death of the settlor. They are called testamentary trusts.

Trusts Explain the concept of trust, identify various types of LO26-6 trusts, and explain the powers and responsibilities of a trustee.

Nature of a Trust A

trust is a legal relationship in which a person who has legal title to property has the duty to hold it for the use or benefit of another person. The person benefited by a trust is considered to have equitable or beneficial title to the property because it is being maintained for her benefit. This means that she is the real owner even though the trustee has the legal title in the trustee’s name. A trust can be created in a number of ways. An owner of property may declare that he is holding certain property in trust. For example, a mother might state that she is holding 100 shares of General Motors stock in trust

Figure 26.3 Trust

Settlor

Transfers legal title to trust property

Trustee

Promises to manage property in best interest of beneficiary Right to sue for breach of fiduciary duty

Holds and administers trust property in accordance with the law and the terms of the trust for the benefit of the beneficiary

Beneficiary

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Part Five Property

Why People Create Trusts Bennett

owns a portfolio of valuable stock. Her husband has predeceased her. She has two children and an elderly father for whom she would like to provide. Why might it be advantageous to Bennett to transfer the stock to a trust for the benefit of the members of her family? First, there may be income tax or estate tax planning advantages in doing so, depending on the type of trust she establishes and the provisions of that trust. For example, she can establish an irrevocable trust for her children and remove the property transferred to her trust from her estate so that it is not taxable at her death. In addition, the trust property can be used for the benefit of others and may even pass to others after the settlor’s death without the necessity of having a will. Many people prefer to pass their property by trust rather than by will because trusts afford more privacy. Unlike a probated will, they do not become items of public record. Trusts also afford greater opportunity for postgift management than do outright gifts and bequests. If Bennett wants her children to enjoy the income of the trust property during their young adulthood without distributing unfettered ownership of the property to them before she considers them able to manage it properly, she can accomplish this through a trust provision. A trust can prevent the property from being squandered or spent too quickly. Trusts can be set up so that a beneficiary’s interest cannot be reached by creditors in many situations. Such trusts, called spendthrift trusts, will be discussed later. Placing property in trust can operate to increase the amount of property held for the beneficiaries if the trustee makes good investment decisions. Another important consideration is that a trust can be used to provide for the needs of disabled beneficiaries who are not capable of managing funds. Ultimately, the advantage of a trust lies in its flexibility. The relationship among the three parties can be structured in myriad ways.

age required by state law for the creation of valid wills and contracts (age 18 in most states).

Creation of Express Trusts There

Doctrine of Cy Pres A doctrine known as cy pres is applicable to charitable trusts when property is given in trust to be applied to a particular charitable purpose that becomes impossible, impracticable, or illegal to carry out. Under the doctrine of cy pres, the trust will not fail if the settlor indicated a general intention to devote the property to charitable purposes. If the settlor has not specifically provided for a substitute beneficiary, the court will direct the application of the property to some charitable purpose that falls within the settlor’s general charitable intention. In the following Citizens National Bank case, the court grapples with the issue of effectuating the donor’s intent in a charitable trust.

are five basic requirements for the creation of a valid express trust, although special and somewhat less restrictive rules govern the establishment of charitable trusts. The requirements for forming an express trust are: 1. Capacity. The settlor must have had the legal capacity to convey the property to the trust. This means that the settlor must have had the capacity needed to make a valid contract if the trust is an inter vivos trust or the capacity to make a will if the trust is a testamentary trust. For example, a trust would fail under this requirement if, at the time the trust was created, the settlor had not attained the

2. Intent and formalities. The settlor must intend to create a trust at the present time. To impose enforceable duties on the trustee, the settlor must meet certain formalities. Under the laws of most states, for example, the trustee must accept the trust by signing the trust instrument. In the case of a trust of land, the trust must be in writing so as to meet the statute of frauds. If the trust is a testamentary trust, it must satisfy the formal requirements for wills. 3. Conveyance of specific property. The settlor must convey specific property to the trust. The property conveyed must be property that the settlor has the right to convey. This need not be a substantial sum. It can be a penny or any interest. 4. Proper purpose. The trust must be created for a proper purpose. It cannot be created for a reason that is contrary to public policy, such as the commission of a crime. 5. Identity of the beneficiaries. The beneficiaries of the trust must be described clearly enough so that their identities can be ascertained. Sometimes, beneficiaries may be members of a specific class, such as “my children.”

Charitable Trusts A

distinction is made between private trusts and trusts created for charitable purposes. In a private trust, property is devoted to the benefit of specific persons, whereas in a charitable trust, property is devoted to a charitable organization or to some other purposes beneficial to society. While some of the rules governing private and charitable trusts are the same, a number of these rules are different. For example, when a private trust is created, the beneficiary must be known at the time or ascertainable within a certain time (established by a legal rule known as the rule against perpetuities). However, a charitable trust is valid even though no definitely ascertainable beneficiary is named and even though it is to continue for an indefinite or unlimited period.



Chapter Twenty-Six Estates and Trusts

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Citizens National Bank of Paris v. Kids Hope United, Inc.    922 N.E.2d 1093 (Ill. 2009)

La Fern Blackman died in 1967. Her will provided that, after the death of her sister, Citizens National Bank of Paris would hold her farmland in trust and pay 75 percent of the income from the land to the Edgar County Children’s Home (ECCH) and the other 25 percent to the trustees of the Embarrass Cemetery. The will further provided, In the event either of the aforesaid organizations shall cease to exist, then said bank as trustee is to distribute said portion  or portions of said net income to such charitable organization or organizations as it deems worthy of said money. Blackman’s sister, Etoile Davis, died in 1971. Her will directed the bank to hold her farmland in trust and give 75 percent of the net income to ECCH and the other 25 percent to the trustees of the Embarrass Cemetery. The will further provided, In the event either of the aforesaid organizations shall cease to function in its present capacity, then the part of the trust fund which would have gone to this organization shall be divided equally between the FIRST METHODIST CHURCH OF PARIS MEMORIAL FOUNDATION, INC., THE EDGAR COUNTY CHAPTER OF THE AMERICAN CANCER SOCIETY, and THE EDGAR COUNTY HEART ASSOCIATION. ECCH was incorporated in Illinois in 1803. Its charter stated that it was formed to “establish an institution for the education of dependent children of Edgar County, Illinois, and for the custody and maintenance of such children and to provide permanent homes for them in approved private families.” In 1900, it erected a Children’s Home facility on Eads Avenue to serve that purpose. In 1980, ECCH amended its articles of incorporation to allow it to become a residential placement resource for children throughout Illinois and to receive state funding. As a result of the amendment, ECCH’s objective was to: provide services to children and youth in the fields of health, welfare and education in the State of Illinois, including multitreatment and educational programs for emotionally handicapped boys and girls of all races in residential treatment centers, day treatment services, counseling services to family, and such other related and auxiliary services as are necessary or desirable from time to time to accomplish these purposes; and to own or lease property, establish and maintain residential treatment centers, homes, schools and other facilities required. In 2003, ECCH merged with the Hudelson Baptist Children’s Home, and ECCH dissolved as an entity and merged all its assets and programs into Hudelson. The Children’s Home facility owned by ECCH was also transferred to Hudelson. In the merger agreement between ECCH and Hudelson, Hudelson “guaranteed that ECCH’s mission of working with children in Edgar and the surrounding counties will be continued for as long as it is financially feasible to do so.” In 2005, Hudelson changed its name to Kids Hope. The Children’s Home that ECCH had built in 1900 closed and later was sold to a school district. The bank, as trustee for the Blackman and Davis trusts, filed a petition in court stating that it believed that ECCH “had ceased to exist,” and asked the court to determine whether this was true and, if so, to approve the distribution of 75 percent of the trust’s net income to the alternate beneficiaries named in the Davis will. The bank and Kids Hope both filed motions for summary judgment. The trial court granted the bank’s motion and found that ECCH had ceased to exist and directed the distribution of trust income to other beneficiaries. Kids Hope appealed, and the appellate court reversed. The bank appealed. Freeman, Justice In interpreting trusts, the goal is to determine the settlor’s intent, which the court will effectuate if it is not contrary to law or public policy. Charitable gifts are viewed with peculiar favor by the courts, and every presumption consistent with the language contained in the instruments of gift will be employed in order to sustain them. In the case at bar, it is true that ECCH ceased to exist as a separate corporate entity following its merger with Kids Hope. However, the important question here is not whether ECCH ceased to exist as a separate entity. Rather, in interpreting the restrictive

condition to determine the testator’s intent, the important question is whether the new corporation with which the original charitable organization merged was no longer suited to carry out the purposes of the bequest. If Kids Hope is not suited to carry out the purposes of Blackman’s bequest, ECCH will have ceased to operate or exist within the meaning of Blackman’s restrictive condition, and the gift to ECCH would lapse. If, however, Kids Hope is suited to carry out the purposes of the bequest, then in our view ECCH did not cease to operate or exist, as Blackman meant those words, even if it did cease to exist as a separate corporate entity.

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Part Five Property

We note that there is nothing in the language of Blackman’s restrictive condition that would indicate that she meant “cease to operate or exist” to refer to ECCH’s separate corporate existence. In the 2003 merger agreement, Hudelson “guaranteed that ECCH’s mission of working with children in Edgar and the surrounding counties will be continued for as long as it is financially feasible to do so.” Moreover, part of the object for which ECCH was established was to “provide permanent homes for the dependent children of Edgar County in approved private

families.” According to the parties’ agreed statement of facts, Kids Hope currently “has families in Edgar County who serve as approved foster homes.” We agree with the appellate court that “the merger did not hinder Kids Hope’s ability to carry out the purposes of Blackman’s original bequest.” Kids Hope is suited to carry out these purposes, and ECCH did not cease to operate or exist as Blackman intended those words.

Totten Trusts A Totten trust is a deposit of money

trust that she administers without express permission in the trust agreement. She must not prefer one beneficiary’s interest to another’s, and she must account to the beneficiaries for all transactions. Unless the trust agreement provides otherwise, the trustee must make the trust productive. The trustee may not delegate the performance of discretionary duties (such as the duty to select investments) to another but may delegate the performance of ministerial duties (such as the preparation of statements of account). A trust may give the trustee discretion as to the amount of principal or income paid to a beneficiary. In such a case, the beneficiary cannot require the trustee to exercise her discretion in the manner desired by the beneficiary. One of the duties of the trustee is to distribute the principal and income of the trust in accordance with the terms of the trust instrument. Suppose Wheeler’s will created a testamentary trust providing that his wife was to receive the income from the trust for life, and at her death, the trust property was to be distributed to his children. During the duration of the trust, the trust earns profits, such as interest or rents, and has expenses, such as taxes or repairs. How should the trustee allocate these items as between Wheeler’s surviving spouse, who is an income beneficiary, and his children, who are remaindermen? The terms of the trust and state law bind the trustee in making this determination, via a duty of impartiality. As a general rule, ordinary profits received from the investment of trust property are allocated to income. For example, interest on trust property or rents earned from leasing real property held in trust would be allocated to income. Ordinary expenses such as insurance premiums, the cost of ordinary maintenance and repairs of trust property, and property taxes, would be chargeable to income. The principal of the trust includes the

in a bank or other financial institution in the name of the depositor as trustee for a named beneficiary. For example, Bliss deposits money in First Bank in trust for his daughter, Bessie. The Totten trust creates a revocable living trust. At Bliss’s death, if he has not revoked this trust, the money in  the account will belong to Bessie. The UPC has abolished the Totten trust as a formal category and instead treats them as payment-on-death accounts.

Powers and Duties of the Trustee In most

express trusts, the settlor names a specific person to act as trustee. If the settlor does not name a trustee, the court will appoint one. Similarly, a court will replace a trustee who resigns, is incompetent, or refuses to act. The trust codes of most states contain provisions giving trustees broad management powers over trust property. These provisions can be limited or expanded by express provisions in the trust instrument. The trustee has a duty of prudence, which means the trustee must use a reasonable degree of skill, judgment, and care. A trustee who claims to have a greater degree of skill will be held to that higher standard. Section 7-302 of the UPC provides that the trustee is held to the standard of a prudent person dealing with the property of another, and if the trustee has special skills or is named trustee based on a representation of special skills, that level of skill is required. The trustee may not commingle the property held in trust with the trustee’s own property or with that of another trust. A trustee owes a duty of loyalty (fiduciary duty) to the beneficiaries. This means that the trustee must administer the trust for the benefit of the beneficiaries and avoid any conflict between personal interests and the interest of the trust. For example, a trustee cannot do business with a

Affirmed in favor of Kids Hope.



Chapter Twenty-Six Estates and Trusts

trust property itself and any extraordinary receipts, such as proceeds or gains derived from the sale of trust property. Modern trust codes give trustees the power to adjust among these categories and allow for the use of unitrusts, which provide a formula or percentage of returns that are treated as income.

3. In some states, creditors of the beneficiary who have furnished necessaries can compel payment. 4. Once the trustee distributes property to a beneficiary, it can be subject to valid claims of others. LO26-7

Liability of Trustee A trustee who breaches any

of the duties of a trustee or whose conduct falls below the standard of care applicable to trustees may incur personal liability. For example, if the trustee invests unwisely and imprudently, the trustee may be personally liable to reimburse the trust estate for the shortfall. The language of the trust affects the trustee’s liability and the level of care owed by the trustee. A settlor might, for example, include language lowering the trustee’s duty of care or relieving the trustee of some liability that he might otherwise incur. The trustee can also have liability to third persons who are injured by the operation of the trust. Because a trust is not in itself a legal entity that can be sued, a third party who has a claim (such as a tort claim or a claim for breach of contract) must file that claim against the trustee of the trust. The trustee’s actual personal liability to a third party depends on the language of the trust and of any contracts entered on behalf of the trust as well as the extent to which the injury complained of by the third party was a result of the personal fault or omission of the trustee.

Spendthrift Trusts Generally, the beneficiary of

a trust may voluntarily assign rights to the principal or income of the trust to another person. In addition, any distributions to the beneficiary are subject to the claims of creditors. Sometimes, however, trusts contain provisions known as spendthrift clauses, which restrict the voluntary or involuntary transfer of a beneficiary’s interest. Such clauses are generally enforced, and they preclude assignees or creditors from compelling a trustee to recognize their claims to the trust. The enforceability of such clauses is usually subject to four exceptions, however: 1. For the most part, a person cannot put property beyond the claims of creditors. Thus, a spendthrift clause is not effective in a trust when the settlor and the beneficiary are the same person. 2. Divorced spouses and minor children of the beneficiary can usually compel payment for alimony and child support.

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List the requirements for the formation of a trust and describe how trusts can be revoked or modified.

Termination and Modification of a Trust  Normally, a settlor cannot revoke or modify a trust unless he reserves the power to do so at the time he establishes the trust. However, a trust may be modified or terminated with the consent of the settlor and all of the beneficiaries. When the settlor is dead or otherwise unable to consent, a trust can be modified or terminated by consent of all the persons with a beneficial interest, but only when this would not frustrate a material purpose of the trust. Because trusts are under the supervisory jurisdiction of a court, the court can permit a deviation from the terms of a trust when unanticipated changes in circumstances threaten accomplishment of the settlor’s purpose.

Implied and Constructive Trusts Under

exceptional circumstances in which the creation of a trust is necessary to effectuate a settlor’s intent or avoid unjust enrichment, the law implies or imposes a trust even though no express trust exists or an express trust exists but has failed. One trust of this type is a resulting trust, which arises when there has been an incomplete disposition of trust property. For example, if Hess transferred property to Wickes as trustee to provide for the needs of Hess’s grandfather and the grandfather died before the trust funds were exhausted, Wickes will be deemed to hold the property in a resulting trust for Hess or Hess’s heirs. Similarly, if Hess had transferred the property to Wickes as trustee and the trust had failed because Hess did not meet one of the requirements of a valid trust, Wickes would not be permitted to keep the trust property as his own. A resulting trust would be implied. A constructive trust is a trust created by operation of law to avoid fraud, injustice, or unjust enrichment. This type of trust imposes on the constructive trustee a duty to convey property he holds to another person on the ground that the constructive trustee would be unjustly enriched if he were allowed to retain it. For example, when a person procures the transfer of property by means of fraud or duress, he becomes a constructive trustee and is under the sole obligation to return the property to its original owner.

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Part Five Property

Problems and Problem Cases 1. John Irvine and Deana Dodge married in 1979. At the time of their marriage, Deana had a son from a previous marriage, Michael Dodge. During their marriage, John and Deana had no children together, nor did they adopt any children. John did not adopt Dodge. In 1983, John and Deana executed wills. The lawyer who drafted the wills retained the wills in his file. When he retired, the law firm that took over his practice retained the files. Deana died in 2008 and John in 2009. At the time of John’s death, he was survived by his stepson, Dodge; his brother, William; and his mother, Va Va. Under the laws of intestacy, Va Va stood to inherit all of John’s property if John left no will. One week after John died, William—who believed his brother had died without a will—sought to be appointed personal representative of his brother’s estate. Later, however, while going through John’s belongings, William found a copy of John’s will. He also obtained the original signed will from the law firm. The will purported to pass all of John’s property to Dodge if Deana predeceased him. There was no indication that John had made another will or had destroyed the will or otherwise attempted to revoke it. Va Va filed an objection to the probate of John’s will, challenging its validity. Will she win? 2. In 2003, Grubbs transferred his individual retirement account (IRA) to Raymond James and Associates Inc., naming Nunnenman as the beneficiary to receive the residue in the event of his death. Grubbs was hospitalized in 2005. He summoned an attorney to the hospital, where he made and executed a last will and testament that did not mention the IRA account. The will left Grubbs’s entire estate to his mother, Shervena, who was also named as executrix. Months after Grubbs’s death, Shervena stated that she found a handwritten note in Grubbs’s Bible that stated: May 2005 My Will I Donnie Grubbs want all of my estate All IRA and any SBC Telco and all other assets and worldly goods to go to my Mother Shervena Grubbs. Being of sound mind. Donnie Grubbs

In her capacity as executrix, Shervena filed an action for an injunction freezing the assets of the IRA account based on the handwritten note, which she claimed indicated the intent to make her the beneficiary of the account. Will she win?

3. Roy and Icie Johnson established two revocable inter vivos trusts in 1966. The trusts provided that upon Roy’s and Icie’s deaths, income from the trusts was to be paid in equal shares to their two sons, James and Robert, for life. Upon the death of the survivor of the sons, the trust was to be “divided equally between all of my grandchildren, per stirpes.” James had two daughters, Barbara and Elizabeth. Robert had four children, David, Rosalyn, Catherine, and Elizabeth. James and Robert disclaimed their interest in the trust in 1979, and a dispute arose about how the trust should be distributed to the grandchildren. The trustee filed an action seeking instructions on how the trusts should be distributed. What should the court hold? 4. Elma Ward died in 2008. Frazier petitioned the court to probate a holographic will made by Ward. The document contains two typewritten sections, separated by one handwritten section. The document reads: [Typewritten section] October 14, 1987 All of our worl[d]ly things, which we owne [sic] will not be sold, given away, borrowed or otherwise disposed of, until one year after either of our death. The one that is left can do what they think is best for them. This includes house, land, trucks, cars, boats, shop & all contents, and contents of the house. [A signature, purporting to be that of Elma Ward is located here] [Handwritten section] To whom it’s [sic] concern[ed]: Everything we own will be sold at both our death[s]. ­Patricia B. Smith—leave to her $1,000 in cash. She has been a dear daughter to her stepdad and me. Jimmy ­Buchanan [$]200. Diane Buchanan Moorehead $200. The rest of the cash from the sale be divided between Sheila Willis, Teresa L. Ward Frazier, Robert E. Ward. [A notary seal, with the signature of Jimmy Wells, is located here. The date “2/2/99” is handwritten above Mr. Wells’s signature, and the date “4/18/2001” is handwritten below Mr. Wells’s signature.] [Typewritten section, identical to that above, is included a second time at this place in the document] [Following the typewritten section, the document contains the signature of Edward Ward and a second signature purported to be that of Elma K. Ward. A second notary seal follows these signatures, which seal is signed by Jimmy Wells with the handwritten dates of 2/12/99, and 4/18/2001.]



Chapter Twenty-Six Estates and Trusts

Two individuals familiar with Ward’s handwriting provided affidavits that the signature on the alleged will was genuine. Ward’s son objected to the probate of this document, arguing that it does not meet the statutory requirements for a will because his mother’s signature was not directly below the handwritten portion of the will. Tennessee law provides that “No witness to a holographic will is necessary, but the signature and all its material provisions must be in the handwriting of the testator and the testator’s handwriting must be proved by two (2) witnesses.” Was this a valid will? 5. Troy and Marie McDonald had a rocky marriage marked by domestic disturbances and substance abuse. They filed for divorce and a judge had issued a final order of dissolution to be effective in October 2005. In the interim, however, Marie and Troy were working toward reconciliation and were contemplating asking the court to withdraw the dissolution order. Tragically, Troy died in a motorcycle accident during the reconciliation period, after the order was filed but before it was officially effective. Troy’s mother claimed that she and Troy’s father should inherit his entire intestate estate because Marie was not a surviving spouse within the meaning of California Law. Marie opposed this. The Probate Code states that “surviving spouse” does not include “[a] person who was a party to a valid proceeding concluded by an order purporting to terminate all marital property rights.” Marie argued that they were getting back together and the divorce was not finalized. Who was correct? 6. Vencie Beard shot and killed his wife, Melba, on April 16, 2011. The death certificate states that the time of her death was 8:59 P.M. Vencie shot himself at the same time, but he did not immediately die from his injuries. Rather, he died later that same night at 10:55 P.M. They each had wills that were identical in structure. Paragraph 2.02 of each will provided for specific cash bequests to nine named individuals if both Vencie and Melba died in a common disaster or under circumstances making it impossible to determine which died first. Paragraph 2.03 of each will provided that if the spouse did not survive the testator by 90 days, Janet Lea Hopkins would receive a portion of a tract of land the Beards co-owned. Paragraph 2.04 of each will provided that if the spouse did not survive the testator by 90 days, Matthew C. Hopkins would receive the remaining portion of that tract of land. In paragraph 2.05 of each will, Vencie and Melba gave “the rest and residue” of their estates to their respective spouses. That paragraph further provided that if the spouse did not survive the testator by 90 days, Beverly Kaye Gilmore and Janet Lea Hopkins would receive the

26-23

residuary estate. The executrix of both estates sought a declaratory judgment from the court to determine whether they died in a common disaster and whether, if so, the Simultaneous Death Act applied to the wills (or only to certain of the paragraphs and not others). What should the court decide? 7. Before 1985, Franklin Timmons and his wife, Kathryn, owned property that included a marina called the “Boatyard,” where Timmons operated the family business. Timmons’s primary income was derived from the Boatyard, and according to him, the business ran at a loss. In 1980, a court awarded a judgment against Timmons in a case involving the Boatyard. Timmons never paid the judgment. In 1985, with the judgment still outstanding and no improvement in their financial conditions, the Timmonses established a Joint Irrevocable Living Trust. They conveyed to the Trust the farm and the Boatyard, which comprised all the real property that they owned and the only significant assets that were capable of responding to a creditor judgment. Under the terms of the Trust, the Timmonses and their son, Jimmy, were named as trustees. The Trust instrument gave trustees discretion to invade the trust principal and to sell the land for their own benefit. Although his property was held by the Trust, Timmons never viewed the Trust as limiting his ability to use the land for himself or to rent it to others. Timmons believed that he could continue to live on the land, operate his business on it, and use the land as his own, as he had done in the past. In 1985, six months after the Trust was created, Kulp, Timmons’s employee, was severely injured while working at the Boatyard. Timmons did not carry workers’ compensation insurance, and he did not reimburse any of Kulp’s medical expenses. Kulp filed a petition for compensation due with the Industrial Accident Board (IAB), and the IAB ordered Timmons to post a $150,000 bond and to pay Kulp’s medical expenses and other benefits. Timmons did not comply with the IAB order, and several years of litigation ensued. Timmons’s son, Jimmy, died in October 1994, and Timmons’s wife, Kathryn, died two years later. As a consequence, Timmons became the sole settlor, trustee, and lifetime beneficiary of the Trust. Kulp’s IAB award still remained unpaid. In 1997, the Superior Court entered a money judgment in favor of Kulp, doubling the initial IAB award to $194,316.74 to compensate Kulp for the delay in payment. Kulp brought an action seeking a determination that the Trust was invalid and that its assets were subject to execution process. Less than one month after this action was filed, Timmons conveyed all his personal property

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Part Five Property

to his daughter-in-law, Beverly, and his granddaughter, Brandi. Thereafter, Beverly and Brandi conveyed a life estate in the conveyed property to Timmons. Timmons argued that as a consequence of that conveyance, and the transfer of his (and his wife’s) assets to the Trust in 1985, he has no assets from which to satisfy the judgment. Can Kulp reach the trust assets to collect his judgment? 8. Almost a century ago, Henry and Martha Kolb started a family-owned floral business in Storm Lake, Iowa. Both the business and the family grew into prominence. After their grandson, Robert, was tragically killed in a hunting accident, the Kolbs established an agreement with the City of Storm Lake to establish a flower garden in the memory of Robert. The agreement provided for the “establishment, installation and maintenance of a formal flower garden” at a specific location within the city park on the north shore of Storm Lake. The agreement made it clear that the garden was a gift to the city, and that the agreement was to “continue during the period of the trust as created in [Henry’s] Will . . . providing for the continued maintenance of said formal flower garden.” The trust was later supplemented for the addition of a water fountain in the garden. The Robert James Kolb Memorial Trust Fund was finally established in 1970. Henry and Martha established the trust by deeding a quarter section of farmland they owned to their sons “Robert H. Kolb and Norman J. Kolb, as Trustees for the use and benefit of the City of Storm Lake.” The warranty deed stated in pertinent part: It is the purpose of the grantors to hereby establish the Robert James Kolb Memorial Trust Fund out of the real estate above described and the proceeds derived from the sale thereof and/or the income derived therefrom, or any investments created by said trust fund. . . . The said trust fund shall be used in connection with improvements needed for the planting and upkeep of flower beds, such as annuals and perennials of all kinds, also flowering bulbs and rose bushes as may be put upon the tract of real estate hereinafter described.

In 1973, Henry and Martha deeded another quarter section of their farmland to their sons, Robert and Norman, as trustees, “for the use and benefit of the City of Storm Lake” to become a “part of the Robert James

Kolb Memorial Trust Fund established by the grantors in the year 1970, in order that this trust and the previously established trust may be handled as a single trust.” Neither warranty deed stated when the trust terminated. The trust operated without much trouble or question for over 30 years under the direction of Robert and Norman as trustees. The reports indicated the income produced from the farmland was more than enough to pay for the trust expenses. The trust disbursements mainly consisted of farm, garden, and fountain expenses, which often equaled $20,000–$30,000. On one occasion, however, the trustees used surplus trust funds to help the Storm Lake School District purchase additional school property. This transaction was memorialized in a 1980 agreement between Norman and the school district. Henry died intestate in 1978 and Martha died a short time later. Despite their deaths, the garden and fountain survived for many years with the help of the city’s maintenance and funds provided by the trust. It was a cherished location in Storm Lake, and often provided an ideal spot for weddings and celebrations. In 2003, however, the existence of the garden and fountain was placed in jeopardy. At this time the city was developing plans for an economic revitalization project called “Project Awaysis,” funded with Vision Iowa grant money. The plans sought to turn the city’s park on the north shore of Storm Lake and surrounding areas into a Midwest vacation destination. Among other things, the project was to provide a new public beach, a lighthouse, a family playground, a lodge, and an indoor/outdoor water park. Most importantly, the plans called for relocating the memorial gardens and fountain within the city’s park. The project was viewed by its planners, and others, as a vital and necessary move for the city to grow and compete for jobs and residents in the future. Norman, as trustee of the Kolb trust, filed a petition for an injunction preventing the removal of the garden and fountain. The trial court ruled against Norman on the injunction and the city began the removal of the garden and fountain. After a later trial, however, the court found that the trust’s purpose had been destroyed and that it therefore became a resulting trust to benefit the Kolbs’ successors. Was this ruling correct?

CHAPTER 27

Insurance Law

H

urricane Katrina struck Louisiana, Mississippi, and Alabama with overwhelming force in late August 2005. For many weeks thereafter, media coverage focused on the tragic personal consequences produced by Katrina and the tremendous devastation the storm inflicted on the Gulf Coast. Billions of dollars of property damage resulted from the hurricane and the flooding it spawned. Large numbers of homeowners simply did not have a property insurance policy. To their dismay, homeowners and commercial property owners who did have property insurance policies discovered that their particular losses may not have been covered by their policies. This was so even though damage from wind is a typical covered peril in a property insurance policy. Coverage disputes between property owners and insurance companies began to spring up with frequency not long after the extensive damage stemming from Hurricane Katrina became apparent. Property owners filed numerous cases against their insurers in an effort to convince courts to rule that typical property insurance policies’ coverage of wind damage would cover a broad range of Katrina-related losses, including those directly related to post-hurricane flooding. In general, however, the plaintiffs had little success. As you read this chapter, consider the hurricane aftermath and think about the following questions: • If wind is a typical covered peril in property insurance policies, how is it possible that losses stemming from Hurricane Katrina might not be covered under such policies? • Is there a typical exclusion from coverage that property insurers could credibly argue as a basis for denying coverage of certain Katrina-connected losses? • Why might a policyholder whose home or building was flattened by the powerful storm be in a stronger position to collect under her insurance policy than, say, a New Orleans insured whose home was destroyed or rendered uninhabitable by the flooding that engulfed the city when the powerful hurricane caused the city’s levee system to fail? Think, too, about these broader questions: • What is the nature of the relationship between an insurer and the insured? Is it collaborative, adversarial, or some of each? • What legal obligations does an insurer owe to an insured? Do ethical obligations also attend the insurer–insured relationship? • When a disaster of Hurricane Katrina’s magnitude strikes, should the terms of an insurance policy be interpreted any differently from how they would have been interpreted in the event of more ordinary losses? • What role do courts play in resolving insurance policy disputes? • Should legislatures and government agencies regulate the terms of insurance policies, or should the content of policies be left to the market?

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LO

Part Five Property

LEARNING OBJECTIVES After studying this chapter, you should be able to: 27-1 Explain the contractual nature of the relationship between an insurer and an insured. 27-2 Describe the effect an insured’s misrepresentation may have on the enforceability of an insurance policy. 27-3 Explain the approach courts normally take to interpretation of an ambiguous provision in an insurance policy. 27-4 Identify circumstances in which an insurer’s breach of a coverage obligation in its policy could subject the insurer to liability beyond the dollar limits set forth in the policy. 27-5 Explain what an insurable interest is and what role it plays in property insurance. 27-6 Identify perils typically covered in and excluded from property insurance policies.

INSURANCE SERVES AS a frequent topic of discussion in various contexts in today’s society. Advertisements for companies offering life, automobile, and property insurance appear daily on television and in the print media. Journalists report on issues of health insurance coverage (or lack thereof) and on legal developments concerning such issues. Persons engaged in business lament the excessive (from their perspective) costs of obtaining liability insurance. Insurance companies and insurance industry critics offer differing explanations for why those costs have reached their present levels. Despite the frequency with which insurance matters receive public discussion and the perceived importance of insurance coverage, major legal aspects of insurance relationships remain unfamiliar to many persons. This chapter, therefore, examines important components of insurance law. We begin by discussing the nature of insurance relationships and exploring contract law’s application to insurance policies in general. We then discuss other legal concepts and issues associated with specific types of insurance, most notably property insurance and liability insurance. Although health insurance issues are largely beyond the scope of this chapter, we briefly address recent years’ public debate over such issues. (See Figure 27.1, which appears later in the chapter.) The chapter concludes with an examination of an important judicial trend: allowing insurers to be held liable for compensatory and punitive damages if they refuse in bad faith to perform their policy obligations.

27-7 Explain the difference between a valued policy of property insurance and an open policy of property insurance. 27-8 Describe how coinsurance and pro rata clauses apply in property insurance policies. 27-9 Explain what is meant by an insurer’s right of subrogation. 27-10 Identify the major types of liability insurance policies and the types of liabilities they typically cover. 27-11 Explain the difference between a liability insurer’s duty to defend and its duty to pay sums owed by the insured. 27-12 Describe the types of circumstances in which an insurer may face bad-faith liability.

Nature and Benefits of Insurance Relationships LO27-1

Explain the contractual nature of the relationship between an insurer and an insured.

Insurance relationships arise from an agreement under which a risk of loss that one party (normally the insured) otherwise would have to bear is shifted to another party (the insurer). The ability to obtain insurance enables the insured to lessen or avoid the adverse financial effects that would be likely if certain happenings were to take place. In return for the insured’s payment of necessary consideration (the premium), the insurer agrees to shoulder the financial consequences stemming from particular risks if those risks materialize in the form of actual events. Each party benefits from the insurance relationship. The insured obtains a promise of coverage for losses that, if they occur, could easily exceed the amounts of the premiums paid. Along with this promise, the insured acquires the “peace of mind” that insurance companies and agents like to emphasize. By collecting premiums from many insureds over a substantial period of time, the insurer stands to profit despite its obligation to make payments covering financial losses that stem from insured-against risks. The insured-against risks, after all, are just that—risks.



Chapter Twenty-Seven Insurance Law

In some instances, events triggering the insurer’s payment obligation to a particular insured may never occur (e.g., the insured’s property never sustains damage from a cause contemplated by the property insurance policy). The insurer nonetheless remains entitled to the premiums collected during the policy period. Other times, events that call the insurer’s payment obligation into play in a given situation may occur infrequently (e.g., a particular insured under an automobile insurance policy has an accident only every few years) or only after many years of premium collection (e.g., an insured paid premiums on his life insurance policy for 35 years prior to his death).

Insurance Policies as Contracts Interested Parties Regardless of the type of insur-

ance involved, the insurance relationship is contractual. This relationship involves at least two—and frequently more than two—interested parties. As noted earlier, the insurer, in exchange for the payment of consideration (the premium), agrees to pay for losses caused by specific events (sometimes called perils). The insured is the person who acquires insurance on real or personal property or insurance against liability, or, in the case of life or health insurance, the person whose life or health is the focus of the policy. The person to whom the insurance proceeds are payable is the beneficiary. Except in the case of life insurance, the insured and the beneficiary will often be the same person. In most but not all instances, the insured will also be the policy’s owner (the person entitled to exercise the contract rights set out in the insurance policy and in applicable law). In view of the contractual nature of the insurance relationship, insurance policies must satisfy all of the elements required for a binding contract.

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Offer, Acceptance, and Consideration   The insurance industry’s standard practice is to have the potential insured make an offer for an insurance contract by completing and submitting an application (provided by the insurer’s agent), along with the appropriate premium, to the insurer. The insurer may then either accept or reject this offer. If the insurer accepts, the parties have an insurance contract under which the insured’s initial premium payment and future premium payments furnish consideration for the insurer’s promises of coverage for designated risks, and vice versa. What constitutes acceptance of the offer set forth in the application may vary somewhat, depending on the type of insurance requested and the language of the application. As a general rule, however, acceptance occurs when the insurer (or agent, if authorized to do so) indicates to the insured an intent to accept the application. It is important to know the precise time when acceptance occurs because the insurer’s contractual obligations to the insured do not commence until acceptance has taken place. If the insured sustains losses after the submission of the application (the making of the offer) but prior to acceptance by the insurer, those losses normally must be borne by the insured rather than the insurer. With property insurance and sometimes other types of insurance, the application may be worded so that insurance coverage begins when the insured signs the application. This arrangement provides temporary coverage until the insurer either accepts or rejects the offer contained in the application. The same result may also be achieved by the use of a binder, an agreement for temporary insurance pending the insurer’s decision to accept or reject the risk. The Stuart case, which follows, deals with interpretation of a property insurance binder issued shortly before an ice storm damaged the property.

Stuart v. Pittman   255 P.3d 482 (Ore. 2011) John Stuart decided to build a new house on a small farm in Yamhill County. In March 2003, Stuart met with Ronald Pittman, a Country Mutual Insurance Co. agent, and told him that he wanted course-of-construction insurance to cover the house while it was being built. Stuart was unfamiliar with the form and content of traditional course-of-construction policies. However, Pittman had been an insurance agent for 19 years and was experienced regarding such policies. During their meeting, Stuart and Pittman discussed, at length, the scope of coverage that the policy would provide—coverage from the start of construction to its finish and coverage beyond what normally would be covered in a homeowner’s policy. Stuart told Pittman he wanted coverage that would provide “safety net,” or “catch basin,” coverage “in all instances that something goes wrong during construction.” Stuart wanted coverage that would include loss resulting from weather, injury, faulty work, and the builder’s failure to perform. Pittman agreed to provide coverage and did not communicate to Stuart any coverage limitations. Relying on Pittman’s oral assurance of coverage, Stuart did not require the builder to carry a performance bond or liability insurance, which Stuart could have required of the builder under the provisions of the construction contract.

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Part Five Property

In August 2003, Stuart met with Pittman and notified him that he had signed a construction contract and that course-ofconstruction insurance needed to be in effect at the beginning of September 2003. Pittman agreed to provide course-of-construction insurance effective September 1, 2003. The builder started construction later that month. In October 2003, Stuart notified Pittman that he had not received the written policy and Pittman told Stuart that he would receive the policy soon. By December 2003, however, Stuart had received only a premium statement from Country Mutual. An ice storm struck the Willamette Valley in January 2004. Because the builder had left the partially completed house open to the weather, snow, ice, and water accumulated inside the house. As a result, the interior sheathing split, water accumulated in the crawl space, and mold grew. Shortly thereafter, Stuart contacted Pittman to inform him of the damage and to initiate an insurance claim. Pittman told Stuart that damage caused by wind, rain, flood, and water would be covered and that mold damage also might be covered. Stuart still had not received his written policy. In March 2004, Stuart received a declaration page from Country Mutual showing that coverage for a “dwelling under construction” had been added to his existing policy. Pittman told Stuart that the addition provided the coverage for the new construction previously discussed. However, the policy that Country Mutual issued contained provisions requiring direct physical loss, as well as exclusions for the perils of faulty workmanship, mold, and damage caused by water backup from sewer drains. Country Mutual later denied Stuart’s insurance claim based on those exclusions. Stuart brought an action against Country Mutual for breach of the oral binder and, alternatively, for failing to deliver a copy of the written policy within a reasonable time. At the conclusion of the trial’s evidentiary phase, Country Mutual moved for a directed verdict, arguing that Stuart had failed to establish that the oral binder provided coverage beyond that expressed in the written policy and that Stuart had failed to establish that he had been damaged by Country Mutual’s failure to deliver the policy in a timely manner. The trial court denied Country Mutual’s motion. A jury subsequently returned a verdict finding that Pittman had entered into an oral contract of insurance on behalf of Country Mutual that eliminated both the requirement for direct physical loss and the exclusions for mold, water damage, and damage by faulty workmanship or construction and further finding that defendant had failed to deliver the written policy within a reasonable period of time. The jury awarded Stuart damages in the amount of $268,417. The trial court entered a supplemental judgment awarding Stuart attorney fees and costs. On appeal, Country Mutual raised multiple assignments of error. The court of appeals, however, reached only Country Mutual’s challenge to the trial court’s denial of Country Mutual’s motion for directed verdict on Stuart’s contract claims under the oral binder and for Country Mutual’s failure to provide a written policy within a reasonable period of time. On the first issue, the court of appeals concluded that there was no evidence from which a jury could have found that Pittman agreed to terms that clearly and expressly waived or superseded the usual policy terms or exclusions. The court reasoned that, even assuming that Pittman agreed to provide “safety net” or “catch basin” coverage “in all instances that something goes wrong during construction,” those terms were too vague to satisfy a relevant Oregon statute, which provides that an oral binder is deemed to include “all the usual terms of the policy except as superseded by the clear and express terms of the binder.” As to Stuart’s claim that Country Mutual had failed to provide a written policy within a reasonable time, the court of appeals concluded that there was no evidence from which a jury could have found that Stuart had been damaged because Country Mutual had failed to deliver the written policy in a reasonable time. Based on the foregoing, the court of appeals reversed the trial court’s judgment. De Muniz, Chief Justice On review, Stuart argues that the Court of Appeals incorrectly construed ORS 742.043(1) by requiring Stuart to show that the usual exclusions of the written policy had been “definitely, explicitly, and unambiguously” superseded by the binder. Stuart further argues that the Court of Appeals erred in concluding that he had not proven that he was damaged by Country Mutual’s failure to timely deliver the written policy. For its part, Country Mutual maintains that (1) the Court of Appeals correctly held that the “usual terms of the policy” are superseded only when the parties have agreed to “clear and express” terms—definite,

express, and unambiguous—that are different from the usual policy terms; and (2) there was no evidence Stuart was damaged by Country Mutual’s failure to timely deliver the policy. According to Country Mutual, the trial court erred in denying its motion for directed verdict and in submitting the case to the jury.  At the outset, we observe that Country Mutual concedes that Pittman entered into an oral binder for course-of-construction insurance covering Stuart’s new residence, and that the binder remained in place at all times relevant to this litigation. Because the jury rendered a verdict in Stuart’s favor, “we do not weigh



Chapter Twenty-Seven Insurance Law

the evidence; we consider the evidence, including inferences, in the light most favorable to plaintiff.” [Citation omitted.] A jury verdict can be set aside only if this court concludes that there was no evidence from which the jury could have found for the plaintiff.  Furthermore, this court reviews a trial court’s denial of a motion for directed verdict for any evidence to support the verdict in plaintiff’s favor.  The answer to the parties’ contentions regarding the trial court’s denial of defendant’s directed verdict motion turns on the proper interpretation of ORS 742.043(1). ORS 742.043 provides, in part: (1) Binders or other contracts for temporary insurance may be made orally or in writing, and shall be deemed to include all the usual terms of the policy as to which the binder was given together with such applicable indorsements as are designated in the binder, except as superseded by the clear and express terms of the binder. (2) Except as provided in subsection (3) of this section and ORS 746.195, within 90 days after issue of a binder a policy shall be issued in lieu thereof, including within its terms the identical insurance bound under the binder and the premium therefor. In interpreting a statute, our paramount goal is to discern the legislature’s intent, and the statute’s own words are the most persuasive evidence of that intent.  The text of ORS 742.043(1) provides that the binder “shall be deemed to include all the usual terms of the policy, except as superseded by the clear and express terms of the binder.” That highlighted text modifies “all the usual terms of the policy” and makes the binder’s clear and express terms controlling over those contained in the usual policy. That reading of the statute also gives effect to the text in subsection (2), which provides that the written policy issued as a result must “include within its terms the identical terms bound under the binder.”  The question remains, however, what the legislature meant by the terms “clear and express.” The Court of Appeals concluded that the terms “clear and express” meant that the oral binder terms must “definitely, explicitly, and unambiguously supersede the terms [in the written policy].”   The Court of Appeals assumed, because of the jury verdict in Stuart’s favor, that Pittman had agreed to provide Stuart with a “safety net” of coverage “in all instances that something goes wrong” and that he even agreed that Country Mutual could provide some type of coverage in the event of “faulty work[.]” Nevertheless, the Court of Appeals concluded that the terms “safety net” and coverage “in all instances that something goes wrong” were too vague and obscure to satisfy the “clear and

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express” requirements of ORS 742.043(1).  For the reasons that follow, we disagree. Words of common usage, such as “clear” and “express,” should be given their plain and ordinary meaning. We agree with the Court of Appeals that, as used in the statute, the term “clear” means “easily understood” and the term “express” means “directly and distinctly stated, rather than implied or left to inference.” Those definitions lead to the unremarkable conclusion that the “clear and express” requirement in ORS 742.043(1) means that those binder terms that are easily understood and expressed, as opposed to implied, will ordinarily be sufficient to supersede the usual or contrary terms in a policy. As noted above, there is evidence that Stuart requested insurance that provided “catch basin” or “safety net” coverage in “all instances that something goes wrong during construction,” in essence an “all risk” policy. Those words were expressed by Stuart to Pittman, not implied, and the request for coverage “in all instances [where] something goes wrong during construction” is easily understood as meaning exactly what it says. Further, Pittman was aware that Stuart wanted a policy that covered perils beyond those usually covered by a traditional homeowner’s policy—the policy needed to cover loss resulting from weather, injury, faulty work, and builder’s failure to perform. Pittman subsequently indicated that Country Mutual’s policy “covered those things.” Pittman’s promise, which contained no exception or qualifications, left no room for an exclusion for faulty work or water- or mold-caused damage. Moreover, after the damage to Stuart’s house, Pittman told Stuart that damage caused by wind, rain, flood, water, and mold would likely be covered. Contrary to the Court of Appeals, we conclude that the terms “safety net” or “catch basin” or coverage “in all instances that something goes wrong during construction” were not vague or obscure. Rather, those terms, in the context in which they were used, were easily understood and were not implied or left to inference, and thus were sufficient under the “clear and express” requirement in ORS 742.043(1). Accordingly, there was evidence in the record from which the jury reasonably could conclude that Pittman agreed to coverage that was different from that expressed in the written policy—eliminating the requirement for direct physical loss and the exclusions for mold, water damage, and faulty workmanship or construction. Under Article VII (Amended), section 3, of the Oregon Constitution, we are required to sustain the jury’s verdict on plaintiff’s claim. The Court of Appeals erred in reaching a contrary conclusion. Decision of the Court of Appeals reversed; jury verdict in favor of Stuart reinstated.

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Part Five Property

Insurer’s Delay in Acting on Application A common insurance law problem is the effect of the insurer’s delay in acting on the application. If the applicant suffers a loss after applying but before a delaying insurer formally accepts, who must bear the loss? As a general rule, the insurer’s delay does not constitute acceptance. Some states, however, have held that an insurer’s retention of the premium for an unreasonable time constitutes acceptance and hence obligates the insurer to cover the insured’s loss. Other states have allowed negligence suits against insurers for delaying unreasonably in acting on an application. The theory of these cases is that insurance companies have a public duty to insure qualified applicants and that an unreasonable delay prevents applicants from obtaining insurance protection from another source. A few states have enacted statutes establishing that insurers are bound to the insurance contract unless they reject the prospective insured’s application within a specified period of time.

For example, a property insurance policy on a commercial office building specifies that the insured must install and maintain a working sprinkler system in the building, but the insured never installs the sprinkler system. The sprinkler system requirement is a warranty, which the insured breached by failing to install the system. This means that the insurer may not be obligated to perform its obligations under the policy. Traditionally, an insured’s breach of warranty has been seen as terminating the insurer’s duty to perform regardless of whether the condition set forth in the breached warranty was actually material to the insurer’s risk (unlike the treatment given to the insured’s misrepresentations, which do not make the insurance policy voidable unless they pertained to a material matter). In view of the potential harshness of the traditional rule concerning the effect of a breach of warranty, some states have refused to allow insurers to escape liability on breach of warranty grounds unless the condition contemplated by the breached warranty was indeed material.

Effect of Insured’s Misrepresentation

Legality The

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Describe the effect an insured’s misrepresentation may have on the enforceability of an insurance policy.

Applicants for insurance have a duty to reveal to insurers all the material (significant) facts about the nature of the risk so that the insurer may make an intelligent decision about whether to accept the risk. When an application for property, liability, or health insurance includes an insured’s false statement regarding a material matter, the insured’s misrepresentation, if relied on by the insurer, has the same effect produced by misrepresentation in connection with other contracts—the contract becomes voidable at the election of the insurer. This means that the insurer may avoid its obligations under the policy. The same result is possible if the insured failed, in the application, to disclose known material facts to the insurer, which issued a policy it would not have issued if the disclosures had been made. However, special rules applicable to misrepresentations in life insurance applications may sometimes limit the life insurer’s ability to use the insured’s misrepresentation as a way of avoiding all obligations under the policy. Warranty/Representation Distinction It ­sometimes becomes important to distinguish between warranties and representations that the insured makes (usually in the application) to induce the insurer to issue an insurance policy. Warranties are express terms in the insurance policy. They are intended to operate as conditions on which the insurer’s liability is based. The insured’s breach of warranty terminates the insurer’s duty to perform under the policy.

law distinguishes between unlawful wagering contracts and valid insurance contracts. A wagering contract creates a new risk that did not previously exist. Such a contract is contrary to public policy and therefore illegal. An insurance contract, however, transfers existing risks—a permissible, even desirable, economic activity. A major means by which insurance law separates insurance contracts from wagering contracts is the typical requirement that the party who purchases a policy of property or life insurance must possess an insurable interest in the property or life being insured. Specific discussion of the insurable interest requirement appears later in the chapter.

Form and Content of Insurance Contracts Writing State law governs whether insurance contracts are within the statute of frauds and must be evidenced by a writing. Some states require specific types of insurance contracts to be in writing. Contracts for property insurance are not usually within the statute of frauds, meaning that they may be either written or oral unless they come within some general provision of the statute of frauds—for example, the “one-year” provision.1 Even when a writing is not legally required, however, wisdom dictates that the parties reduce their agreement to written form whenever possible. Reformation of Written Policy As one would expect, insurance companies’ customary practice is to issue written policies of insurance regardless of whether the applicable The usual provisions of the statute of frauds are discussed in detail in Chapter 16. 1



Chapter Twenty-Seven Insurance Law

statute of frauds requires a writing. An argument sometimes raised by insureds is that the written policy issued by the insurer did not accurately reflect the content of the parties’ actual agreement. For instance, after the occurrence of a loss for which the insured thought there was coverage under the insurance contract, the insured learns that the loss-causing event was excluded from coverage by the terms expressly stated in the written policy. In such a situation, the insured may be inclined to argue that the written policy should be judicially reformed, so as to make it conform to the parties’ supposed actual agreement. Although reformation is available in appropriate cases, courts normally presume that the written policy of insurance should be treated as the embodiment of the parties’ actual agreement. Courts consider reformation an extreme remedy. Hence, they usually refuse to grant reformation unless either of two circumstances is present. The first reformation-triggering circumstance exists when the insured and the insurer, through its agent or agents, were mutually mistaken about a supposedly covered event or other supposed contract term (i.e., both parties believed an event was covered by, or some other term was part of, the parties’ insurance agreement, but the written policy indicated otherwise). The alternative route to reformation calls for proof that the insurer committed fraud as to the terms contained in the policy or otherwise engaged in inequitable conduct. Interpretation of Insurance Contracts LO27-3

Explain the approach courts normally take to interpretation of an ambiguous provision in an insurance policy.

Modern courts realize that many persons who buy insurance do not have the training or background to fully understand the technical language often contained in insurance policies. As a result, courts interpret insurance policy provisions as they would be understood by an average person. In addition, courts construe ambiguities in an insurance contract against the insurer, the drafter of the contract (and hence the user of the ambiguous language). This rule of construction means that if a word or phrase used in an insurance policy is equally subject to two possible interpretations, one of which favors the insurer and the other of which favors the insured, the court will adopt the interpretation that favors the insured.  A number of states purport to follow the reasonable expectations of the insured approach to interpretation of insurance policies. Analysis of judicial decisions reveals, however, that this approach’s content and effect vary among the states ostensibly subscribing to it. Some states do little more than attach the reasonable expectations

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label to the familiar principles of interpretation set forth in the preceding paragraph. A few states give the reasonable expectations approach a much more significant effect by allowing courts to effectively read clauses into or out of an insurance policy, depending on whether reasonable persons in the position of the insured would have expected such clauses to be in a policy of the sort at issue. When applied in the latter manner, the reasonable expectations approach tends to resemble reformation in its effect. Clauses Required by Law The insurance business is highly regulated by the states, which recognize the importance of the interests protected by insurance and the difference in bargaining power that often exists between insurers and their insureds. In an attempt to remedy this imbalance, many states’ statutes and insurance regulations require the inclusion of certain standard clauses in insurance policies. Many states also regulate such matters as the size and style of the print used in insurance policies. Laws in a growing number of states encourage or require the use of plain, straightforward language—rather than insurance jargon and legal terms of art—whenever such language is possible to use. Notice and Proof of Loss-Causing Event The insured (or, in the case of life insurance, the beneficiary) who seeks to obtain the benefits or protection provided by an insurance policy must notify the insurer that an event covered by the policy has occurred. In addition, the insured (or the beneficiary) must furnish reasonable proof of the losscausing event. Property insurance policies, for instance, ordinarily require the insured to furnish a sworn statement (called a proof of loss) in which the covered event and the resulting damage to the insured’s property are described. Under life insurance policies, the beneficiary is usually expected to provide suitable documentation of the fact that the insured person has died. Liability insurance policies call for the insured to give the insurer copies of liability claims made against the insured. Time Limits Insurance policies commonly specify that notice and proof of loss must be given within a specified time. Policies sometimes state that compliance with these requirements is a condition of the insured’s recovery and that failure to comply terminates the insurer’s obligation. Other times, policies merely provide that failure to comply suspends the insurer’s duty to pay until compliance occurs. Some courts require the insurer to prove it was harmed by the insured’s failure to give notice before allowing the insurer to avoid liability on the ground of tardy notice.

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Part Five Property

Cancellation and Lapse When a party with the power to terminate an insurance policy (extinguish all rights under the policy) exercises that power, cancellation has occurred. Lapse occurs at the end of the term specified in a policy written for a stated duration, unless the parties take action to renew the policy for an additional period of time. Alternatively, lapse may occur as a result of the insured’s failure to pay premiums or some other significant default on the part of the insured.

Performance and Breach by Insurer Identify circumstances in which an insurer’s breach of a

LO27-4 coverage obligation in its policy could subject the insurer

to liability beyond the dollar limits set forth in the policy.

The insurer performs its obligations by paying out the sums (and taking other related actions) contemplated by the policy’s terms within a reasonable time after the occurrence of an event that triggers the duty to perform. If the insurer fails or refuses to pay despite the occurrence of such an event, the insured may sue the insurer for breach of contract. By proving that the insurer’s denial of the insured’s claim for payment constituted a breach, the insured becomes entitled to recover compensatory damages in at least the amount that the insurer would have had to pay under the policy if the insurer had not breached. What if the insurer’s breach caused the insured to incur consequential damages that, when added to the amount due under the policy, would lead to a damages claim exceeding the dollar limits set forth in the policy? Assume that XYZ Computer Sales’s store building is covered by a property insurance policy with Secure Insurance Co., that the building is destroyed by an accidental fire (a covered peril), and that the extent of the destruction makes the full $500,000 policy limit due from Secure to XYZ. Secure, however, denies payment because it believes—erroneously—that XYZ officials committed arson (a cause, if it had been the actual one, that would have relieved Secure from any duty to pay). Because it needs to rebuild and take other related steps to stay in business but is short on available funds as a result of Secure’s denial of its claim, XYZ borrows the necessary funds from a bank. XYZ thereby incurs substantial interest costs, which are consequential damages XYZ would not have incurred if Secure had performed its obligation under the policy. Assuming that XYZ’s consequential damages would have been foreseeable to Secure, most states would allow XYZ to recover the consequential damages in addition to the amount due from

Secure under the policy.2 This is so even though the addition of the consequential damages would cause XYZ’s damages recovery to exceed the dollar limit set forth in the parties’ insurance policy. The breaching insurer’s liability may exceed the policy limits despite the insurer’s good-faith (though incorrect) basis for denying the claim because a good-faith but erroneous refusal to pay is nonetheless a breach of contract. If the insurer could point to the policy limits as a maximum recovery in this type of situation, it would have an all-too-convenient means of avoiding responsibility for harms that logically flowed from its breach of contract. Many states’ laws provide that if an insured successfully sues her insurer for amounts due under the policy, the insured may recover interest on those amounts (amounts that, after all, should have been paid by the insurer much sooner and without litigation). Some states also have statutes providing that insureds who successfully sue insurers are entitled to awards of attorney fees. Punitive damages are not allowed, however, when the insurer’s breach of contract consisted of a good-faith (though erroneous) denial of the insured’s claim. Later in this chapter, we will explore the trend toward allowing punitive damages when the insurer’s breach was in bad faith and thus amounted to the tort of bad-faith breach of contract.

Property Insurance Owners of residential and commercial property always face the possibility that their property might be damaged or destroyed by causes beyond their control. These causes include, to name a few notable ones, fire, lightning, hail, and wind. Although property owners may not be able to prevent harm to their property, they can secure some protection against resulting financial loss by contracting for property insurance and thereby transferring certain risks of loss to the insurer. Persons holding property interests that fall short of ownership may likewise seek to benefit, as will be seen, from the risk-shifting feature of property insurance.

Even though the terms of the insurance policy almost certainly would state that Secure’s payment obligation is limited to costs of repair or replacement or to the property’s actual cash value—that is, without any coverage for consequential harms experienced by the insured—Secure cannot invoke this policy language as a defense. If Secure had performed its contract obligation, its payment obligation would have been restricted to what the policy provided in that regard. Having breached the insurance contract, however, Secure stands potentially liable for consequential damages to the full extent provided for by ­general c­ontract law. For additional discussion of damages for breach of c­ontract, see Chapter 18. 2



Chapter Twenty-Seven Insurance Law

The Insurable Interest Requirement  LO27-5

Explain what an insurable interest is and what role it plays in property insurance.

As noted earlier in this chapter, in order for a property insurance contract not to be considered an illegal wagering contract, the person who purchases the policy (the policy owner) must have an insurable interest in the property being insured. One has an insurable interest if he, she, or it possesses a legal or equitable interest in the property and that interest translates into an economic stake in the continued existence of the property and the preservation of its condition. In other words, a person has an insurable interest if he would suffer a financial loss in the event of harm to the subject property. If no insurable interest is present, the policy is void. Examples of Insurable Interest The legal owner of the insured property would obviously have an insurable interest. So might other parties whose legal or equitable interests in the property do not rise to the level of an ownership interest. For example, mortgagees and other lienholders would have insurable interests in the property on which they hold liens. A nonexhaustive list of other examples would also include holders of life estates in real property, buyers under as-yet unperformed contracts for the sale of real property, and lessees of real estate.3 In the types of situations just noted, the interested party stands to lose financially if the property is damaged or destroyed. Timing and Extent of Insurable Interest A sensible and important corollary of the insurable interest principle is that the requisite insurable interest must exist at the time of the loss (i.e., at the time the subject property was damaged). If an insurable interest existed when the holder thereof purchased the property insurance but the interest was no longer present when the loss occurred, the policy owner is not entitled to payment for the loss. This would mean, for example, that a property owner who purchased property insurance would not be entitled to collect from the insurer for property damage that occurred after she had transferred ownership to someone else. Similarly, a lienholder who purchased property insurance could not collect

Chapter 28 contains a detailed discussion of security interests in real property. Chapter 29 addresses security interests in personal property. Chapter 24 contains a discussion of life estates and an examination of contracts for the sale of real property. Leases of real estate are explored in Chapter 25. 3

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under the policy if the loss took place after his lien had been extinguished by payment of the underlying debt or by another means.4 The extent of a person’s insurable interest in property is limited to the value of that interest. For example, Fidelity Savings & Loan extends Williams a $250,000 loan to purchase a home and takes a mortgage on the home as security. In order to protect this investment, Fidelity obtains a $250,000 insurance policy on the property. Several years later, the house is destroyed by fire, a cause triggering the insurer’s payment obligation. At the time of the fire, the balance due on the loan is $220,000. Fidelity’s recovery under the insurance policy is limited to $220,000 because that amount is the full extent of its insurable interest. (An alternative way by which mortgagees protect their interest is to insist that the property owner list the mortgagee as the loss payee under the property owner’s policy. This means that if the property is destroyed, the insurer will pay the policy proceeds to the mortgagee. Once again, however, the mortgagee’s entitlement to payment under this approach would be limited to the dollar value of its insurable interest, with surplus proceeds going to the insured property owner.)

Covered and Excluded Perils  LO27-6

Identify perils typically covered in and excluded from property insurance policies.

Property insurers usually do not undertake to provide coverage for losses stemming from any and all causes of harm to property. Instead, property insurers tend to either specify certain causes (covered perils) as to which the insured will receive payment for resulting losses—meaning that there is no coverage regarding a peril not specified—or set forth a seemingly broad statement of coverage but then specify certain perils concerning which there will be no payment for losses (excluded perils). Sometimes, property insurers employ a combination of these two approaches In the life insurance context, the requisite insurable interest must exist at the time the policy was issued but need not exist at the time of the insured’s death. Persons who stand to suffer a financial loss in the event of the insured’s death have the insurable interest necessary to support the purchase of a life insurance policy on the insured. The insured and his or her spouse, parents, children, and other dependents thus ­possess an insurable interest in the insured’s life. In addition, the business associates of the insured may also have an insurable interest in his or her life. Such persons would include the insured’s employer, business partners, or shareholders in a closely held corporation with which the insured is connected. Creditors of the insured also have an insurable interest, but only to the extent of the debt owed by the insured. 4

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Part Five Property

The Global Business Environment A California statute, the Holocaust Victim Insurance Relief Act of 1999 (HVIRA), provided that if an insurer doing business in California sold insurance policies to persons in Europe between 1920 and 1945 (Holocaust-era policies), the insurer was to file certain information about those policies with the California insurance commissioner. The reporting requirement also applied to insurance companies that did business in California and were “related” to a company that sold Holocaust-era policies, even if the relationship arose after the policies were issued. A “related company” was defined as any “parent, subsidiary, reinsurer, successor in interest, managing general agent, or affiliate company of the insurer.” Insurance companies subject to HVIRA were expected to provide this information: (1) the number of Holocaust-era insurance policies; (2) the holder, beneficiary, and current status of each such policy; and (3) the city of origin, domicile, or address for each policyholder listed in the policies. In addition, HVIRA required the insurers to certify whichever one of the following was accurate: (1) that the proceeds of the policies were paid; (2) that the beneficiaries or heirs could not, after diligent search, be located, and the proceeds were distributed to ­Holocaust survivors or charities; (3) that a court of law had certified a plan for the distribution of the proceeds; or (4) that the proceeds had not been distributed. HVIRA instructed the California insurance commissioner to store the information disclosed under the statute in a Holocaust Era Insurance Registry, which was available to the public. In addition, HVIRA required the insurance commissioner to “suspend the certificate of authority to conduct insurance business in the state of any insurer that fails to comply” with HVIRA’s reporting requirements. Various U.S.-based, German, and Italian insurance companies filed suit in a federal district court in an effort to have HVIRA invalidated on constitutional grounds. The district court held the statute unconstitutional on various grounds, but the U.S. Court of Appeals for the Ninth Circuit reversed. Seeing no constitutional obstacle, the Ninth Circuit regarded HVIRA as legitimate, state-related legislative action that fit within the customary authority of states to regulate regarding

by specifying certain covered perils and certain excluded perils. For an example, see the Michigan Battery Equipment case, which follows shortly. Typical Covered Perils The effects of these approaches are essentially the same, as most property insurers tend to provide coverage for the same sorts of causes of harm to property. The perils concerning which property insurance

insurance-related matters. The U.S. Supreme Court granted the insurers’ petition for certiorari. In American Insurance Association v. Garamendi, 539 U.S. 396 (2003), the Supreme Court identified Article II of the U.S. Constitution as the key constitutional provision at issue in the case. Article II reserves to the federal executive branch the power to conduct foreign policy. Pointing to relevant history as necessary background, the Court observed that after a 1990 treaty lifted a previous moratorium on certain claims related to the Holocaust, various class action lawsuits were filed in U.S. courts against non-U.S. firms that allegedly had done business in Germany during the Nazi era. These cases drew protests from the defendant firms and from various foreign governments. Following these protests, the executive branch of the U.S. government entered into agreements with the governments of Germany, Austria, and France during 2000 and 2001. The agreements outlined a Holocaust-related claims resolution process under which the foreign governments were to create foundations that would be funded by those governments and certain foreign firms. Foundation funds would satisfy valid Holocaust-related claims. The claims to be covered by the agreements included insurance claims the resolution of which was to be eased by agreement provisions calling for the foundations to negotiate with European insurers. The agreements stated that the claims resolution process was in the foreign policy interest of the United States. In addition, the federal government agreed to use its “best efforts” to have Holocaust-related claims go through the process rather than through the courts or other mechanisms set up by state and local governments. After taking into account the history, purposes, and content of the 2000 and 2001 agreements entered into by the executive branch and the governments of Germany, Austria, and France, the Court concluded that HVIRA posed a significant obstacle to, if not an outright conflict with, the foreign policy objectives articulated in the agreements. This meant that the federal government’s Article II foreign policy power must preempt—that is, take precedence over—HVIRA. Therefore, the Court reversed the Ninth Circuit’s decision and held HVIRA unconstitutional.

policies typically provide benefits include fire, lightning, hail, and wind. In addition, property insurance policies often cover harms to property resulting from causes such as the impact of an automobile or aircraft (e.g., an automobile or aircraft crashes into an insured building), vandalism, certain collapses of buildings, and certain accidental discharges or overflows from pipes or heating and airconditioning systems.



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Michigan Battery Equipment, Inc. v. Emcasco Insurance Co.    892 N.W.2d 456 (Mich. Ct. App. 2016)

Emcasco Insurance Co. (EMC) was the insurer and Michigan Battery Equipment, Inc. was the insured under a property insurance policy that applied to Michigan Battery’s warehouse building. Because of prolonged water infiltration through deteriorated rubber grommets in the building’s roof, the roof trusses of the warehouse rotted. When snow and ice accumulated on the roof, the rotted trusses split, cracked, and partially collapsed. Michigan Battery submitted a claim to EMC regarding the roof damage, but EMC denied the claim on the ground that an exclusion in the insurance policy applied. Regarding the coverage denial as unjustified, Michigan Battery sued EMC in a Michigan court. The court granted summary judgment in favor of EMC, ruling that the roof damage resulted from wet rot—a risk excluded by a provision in the insurance policy. Michigan Battery appealed to the Michigan Court of Appeals. (Further information about the insurance policy’s terms appears in the following edited version of the Court of Appeals opinion.) Saad, Judge The question on appeal is whether EMC’s insurance policy covers the damage to Michigan Battery’s roof. To resolve this dispute, we must examine the terms of the insurance policy and determine whether the damage is excluded from coverage under any exclusion. Insurance policies must be enforced in accordance with their terms. “The language of insurance contracts should be read as a whole and must be construed to give effect to every word, clause, and phrase.” [Citation omitted.] To determine the intent of the parties, a court must first ascertain whether the policy provides coverage to the insured. Then, it must determine whether that coverage is negated by an exclusion. Where a contract provision is ambiguous, the contract is construed in favor of the insured. However, “[a] court should not create ambiguity in an insurance policy where the terms of the contract are clear and precise.” Henderson v. State Farm Fire & Casualty Co., 596 N.W.2d 190 (Mich. Sup. Ct. 1999). Instead, contract terms should be interpreted using their plan and ordinary meanings. Id. Michigan Battery insured its property with an “all-risk” policy issued by EMC on its warehouse and attached offices. “Notwithstanding the presence of an ‘all-risks’ provision in an insurance policy, the loss will not be covered if it comes within any specific exclusion contained in the policy.” 10A Couch, Insurance, 3d § 148.68. Here, the policy provides for various exclusions, of which two were the focus of the arguments at the trial court: (1) the exclusion for damage caused by collapse; and (2) the exclusion for damage caused by fungus, wet rot, dry rot, and bacteria. Such exclusionary clauses are strictly construed in favor of the insured. However, “[c]lear and specific exclusions must be given effect,” and “coverage under a policy is lost if any exclusion within the policy applies to an insured’s particular claims.” Auto-Owners Insurance Co. v. Churchman, 489 N.W.2d 431 (Mich. Sup. Ct. 1992). Because the language of the policy is controlling, we turn our attention to the rot exclusion in the policy, which provides in pertinent part: B. Exclusions 1. We will not pay for loss or damage caused directly or indirectly by any of the following. Such loss or damage is

excluded regardless of any other cause or event that contributes concurrently or in any sequence to the loss. [Exclusions (a) through (g) omitted]; h. “Fungus,” Wet Rot, Dry Rot And Bacteria Presence, growth, proliferation, spread or any activity of “fungus,” wet or dry rot or bacteria. But if “fungus,” wet or dry rot or bacteria results in a “specified cause of loss,” we will pay for the loss or damage caused by that “specified cause of loss.” This exclusion does not apply: 1. When “fungus,” wet or dry rot or bacteria results from fire or lightning; or 2. To the extent that coverage is provided in the Additional Coverage—Limited Coverage For “Fungus,” Wet Rot, Dry Rot And Bacteria with respect to loss or damage by a cause of loss other than fire or lightning. Exclusions B.1.a. through B.1.h. apply whether or not the loss event results in widespread damage or affects a substantial area. As the trial court properly held, the plain language of the above-quoted insurance policy provisions excludes from coverage damage caused by fungus, wet rot, dry rot, and bacteria. However, this exclusion has exceptions: (1) when the fungus, wet rot, dry rot, or bacteria results from fire or lightning; (2) to the extent that coverage is provided in the “Additional Coverage” provision; and (3) where the fungus, rot, or bacteria “results in a ‘specified cause of loss.’” As a result, because there is no question that wet rot caused the damage at issue, we must determine if any of the exceptions to the rot exclusion applies. The first exception does not apply because there is nothing on the record to show, and the parties do not argue, that the wet rot here was the result from fire or lightning. Indeed, the record shows that the wet rot was caused by water leakage through grommets located in the roof. Additionally, the second exception related to the rot being covered under the “Additional Coverage” does not apply. Under this “Additional Coverage,” damage from fungus, rot, and bacteria is

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covered where the fungus, rot, or bacteria is the result of (1) “a specified cause of loss” other than fire or lightning or (2) flood. The term “specified causes of loss” is defined as meaning fire; lightning; explosion; windstorm or hail; smoke; aircraft or vehicles; riot or civil commotion; vandalism; leakage from fireextinguishing equipment; sinkhole collapse; volcanic action; falling objects; weight of snow, ice or sleet; water damage. And “water damage” is further defined as accidental discharge or leakage of water or steam as the direct result of the breaking apart or cracking of a plumbing, heating, air conditioning or other system or appliance (other than a sump system including its related equipment and parts), that is located on the described premises and contains water or steam. Here, there is nothing on the record to establish, and the parties do not argue, that the wet rot in the warehouse was the result of or caused by a specified cause of loss. Likewise, there is nothing in the record to support that the damage was caused by flood. As already noted, the wet rot damage was caused by water intrusion through deteriorated rubber grommets in the roof. Accordingly,

Fire as a Covered Peril Historically, the importance of coverage against the peril of fire made fire insurance a commonly used term. Various insurance companies incorporated the term into their official firm name; the policies these companies issued came to be called fire insurance policies even when they covered perils in addition to fire (as policies increasingly have done in this century). As a result, judges, commentators, and persons affiliated with the insurance industry will sometimes refer to today’s policies as fire insurance policies despite the usual property insurer’s tendency to cover not only fire but also some combination of the other perils mentioned in the preceding paragraph. Whether the term used is property insurance (generally employed in this chapter) or fire insurance, reference is being made to the same type of policy. Fire-related losses covered by property insurance policies are those resulting from accidental fires. An accidental fire is one other than a fire deliberately set by, or at the direction of, the insured for the purpose of damaging the property. In other words, the insured obtains no coverage for losses stemming from the insured’s act of arson. This commonsense restriction on an insurer’s duty to pay for losses also applies to other harms the insured deliberately caused to his property.

because the wet rot was not the result of a “specified cause of loss” and was not the result of flood, the “Additional Coverage” provision simply does not apply. Similarly, the third exception is not implicated. The rot in the trusses resulted in the roof and trusses to fall down a [few] feet, which, importantly, is not one of the enumerated specified causes of loss. Therefore, the wet rot and resulting damage is not covered under the policy because it is excluded under the general exclusion in section B.1.h and none of the exclusion’s exceptions applies. In brief, the policy plainly identifies the risks that EMC was willing to [cover] and did contract to cover. [U]nfortunately for Michigan Battery, wet rot is not one of those risks. Indeed, this risk was specifically excluded from coverage, and had Michigan Battery desired  to obtain coverage, it could have purchased a rider for this specific loss. Consequently, because EMC identified wet rot as a particular type of risk that it was unwilling to insure, Michigan Battery cannot recover under the policy. Trial court’s grant of summary judgment in favor of EMC affirmed.

For purposes of fire coverage, insurance contracts sometimes distinguish between friendly fires, which are those contained in a place intended for a fire (such as fires in a woodstove or fireplace), and hostile fires, which burn where no fire is intended to be (such as fires caused by lightning, outside sources, or electrical shorts, or those that began as friendly fires but escaped their boundaries). Losses caused by hostile fires are covered; those stemming from friendly fires may not be (depending, of course, upon the language of the policy at issue). As a general rule, covered fire losses may extend beyond direct damage caused by the fire. Indirect damage caused by smoke and heat is usually covered, as is damage caused by firefighters in their attempts to put out the fire. Typical Excluded Perils Although flood-related harm to property may seem similar to harm stemming from some of the weather-related causes listed earlier among the typical covered perils, it does not usually receive the same treatment. Property insurance policies frequently exclude coverage for flood damage. On this point, however, as with other questions regarding perils covered or excluded, the actual language of the policy at issue must always be consulted before a coverage issue is resolved in any given



Chapter Twenty-Seven Insurance Law

case.5 Other typical exclusions include earthquake damage and harm to property stemming from war or nuclear reaction, radiation, or contamination. As previously indicated, property insurance policies exclude coverage for losses caused by the insured’s deliberate actions that were intended to cause harm to the property. Additional Coverages Even as to perils for which there may not be coverage in the typical property insurance policy, the property owner may sometimes be able to purchase a specialized policy (e.g., a flood insurance policy) that does afford coverage for such perils. Other times, even if coverage for a given peril is not provided by the terms of most standard property insurance policies, it may nonetheless be possible for the property owner to have coverage for that peril added to the policy by paying an additional premium. This is sometimes done, for example, by policy owners who desire earthquake coverage. Personal Property Insurance Although the broad term property insurance is what has been employed, the discussion so far in this section has centered around policies providing coverage for harm to real property. Items of personal property are, of course, insurable as well. Property insurance policies commonly known as homeowners’ policies—because the real property serving as the policy’s primary subject is the insured’s dwelling—cover not only harm to the dwelling but also to personal property located inside the dwelling or otherwise on the subject real property. (Sometimes, depending on the policy language, there may be coverage even when the item of personal property was not located at the designated real property when the item was damaged.) Property insurance policies covering office buildings and other commercial real estate often provide some level of personal property coverage as well. When personal property coverage is included in a policy primarily concerned with real property coverage, the perils insured against in the personal property coverage tend to be largely the same as, though not necessarily identical to, those applicable to the real property coverage. Lessees of residential or commercial real estate may obtain insurance policies to cover their items of personal property that are on the leased premises. Such policies are highly advisable because the apartment or office building It may be that a type of peril frequently excluded in property insurance policies is in fact a covered peril under the language of the policy at issue. Alternatively, losses that at first glance appear to have resulted from an excluded peril may sometimes be characterized as having resulted, at least in part, from a covered peril. In the latter event, there may be some coverage for the losses. 5

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owner’s insurance policy on the real property is likely to furnish little or no coverage for the tenant’s personal property. Automobile insurance policies are in part personal property insurance policies because they provide coverage (under what are usually called the comprehensive and collision sections) for car damage resulting from such causes as fire, wind, hail, vandalism, or collision with an animal or tree. As will be seen, automobile insurance policies also contain significant features of another major type of insurance policy to be discussed later—liability insurance. Other specialized types of personal property insurance are also available. For example, many farmers purchase crop insurance in order to guard against the adverse financial effects that would result if a hailstorm or other covered peril severely damaged a season’s crop.

Nature and Extent of Insurer’s Payment Obligation Property insurance policies are indem-

nity contracts. This means that the insurer is obligated to reimburse the insured for his actual losses associated with a covered harm to the insured property. The insured’s recovery under the policy thus cannot exceed the extent of the loss sustained. Neither may it exceed the extent of the insured’s insurable interest or the amount of coverage that the insured purchased (the policy limits).6 Policy provisions other than the policy limits also help define the extent of the insurer’s obligation to pay. When covered real property is damaged but not destroyed, the cost of repair is normally the relevant measure. Many policies provide that when covered real property is destroyed, the insurer must pay the actual cash value (or fair market value) of the property. Some policies, however, establish cost of replacement as the payment obligation in this situation. The policies that call for payment of the actual cash value frequently give the insurer the option to pay the cost of replacement, however, if that amount would be less than the actual cash value. As to covered personal property, the controlling standard is typically the least of the following: cost of repair, cost of replacement, or actual cash value.7

Some insurers, however, provide, in exchange for a more substantial premium than would be charged for a policy without this feature, a homeowner’s policy under which the insurer could become obligated to pay more than the policy limits if the insured’s home was destroyed and the cost to replace it would actually exceed the policy limits. 6

Concerning certain designated items of personal property such as furs or jewelry, policies often set forth a maximum insurer payout (such as $1,000) that is less than the general policy limits applicable to personal property. Such a payout limitation would operate as a further restriction on the extent of the insurer’s obligation. 7

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Part Five Property

Many property insurance policies supplement the above provisions by obligating the insurer to pay the insured’s reasonable costs of temporarily living elsewhere if the insured property was her residence and the damage to the residence made it uninhabitable pending completion of repairs or replacement. Comparable benefits may sometimes be provided in policies covering business property. Lost profits and similar consequential losses resulting from harm to or destruction of one’s insured property, however, do not normally fall within the insurer’s payment obligation unless a specific provision obligates the insurer along those lines.8 Regardless of whether the damaged or destroyed property is real or personal in nature, the particular language of the policy at issue must always be consulted before a definite determination can be made concerning what is and is not within the insurer’s duty to pay. Valued and Open Policies  LO27-7

Explain the difference between a valued policy of property insurance and an open policy of property insurance.

When insured real property is destroyed as a result of fire or another covered peril, the amount to be paid by the insurer may be further influenced by the type of policy involved. Some property insurance contracts are valued policies. If real property insured under a valued policy is destroyed, the insured is entitled to recover the face amount of the policy regardless of the property’s fair market value. For example, in 1985, Douglas purchased a home with a fair market value of $90,000. Douglas also purchased a valued policy with a face amount of $90,000 to insure the house against various risks, including fire. The home’s fair market value decreased in later years because of deterioration in the surrounding neighborhood. In 2017, when the home had a fair market value of only $75,000, it was destroyed by fire. Douglas is entitled to $90,000 (the face amount of the valued policy) despite the reduction in the home’s fair market value. Most property insurance policies, however, are open policies. Open policies allow the insured to recover the fair market value (actual cash value) of the property at the time it was destroyed, up to the limits stated in the policy. Thus, if Douglas had had an open policy in the example presented in the previous paragraph, he would have been Recall, however, that if the insurer violates its payment obligation by wrongfully failing or refusing to pay what the policy contemplates, the insurer has committed a breach of contract. As noted in this chapter’s earlier discussion of insurance policies as contracts, fundamental breach of contract principles dictate that the breaching insurer is potentially ­liable for consequential damages. 8

entitled to only $75,000 when the home was destroyed by fire. Suppose instead that Douglas’s home had increased in value, so that at the time of the fire its fair market value was $200,000. In that event, it would not matter what type of policy (valued or open) Douglas had. Under either type of policy, his recovery would be limited to the $90,000 face amount of the policy. Coinsurance Clause  LO27-8

Describe how coinsurance and pro rata clauses apply in property insurance policies.

Some property insurance policies contain a coinsurance clause, which may operate as a further limit on the insurer’s payment obligation and the insured’s right to recovery. A coinsurance clause provides that in order for the insured to be able to recover the full cost of partial losses, the insured must obtain insurance on the property in an amount equal to a specified percentage (often 80 percent) of the property’s fair market value. For example, PDQ Corporation has a fire insurance policy on its warehouse with Cooperative Mutual Insurance Group. The policy has an 80 percent coinsurance clause. The warehouse had a fair market value of $400,000, meaning that PDQ was required to carry at least $320,000 of insurance on the building. PDQ, however, purchased a policy with a face amount of only $240,000. A fire partially destroyed the warehouse, causing $200,000 worth of damage to the structure. Because of the coinsurance clause, PDQ will recover only $150,000 from Cooperative. This figure was arrived at by taking the amount of insurance carried ($240,000) divided by the amount of insurance required ($320,000) times the loss ($200,000). The coinsurance formula for recovery for partial losses is stated as follows: Amount of insurance carried ________________ ​         ​ × Fair market value × Loss = Recovery Coinsurance percent Remember that the coinsurance formula applies only to partial losses (i.e., damage to, but not complete destruction of, property). If PDQ’s warehouse had been totally destroyed by the fire, the formula would not have been used. PDQ would have recovered $240,000—the face amount of the policy—for the total loss. If the formula had been used, it would have indicated that Cooperative owed PDQ $300,000—more than the face amount of the policy. This result would be neither logical nor in keeping with



Chapter Twenty-Seven Insurance Law

the parties’ insurance contract. Whether the loss is total or partial, the insured is not entitled to recover more than the face amount of the policy. Pro Rata Clause With the limited exception of the valued policy (discussed above), the insured cannot recover more than the amount of the actual loss. A rule allowing the insured to recover more than the actual loss could encourage unscrupulous persons to purchase policies from more than one insurer on the same property—thus substantially overinsuring it—and then intentionally destroy the property in a way that appeared to be a covered peril (e.g., committing arson but making the fire look accidental). In order to make certain that the insured does not obtain a recovery that exceeds the actual loss, property insurance policies commonly contain a pro rata clause, which applies when the insured has purchased insurance policies from more than one insurer. The effect of the pro rata clause is to apportion the loss among the insurance companies. (Applicable state law sometimes contains a rule having this same effect.) Under the pro rata clause, the amount any particular insurer must pay the insured depends on the percentage of total insurance coverage represented by that insurer’s policy. For example, Mumford purchases two insurance policies to cover his home against fire and other risks. His policy from Security Mutual Insurance Corp. has a face amount of $50,000; his policy from Reliable Insurance Co. is for $100,000. Mumford’s home is partially destroyed by an accidental fire, with a resulting loss of $30,000. Security Mutual must pay Mumford $10,000, with Reliable having to pay the remaining $20,000 of the loss. The formula for determining each insurer’s liability under a pro rata clause is stated as follows: Amount of  insurance policy ________________ ​         ​ × Loss = Liability of insurer Total coverage by all insurers Thus, Security Mutual’s payment amount was calculated as follows: $50,000 (Security Mutual’s policy) ________________ ​         ​ × $30,000 (Loss) = $10,000 $150,000 (Total of  both policies) Reliable’s payment amount could be similarly calculated by substituting $100,000 (Reliable’s policy amount) for the $50,000 (Security Mutual’s policy amount) in the

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numerator of the equation. This formula may be used for both partial and total losses. However, each company’s payment obligation is limited by the face amount of its policy. Thus, Security Mutual could never be liable for more than $50,000. Similarly, Reliable’s liability is limited to a maximum of $100,000.

Right of Subrogation LO27-9 Explain what is meant by an insurer’s right of subrogation.

The insurer may be able in some instances to exercise a right of subrogation if it is required to pay for a loss under a property insurance contract. Under the right of subrogation, the insurer obtains all of the insured’s rights to pursue legal remedies against anyone who negligently or intentionally caused the harm to the property. For example, Arnett purchased a property insurance policy on her home from Benevolent Insurance Company. Arnett’s home was completely destroyed by a fire that spread to her property when her neighbor, Clifton, was burning leaves and negligently failed to control the fire. After Benevolent pays Arnett for her loss, Benevolent’s right of subrogation entitles it to sue Clifton to recover the amount Benevolent paid Arnett. Arnett will be obligated to cooperate with Benevolent and furnish assistance to it in connection with the subrogation claim. If the insured provides the liable third party a general release from liability, the insurer will be released from his payment obligation to the insured. Suppose that in the above scenario, Clifton persuaded Arnett to sign an agreement releasing him from liability for the fire. Because this action by Arnett would interfere with Benevolent’s right of subrogation, Benevolent would not have to pay Arnett for the loss. A partial release of Clifton by Arnett would relieve Benevolent of responsibility to Arnett to the extent of her release.

Duration and Cancellation of Policy Prop-

erty insurance policies are usually effective for a designated period such as six months or a year. They are then extended for consecutive periods of like duration if the insured continues to pay the necessary premium and neither the insured nor the insurer elects to cancel the policy. The insured is normally entitled to cancel the policy at any time by providing the insurer written notice to that effect or by surrendering the policy to the insurer. Although property insurers usually have some right to cancel policies, terms of the policies themselves and/or governing law typically limit the grounds on which property insurers may do so. Permitted grounds for cancellation include the insured’s nonpayment of the premium and, as a general rule, the insured’s

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Part Five Property

misrepresentation or fraud (see this chapter’s discussion of contract law’s applicability to insurance policies). Policy provisions and/or applicable law typically provide that if the property insurer intends to cancel the policy, the insured must be given meaningful advance written notice (often 30 days) of this intent before cancellation takes effect. Another cancellation basis exists by virtue of the increase of hazard clauses that appear in many property

insurance policies. An increase of hazard clause provides that the insurer’s liability will be terminated if the insured takes any action materially increasing the insurer’s risk. Some increase-of-hazard provisions also specify certain types of behavior that will cause termination. Common examples of such behavior include keeping highly explosive material on the property and allowing the premises to remain vacant for a lengthy period of time.

Figure 27.1 The Health Insurance Debate The seemingly ever-rising costs of health care services pose a major problem for those who lack health insurance. Even those who have such insurance may find themselves obligated to pay very substantial medical bills associated with serious illnesses or injuries because health insurance policies do not cover the full cost of health care services. Most Americans who have health insurance receive their coverage through a group policy, in which an insurer agrees to furnish coverage of persons who belong to a particular group. The most common group consists of employees of a particular firm that has chosen to work with an insurer to set up a policy for its employees. Group policies tend to be less expensive, premium-wise, for insured persons than individual policies would be. However, many millions of Americans do not have health insurance, typically because they have no access (or no affordable access) to a group policy and cannot afford an individual policy. Movements for health insurance reform have come and gone over the past decades, with legislation enacted prior to 2010 usually nibbling around the edges of the access-to-health-insurance problem or being restricted to a particular segment of the population. (The laws establishing the Medicare program of health coverage for persons 65 years of age or older would be an example of the latter.) In 2010, however, Congress enacted the Patient Protection and Affordable Care Act (hereinafter, “Affordable Care Act” or “ACA”)—easily the most sweeping health insurance reform to become law as of that time. The complex Affordable Care Act cannot be fully summarized here. It is fair to say, however, that the single ACA provision triggering the most public attention and debate was a provision that took effect in 2014: the requirement that every person have health insurance in force or pay a penalty for not having obtained such coverage. Proponents of the ACA maintained that the everyone-must-have-insurance provision (often known as the individual mandate) took direct aim at the problem of so many millions being uninsured and that the measure was critical to the statute’s health care cost-containment goals. Critics of the law vowed to seek repeal of the statute and complained in particular about the individual mandate. Certain objectors to the ACA went further, singling out the individual mandate as the target of constitutional challenges initiated in court. After mixed results in the federal district courts and circuit courts of appeal, the U.S. Supreme Court issued a 2012 decision that upheld the have-insurance-or-pay-a-penalty provision as a valid exercise of the Taxing Power extended to Congress by the U.S. Constitution. (See National Federation of Independent Business v. Sebelius, which is excerpted and discussed in Chapter 3.) Other provisions in the ACA included, among others: elimination of health insurers’ ability to deny coverage on the basis of a would-be insured’s preexisting health condition; elimination of insurers’ caps on lifetime benefits paid out to an insured; a provision permitting adult children to remain insured under their parents’ health policies until the age of 26; requirements that health insurance policies cover certain essential benefits; directions to states to establish health benefit exchanges in order to help individuals and small employers obtain coverage; tax credits for persons of certain incomes in order to help defer some of the costs of obtaining health insurance; a tax increase on high-income earners, in order to help fund ACA-related expenditures; a requirement that employers with more than 200 employees automatically enroll full-time employees in health coverage; and provisions regarding an expansion of the existing Medicaid program (which provides health coverage for low-income persons). Since the ACA’s enactment, critics of the law vowed that they would “repeal and replace” it if they acquired the political means to do so. The repeal-and-replace movement went into high gear in early 2017, with the same political party having assumed control of the White House, the House of Representatives, and the Senate. In May 2017, the House passed a bill that, if it were enacted, would replace the ACA with a statutory program that its proponents claimed would control health care costs better and without a mandate that everyone have insurance. Critics charged that if the bill became law, it would not control costs effectively and would cause millions of persons who obtained insurance under the ACA to lose their coverage or find it far more expensive (particularly if they had a preexisting condition). As this book went to press, the Senate was considering whether to accept or modify the House bill or to develop a new bill. In dramatic fashion, the movement to repeal and replace the ACA failed in July 2017 when the Senate failed to pass the proposed legislation. As this text goes to press, legal challenges continue. Whatever the outcome of the legislative moves, the health insurance debate seems destined to continue for years to come.



Chapter Twenty-Seven Insurance Law

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CYBERLAW IN ACTION As this text goes to press in 2020, cyber attacks continue to dominate media reports around the world, as hackers seem to have proven that their illicit business models are effective. Concerns about data security and malicious online activities have given rise to an emerging market for cyber coverage, and the cyber insurance market is projected to grow to $20 billion by 2025. A 2019 survey of 1,200 business leaders found that cyber risks now top the list of concerns on the mind of policyholders, followed by rising medical costs, employee benefit costs, the ability to attract and retain talent, and exposure to legal liability. This is not surprising, given the average cost to a U.S. company of $230 per compromised record, and more for certain industries like health care, where specific additional fines exist. The types of coverage most often desired are for cyber fraud (e.g., phishing scams and business e-mail compromise) and ransomware. In 2019, the incidence of ransomware attacks rose by 105%, with a particular focus on IT vendors and their customers. To release

Liability Insurance LO27-10

Identify the major types of liability insurance policies and the types of liabilities they typically cover.

As its name suggests, liability insurance provides the insured the ability to transfer liability risks to the insurer. Under policies of liability insurance, the insurer agrees, among other things, to pay sums the insured becomes legally obligated to pay to another party. This enables the insured to minimize the troublesome or even devastating financial effects that he could experience in the event of his liability to someone else.

Types of Liability Insurance Policies  Liability insurance policies come in various types. These include, but are not limited to, personal liability policies designed to cover a range of liabilities an individual person could face; business liability policies (sometimes called comprehensive general liability policies) meant to apply to various liabilities that sole proprietors, partnerships, and corporations might encounter in their business operations; professional liability policies (sometimes called malpractice insurance policies) that cover physicians, attorneys, accountants, and members of other professions against liabilities to clients and sometimes other persons; and workers’ compensation policies under which insurers agree to cover employers’ statutorily required obligation to pay benefits to injured workers. Some policies combine property insurance features with liability insurance components. Automobile insurance

data, hackers requested an average payment of $224,871. Several high-profile attacks were launched against municipal governments, schools, and health-care organizations, with some victims paying six- or seven-figure ransom extortion payments. Those who refused often incurred costs 5 to 10 times greater as they were forced to recreate data and the systems by which it is stored. Additionally, property damage and bodily injury flowing from technology failures are beginning to be included in some policies, as concerns begin to emerge with an increasing use of self-driving cars and other Internet-connected technologies. In terms of emerging statutory trends, California’s Consumer Privacy Act (CCPA) went into effect on January 1, 2020, and is expected to be a model for data privacy laws in the United States. As it pertains to cyber insurance, the CCPA is expected to have a big impact on businesses because of the provision permitting them to be fined by the government for CCPA violations and sued by individuals in situations involving data breaches. Cyber insurance policies are likely to follow this trend and cover violations under the CCPA.

policies, for instance, afford property insurance when they cover designated automobiles owned by the insured against perils such as vandalism, hail, and collisions with animals, telephone poles, and the like. Other sections of automobile insurance policies provide liability insurance to the insured (the policy owner), members of her household, and sometimes other authorized drivers when their use of a covered automobile leads to an accident in which they face liability to another party. Typical homeowners’ policies also combine property and liability insurance features. Besides covering the insured’s home and contents against perils of the types discussed earlier in this chapter, these policies normally provide the insured coverage for a range of liabilities he may face as an individual.

Liabilities Insured Against Although

the different types of liability insurance policies discussed above contain different terms setting forth the liabilities covered and not covered, liability policies commonly afford coverage against the insured’s liability for negligence but not against the insured’s liability stemming from deliberate wrongful acts (most intentional torts and most behavior constituting a crime). Liability policies tend to reach this common ground in the same sorts of ways property insurance policies define the scope of coverage—by listing particular liabilities that are covered and stating that an unlisted liability is not covered, by setting forth a seemingly broad statement of coverage and then specifying exclusions from coverage, or by employing a combination of the previous approaches (e.g., specifying certain covered liabilities

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and certain excluded liabilities). The World Harvest Church case, which follows shortly, helps to illustrate this point. Personal Liability and Homeowners’ Policies Personal liability policies and the liability sections of homeowners’ policies often state that coverage is restricted to instances of “bodily injury” and “property damage” experienced by a third party as a result of an “occurrence” for which the insured faces liability. These sorts of policies normally define occurrence as an “accident” resulting in bodily injury or property damage. The provisions just noted often lead to the conclusion that intentional torts and most criminal behavior, if committed or engaged in by the insured, would fall outside the coverage of the policy at issue because they are not accidents (whereas instances of the insured’s negligence would be). This conclusion is underscored by typical clauses purporting to exclude coverage for bodily injury or property damage the insured intended to cause. The occurrence, bodily injury, and property damage references in liability policies also indicate that harms stemming from, for example, breach of contract would not be covered either (no accident, no bodily injury, no property damage). In addition, personal liability policies and liability sections of homeowners’ policies tend to specify that if bodily injury or property damage results from the insured’s business or professional pursuits, it is not covered. The respondeat superior doctrine is discussed in Chapter 36. Although the insured’s own intentional torts would not normally be covered, business liability policies sometimes provide that if the insured is liable on respondeat superior grounds for an employee’s intentional tort such as battery, the insured will be covered unless the insured directed the employee to commit the intentional tort. 9

Business Liability Policies Business liability policies also feature coverage for bodily injury and property damage stemming from the insured’s actions. The relevant range of actions, of course, is broadened to include the insured’s business pursuits or “conduct of business.” A major focus remains on unintentional wrongful conduct (usually negligence) of the insured, with the insured’s deliberate wrongful acts normally being specifically excluded from coverage. Another typical exclusion is the pollution exclusion, which deprives the insured of coverage for actions that lead to pollution of other parties’ property, unless the pollution occurs suddenly and accidentally. Business liability policies also tend to provide the insured coverage in instances where the insured would be liable for certain torts of his employees (normally under the respondeat superior doctrine).9 In addition, business liability policies sometimes afford coverage broader than instances of tortious conduct producing physical injury or property damage. Some policies, for instance, contain a clause that contemplates coverage for the insured’s defamation of another person or invasion of that person’s privacy (though other policies specifically exclude coverage for those same torts). Furthermore, the broad “conduct of business” language in certain policies, as well as specialized clauses (in some policies) referring to liability stemming from advertising or unfair competition, may contemplate coverage for the insured’s legal wrongs that cause others to experience economic harm. In the end, the particular liabilities covered by a business liability policy cannot be determined without a close examination of the provisions in the policy at issue. It may become necessary for a court to interpret a policy provision whose meaning is unclear or scope is uncertain.

World Harvest Church v. Grange Mutual Casualty Co.    68 N.E.3d 738 (Ohio 2016)

World Harvest Church (WHC) operated a preschool in an Ohio city. A.F., the two-and-one-half-year-old son of Michael and Lacey Faieta, attended the preschool. On one school day, WHC employee Richard Vaughan filled in for A.F.’s regular teacher. When Mr. Faieta picked up A.F. from the preschool that day, A.F. seemed anxious and upset, his eyes were red, and he clung to his father’s side as his belongings were gathered. On the way home, A.F. said that Vaughan had “spanked” him. A.F. also complained of pain. After the Faietas noticed numerous bright red marks and abrasions on A.F.’s back, buttocks, and upper thigh areas, they learned from A.F. that what he had referred to as spanking consisted of Vaughan’s striking him repeatedly with a ruler. The Faietas spoke with their pediatrician and the police, who advised the Faietas to take A.F. to the hospital. Emergency room personnel at the hospital found A.F.’s injuries to be consistent with physical abuse. When the Faietas complained to WHC’s preschool headmaster, they were told not to come to WHC and were threatened with the filing of trespass charges if they did so. On behalf of A.F., the Faietas sued WHC and Vaughan. They asserted claims for assault and battery against Vaughan, claims for negligence and intentional infliction of emotional distress against Vaughan and WHC, and claims for negligent hiring and supervision and respondeat superior against WHC. (Negligent hiring and supervision, if established, would be bases of direct liability. Respondeat superior, under which an employer is liable for an employee’s tort if the employee was acting within the scope of employment, is a form



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of vicarious liability.) WHC admitted in response to the complaint that Vaughan was an employee of WHC and that at all relevant times, he had acted within the scope of his employment. WHC denied, however, that any acts by Vaughan were unlawful or otherwise actionable. An Ohio jury returned a verdict in favor of the Faietas for more than $5 million in compensatory damages, punitive damages, and attorney fees. Vaughan was held liable for part of that award, but WHC was held liable for the bulk of it. Most of WHC’s liability stemmed from the direct liability grounds noted above, but a portion of it was based on WHC’s vicarious liability under the respondeat superior doctrine for Vaughan’s torts. Later, the Faietas and WHC settled the case for approximately $3.1 million. At the time of the incident that gave rise to the Faietas’ lawsuit, WHC was insured under a commercial liability policy issued by Grange Mutual Casualty Co. (Grange). When the Faietas filed their complaint in the case referred to above, WHC submitted a claim under the Grange policy and asked Grange to defend WHC in the lawsuit. Grange agreed to defend the matter and retained a law firm to do so but also expressly reserved its right to deny coverage and refuse payment of any claim. After the jury ruled in favor of the Faietas, WHC demanded that Grange cover the damage award assessed against WHC. Grange refused, taking the position that a policy provision excluding coverage for abuse or molestation applied. WHC then sued Grange, contending that Grange had unjustifiably denied coverage under the liability policy. An Ohio trial court ruled that Grange must indemnify WHC for the compensatory damages and attorney fees awarded to the Faietas, but not for the punitive damages. Grange appealed to the Ohio Court of Appeals, which concluded that Grange must indemnify WHC for the attorney fees awarded to the Faietas and for the portion of the compensatory damages attributable to WHC’s vicarious liability under respondeat superior, but not for the other compensatory damages and the punitive damages. Grange and WHC both asked the Supreme Court of Ohio to grant review of the court of appeals decision. The state supreme court granted Grange’s petition for review but denied WHC’s. (Further discussion of the relevant provisions of the insurance policy at issue will appear in the following edited version of the state supreme court’s opinion.) O’Connor, Chief Justice In this appeal, we address whether an abuse or molestation exclusion in a commercial liability insurance policy excludes coverage for an award of damages based on the insured’s vicarious liability for a claim arising from its employee’s physical abuse of a child in the insured’s care and custody. In its commercial general liability policy, Grange agreed to pay those sums that WHC, the insured, would become legally obligated to pay as damages because of “bodily injury” or “property damage” as those terms were defined in the policy. The policy applied only to “bodily injury” caused by an “occurrence,” which the policy defined as an “accident.” But the policy excluded from coverage “bodily injury” that was “expected or intended from the standpoint of the insured.” Two endorsements further modified the coverage for bodily injury. An endorsement regarding corporal punishment stated that the exclusion for bodily injury did not apply if the injury resulted from “corporal punishment to [WHC’s] student administered by or at the direction” of the insured. A second endorsement, titled the “Abuse or Molestation Exclusion” (“the abuse exclusion”), further modified the coverage for “bodily injury” and stated: This insurance does not apply to “bodily injury,” “property damage” or “personal and advertising injury” arising out of: 1. The actual or threatened abuse or molestation by anyone of any person while in the care, custody or control of any insured, or 2. The negligent: a. Employment; b. Investigation;

c. Supervision; d. Reporting to the proper authorities, or failure to so report; or e. Retention; of a person for whom any insured is or ever was legally responsible and whose conduct would be excluded by Paragraph 1 above. We accepted Grange’s discretionary appeal but denied WHC’s cross-appeal. The [key] issue presented is whether the abuse exclusion [quoted above] bars coverage under the policy for the sum awarded based on WHC’s vicarious liability for claims arising from its employee’s physical abuse of a child. Grange contends that all damages arising out of the abuse are excluded from coverage regardless of the cause of action asserted against WHC. WHC counters that only those damages awarded because of the direct liability of a bad actor and the direct liability of the employer would be excluded from coverage, not those damages based on the employer’s vicarious liability for its employee’s abuse. Central to WHC’s claim is its assertion that the exclusion contains no language excluding damages awarded based on the insured’s vicarious liability. WHC also contends that (1) Vaughan’s actions constituted “excessive corporal punishment” rather than abuse and are therefore covered by the policy, and (2) the abuse exclusion is intended to exclude only sexual abuse, not physical abuse, from coverage. Although presented as counterarguments, these contentions raise issues that we declined to address when we denied discretionary review of WHC’s cross-appeal. Because we did not accept the cross-appeal, these arguments are outside the scope of this appeal. Indeed, the appellate court squarely addressed these arguments when it concluded that the exclusion unambiguously

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applied to physical abuse and not just sexual abuse. [According to the appellate court,] “[t]he plain and ordinary meaning of the word  ‘abuse,’ which is not defined in the [Grange] policies, is, as pertinent here, physical maltreatment” [and that] “WHC’s narrow construction of the term ‘abuse’ as only ‘sexual abuse’ is [inconsistent with common definitions] which define the term more broadly to include physical abuse.” Additionally, [as the Court of Appeals noted], “it was conclusively determined in the [Faietas’] personal-injury case that Vaughan’s battery constituted abuse of the Faietas’ minor child.” The appellate court similarly rejected WHC’s argument that the corporal-punishment endorsement permitted coverage. [Therefore, the court] concluded that “the . . . corporal punishment endorsement does not change the fact that claims concerning Vaughan’s battery and WHC’s negligent supervision are excluded under the policy’s abuse or molestation exclusion.” These conclusions are not before this court on Grange’s appeal, and therefore, we do not review them. The scope of this appeal is limited to whether the abuse exclusion eliminates coverage for damages awarded for WHC’s vicarious liability for abuse. The appellate court concluded that “unless corporate management committed the intentionally wrongful conduct, the corporate insured will not be denied coverage on the basis of an employee’s intentional tort,” and that “WHC’s corporate management did not commit Vaughan’s intentionally wrongful conduct.” In other words, as the appellate court later clarified, even if Vaughan acted intentionally, and thus his conduct was excluded from coverage because it was not accidental and thus not an “occurrence,” coverage turned on whether Vaughan’s act was intentional from the perspective of WHC, the entity seeking coverage. And because WHC did not intend the act, Grange could not deny coverage.  The effect of the abuse exclusion on the issue of coverage is central to the inquiry and the basis of this appeal. Insurance contracts are construed by the same rules used to construe contracts. [O]ur task when interpreting an insurance policy is to “examine the insurance contract as a whole and presume that the intent of the parties is reflected in the language used in the policy.” [Citation omitted.] Moreover, “[w]e look to the plain and ordinary meaning of the language used in the policy unless another meaning is clearly apparent from the contents of the policy.” [Citation omitted.] An exclusion in an insurance policy will be interpreted as applying only to that which is clearly intended to be excluded. Ambiguity in the policy language is construed against the insurer and liberally in favor of the insured, particularly when the ambiguity exists in a provision that purports to limit or qualify coverage under the insurance policy.  With these principles in mind, we turn to the policy language in this case. The language of the abuse exclusion is broad. It excludes from coverage “‘bodily injury’ . . . arising out of . . . [t]he actual or threatened abuse or molestation by anyone of any person while in the care, custody, or control of any insured.” It excludes

from coverage actual or threatened abuse or molestation. And it covers actual or threatened abuse or molestation by anyone. The victim, however, must be in the care, custody, or control of an insured. Additionally, the abuse exclusion eliminates coverage for damages awarded for claims of bodily injury arising from the insured’s negligence in employing, investigating, supervising, or retaining the bad actor, as well as from negligence in reporting, or failing to report, the abuse or molestation to the authorities. We do not find any language in the abuse exclusion that limits its application to damages awarded for an insured’s direct liability. The failure to include an express denial of coverage for claims of vicarious liability does not support the interpretation advanced by WHC, i.e., that the policy must therefore cover vicarious liability. Nor does it render the exclusion ambiguous. The exclusion covers a narrow category of conduct—actual or threatened abuse by anyone. But construing the exclusion to apply only to that which is clearly excluded, as we must, its plain wording states that there is no coverage as long as the claim is for bodily injury that arises out of the abuse by anyone of any person while in the care, custody, or control of the insured. We find that the abuse exclusion simply does not limit the exclusion to claims for bodily injury arising from direct liability, while failing to exclude claims for bodily injury arising from vicarious liability, for the same conduct. Indeed, the language in the exclusion is simple and unambiguous: there is no coverage for any injury arising from abuse or molestation. To hold otherwise, we would have to insert language into the exclusion. We may not do so, particularly when the terms of the policy are clear and unambiguous. “Where a written agreement is plain and unambiguous, it does not become ambiguous by reason of the fact that in its operation it will work a hardship on one of the parties thereto and corresponding advantage to the other.” [Citation omitted.] To hold that the exclusion applies to claims of direct liability but not to vicarious liability would require rewriting the policy language. Here, WHC’s vicarious liability arose from its admission that Vaughan acted within the scope of his employment when he committed the abusive acts while A.F. was in WHC’s care, custody, and control. And those acts gave rise to the damages awarded. Thus, the language of the abuse exclusion encompasses WHC’s vicarious liability. For the foregoing reasons, we conclude that the language of Grange’s abuse exclusion bars coverage for an award of damages based on WHC’s vicarious liability for [torts] arising from Vaughan’s abuse of A.F. while in WHC’s care and custody. Because we hold that coverage is excluded, and there are no remaining covered claims for damages awarded in the Faietas’ lawsuit, we also conclude that the policy does not provide coverage for an award of attorney fees. Accordingly, we reverse the judgment of the court of appeals. Court of Appeals judgment in favor of WHC reversed; final judgment entered in favor of Grange.



Chapter Twenty-Seven Insurance Law

Other Liability Policies Professional liability policies also afford coverage for the insured’s tortious conduct, this time in the practice of his or her profession. Negligent professional conduct producing harm to a third party (normally bodily injury in the medical malpractice setting but usually economic harm in the legal or other professional malpractice context) would be a covered liability. Wrongful professional conduct of an intentional nature typically would not be covered. Automobile liability policies cover liability for physical injury and property damage stemming from the insured’s (and certain other drivers’) negligent driving. Once again, however, there is no coverage for liability arising from the insured’s (or another driver’s) deliberate vehicle operation acts of a wrongful nature. Workers’ compensation policies tend to approach coverage questions somewhat differently, primarily because injured employees need not prove negligence on the part of their employer in order to be entitled to benefits. Therefore, the insurer’s obligation under a workers’ compensation policy is phrased in terms of the liability the insured employer would face under state law.

Insurer’s Obligations LO27-11

Explain the difference between a liability insurer’s duty to defend and its duty to pay sums owed by the insured.

Duty to Defend When another party makes a legal claim against the insured and the nature and allegations of the claim are such that the insurer would be obligated to cover the insured’s liability if the claim were proven, the insurer has a duty to defend the insured. A commonsense precondition of this duty’s being triggered is that the insured must notify the insurer that the claim has been made against her. The duty to defend means that the insurer must furnish, at its expense, an attorney to represent the insured in litigation resulting from the claim against her. If the insurer fails to perform its duty to defend in an instance where the duty arose, the insurer has breached the insurance contract. Depending on the facts, the breaching insurer would at least be liable for compensatory damages (as indicated

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in this chapter’s earlier discussion of insurance policies as contracts)10 and potentially for punitive damages as well under the bad-faith doctrine examined later in this chapter. Sometimes it is quite clear that the insurer’s duty to defend applies or does not apply, given the nature of the claim made against the insured. Other times, however, there may be uncertainty as to whether the claim alleged against the insured would fall within the scope of the liability insurance policy. Such uncertainty, of course, means that it is not clear whether the insurer has a duty to defend. Insurers tend to take one of two approaches in an effort to resolve this uncertainty. Under the first approach, the insurer files a declaratory judgment action against the insured. In this suit, the insurer asks the court to determine whether the insurer owes obligations to the insured under the policy in connection with the particular liability claim made against the insured by the injured third party. The other option insurers often pursue when it is unclear whether the liability policy applies is to retain an attorney to represent the insured in the litigation filed by the third party—thus fulfilling any duty to defend that may be owed—but to do so under a reservation of rights notice. By providing the reservation of rights notice to the insured, the insurer indicates that it reserves the right, upon acquisition of additional information, to conclude (or seek a later judicial determination) that it does not have the obligation to pay any damages that may be assessed against the insured as a result of the third party’s claim. The insurer’s reservation of rights also serves to eliminate an argument that by proceeding to defend the insured, the insurer waived the ability to argue that any actual liability would not be covered. The Medmarc case, which follows, illustrates issues that courts encounter in deciding whether an insurer had the duty to defend.

The compensatory damages in such an instance would normally be the reasonable costs incurred by the insured in retaining an attorney and paying him to represent her. Of course, if the insured ended up being held liable in the third party’s suit and the insurer wrongfully refused to pay the damages assessed against the insured in that case, the insured’s compensatory damages claim against the breaching insurer would be increased substantially. 10

Medmarc Casualty Insurance Co. v. Avent America, Inc.    612 F.3d 607 (7th Cir. 2010)

Consumers initiated class action litigation against Avent America, Inc. for not having informed them of the health risks associated with the potential leaching of Bisphenol-A (“BPA”), which Avent used in certain plastic products it manufactured and sold. These products included bottles and “sippy cups” used by infants and young children. The plaintiffs were parents who purchased Avent’s products for their children and did not know of the potential health dangers associated with BPA exposure (including, according to lab animal studies

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the plaintiffs cited, early sexual maturation in females, increased obesity, and increased neuron-behavioral problems such as ADD/HD and autism). The plaintiffs alleged that Avent was aware of a large body of research indicating that BPA, even at low levels, is harmful to humans and is particularly harmful to children; that despite this knowledge, Avent marketed its products as superior in safety to other products for infants and toddlers; that the plaintiffs would not have purchased Avent’s products if they had known that using products containing BPA could be harmful to their children; that upon learning of the safety problems associated with products containing BPA, the plaintiffs stopped using the products; and that they therefore did not receive the full benefit of their purchases. The plaintiffs’ complaint alleged various legal claims that emphasized the prevailing consensus regarding a need to be concerned about exposure to BPA for humans. Their complaint, however, did not allege that any of the negative health effects had manifested themselves in their children. Moreover, the plaintiffs did not allege that they or their children ever used the products or were actually exposed to the BPA. Instead, they alleged an economic harm stemming from their purchases of an unusable product. The federal district court eventually dismissed some of the legal claims pleaded by the plaintiffs but permitted the case to go forward on the theory that Avent had been unjustly enriched. Various insurers, including Medmarc Casualty Insurance Co., provided Avent with liability insurance during the time period contemplated by the plaintiffs’ complaint. Avent informed its insurers of the class action litigation and requested that they defend the case and cover amounts Avent would be required to pay if it lost the case. Because the relevant insurers’ polices all read essentially the same way in the portions important to this case, the insurers will be referred to collectively as “Medmarc.” The relevant policy language stated as follows: We will pay those sums that the insured becomes legally obligated to pay as damages because of “bodily injury” or “property damage” included within the “products-completed operations hazard” to which this insurance applies. We will have the right and duty to defend the insured against any “suit” seeking those damages. However, we will have no duty to defend the insured against any “suit” seeking damages for “bodily injury” or “property damage” to which this insurance does not apply. The policies defined “bodily injury” as “bodily injury, sickness or disease sustained by a person, including death resulting from any of these at any time.” Medmarc declined to furnish Avent a defense in the class action case and further denied that its policy would cover Avent if Avent lost the case. Avent and Medmarc then became involved in litigation over the duty-to-defend and coverage issues. The federal district court considering that case ruled that Medmarc had no duty to defend and no coverage obligation because, in the court’s view, the class action case against Avent did allege “bodily injury” and thus did not come within Medmarc’s policy language. The court therefore granted summary judgment in favor of Medmarc. Avent appealed to the U.S. Court of Appeals for the Seventh Circuit. Flaum, Circuit Judge The plaintiffs in the underlying [class action case against Avent] are parents who bought Avent products containing BPA and then refused to use the products once they learned of the dangers of BPA. The case at hand hinges on whether the underlying lawsuit states claims for damages “because of bodily injury,” and is therefore covered by the insurance policies. Avent argues that the underlying suit’s claims that the plaintiffs will not use the products out of fear of bodily injury sufficiently state claims for damages “because of bodily injury.” Medmarc argues that the underlying suit is not covered by the policies because the claims are limited to economic damages due to the purchase of unusable products and these damages are not “because of bodily injury.” In assessing whether the district court correctly [ruled in favor of] Medmarc we must begin our analysis with a review of the general standard for duty to defend under Illinois law. An insurer must provide its insured with a defense when “the allegations in the complaint are even potentially within the scope of

the policy’s coverage.” [Citation omitted.] “If the underlying complaints allege facts within or potentially within policy coverage, the insurer is obligated to defend its insured even if the allegations are groundless, false, or fraudulent.” [Citation omitted.] When considering whether an insurance company has a duty to defend, the court “should not simply look to the particular legal theories pursued by the claimant, but must focus on the allegedly tortious conduct on which the lawsuit is based.” [Citation omitted.] Although we focus on factual allegations above legal theories, factual allegations are only important insofar as they point to a theory of recovery. Therefore, based on these standards, we must consider whether the allegations in the complaint point to a theory of recovery that falls within the insurance contract: Do the allegations amount to a claim for damages “because of bodily injury”? Avent characterizes the complaint as alleging: (1) the underlying plaintiffs purchased BPA-containing products manufactured, sold, and/or distributed by Avent and that BPA migrates from those products; (2) BPA potentially causes a wide variety



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of adverse health problems that may not manifest for years; and (3) Avent somehow violated a standard of care by manufacturing, selling, and/or distributing BPA-containing baby products that allegedly cause these injuries. Based on this chain of allegations, Avent argues that the complaints state claims for damages because of bodily injury and therefore fall within the policy coverage. [Medmarc argues, however, that it does not] owe Avent a defense because there are no allegations in the complaint that the products caused bodily injury. Rather, the complaints allege that, due to the risk of potential bodily harm from BPA exposure, the plaintiffs did not receive the full benefit of their bargain (because they now will not use the product) and therefore incurred purely economic damages unrelated to bodily injury. We agree with Medmarc’s assessment of the complaints. The problem with Avent’s argument is that, even if the underlying plaintiffs proved every factual allegation in the underlying complaint, the plaintiffs could not collect for bodily injury because the complaints do not allege any bodily injury occurred. Additionally, the complaint does not allege that the underlying plaintiffs now have an increased risk of bodily injury for which they should be compensated. The closest the complaint comes to alleging bodily injury is [its contention] that Avent was aware of a large body of scientific research that BPA exposure can cause physical harm. Proving such allegations would not entitle the plaintiffs to recover for bodily injury or for damages flowing from bodily injury because these allegations lack the essential element of actual physical harm to the plaintiffs. Avent recognizes this gap in the underlying complaints, but rebuts it with the argument that the plaintiffs left these claims out to make it easier to be certified as a class. Avent argues [in its brief] that “[i]t is precisely these ‘whims’ that are not, under Illinois law, supposed to change whether or not particular factual allegations are sufficient to trigger coverage under general liability insurance policies.” Although Illinois courts have recognized that a duty to defend should not be at the mercy of the drafting whims of plaintiffs’ attorneys, these omissions were not mere whims. In the underlying case, the plaintiffs’ attorneys have limited their claims solely to economic damages that resulted from the plaintiffs purchasing a product from which they cannot receive a full benefit because they were falsely led

to believe that it was safe. This is not a drafting whim (or mistake) on the part of the plaintiffs’ attorneys, but rather a serious strategic decision to pursue only this limited claim. The strategic intention behind this decision is clear from the plaintiffs’ concession in the underlying suit that they are seeking only economic damages and do not claim any bodily injury. The district court in the underlying suit also acknowledged this strategic decision when it found that the complaint does validly set out a claim for economic damages but not damages for physical harm. Avent relies heavily on Ace Am. Ins. Co. v. RC2 Corp., 568 F. Supp. 2d 946 (N.D. Ill. 2008) to support its argument that this complaint could be construed to make claims for damages because of bodily injury. The underlying complaint in RC2 dealt with children exposed to lead paint in toys. In coming to the conclusion that the insurers in RC2 had a duty to defend, the district court found that exposure to lead paint constituted a bodily injury. Avent characterizes the underlying complaint in RC2 in much the same way it characterizes the underlying complaints in this case. However, the complaint in RC2 is not as similar to the complaint in this case as Avent claims. In RC2, the underlying complaint specifically alleged that the named plaintiffs and the class members “suffered an increased risk of serious health problems making periodic examinations reasonable and necessary.” Such allegations are absent from the complaint in this case. Avent claims that the district court placed too much weight on this distinction, but this distinction is exactly what the district court should have focused on. In RC2, the complaint alleged that the product caused bodily injury, albeit in the form of an increased risk of future harm. In this case, there is no claim of bodily injury in any form. The theory of relief in the underlying complaint is that the plaintiffs would not have purchased the products had Avent made certain information known to the consumers and therefore the plaintiffs have been economically injured. The theory of the relief is not that a bodily injury occurred and the damages sought flow from that bodily injury. [Medmarc therefore owed Avent] no duty to defend.

Duty to Pay Sums Owed by Insured If a third party’s claim against the insured falls within the liabilities covered by the policy, the insurer is obligated to pay the compensatory damages held by a judge or jury to be due and owing from the insured to the third party. In addition, the insured’s obligation to pay such expenses as court costs would also be covered. These payment obligations

are subject, of course, to the policy limits of the insurance contract involved. For example, if the insured is held liable for compensatory damages and court costs totaling $150,000, but the policy limits of the relevant liability policy are $100,000, the insurer’s contractual obligation to pay sums owed by the insured is restricted to $100,000.

District court’s decision in favor of Medmarc affirmed.

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CYBERLAW IN ACTION So-called bugs in Version 5.0 of America Online, Inc.’s Internet access software (“AOL 5.0”) drew the ire of large numbers of disgruntled customers. In numerous cases that were later consolidated, these customers sued AOL. Relying on a variety of legal theories, the plaintiffs contended that AOL 5.0 was defective and that, as a result, their computers crashed or they experienced other loss of use of their computers, computer systems, and computer software and data. AOL called upon its liability insurer, St. Paul Mercury Insurance Co., to defend it against the customers’ claims. St. Paul refused, contending that the claims did not fall within the coverage obligations St. Paul had assumed. AOL retained legal counsel to defend it against the customers’ claims and then sued St. Paul for an alleged breach of the contract of insurance. Concluding that the claims against AOL were not covered by the policy St. Paul issued, a federal district court granted summary judgment in favor of St. Paul. AOL appealed. In America Online, Inc. v. St. Paul Mercury Insurance Co., 347 F.3d 89 (4th Cir. 2003), the U.S. Court of Appeals for the Fourth Circuit considered AOL’s appeal. The court began its analysis by noting basic rules applicable to insurance policy interpretation and determinations of whether a liability insurer must defend its policyholder against third parties’ claims. First, if the language of the policy is unambiguous, the court will “give the words their ordinary meaning and enforce the policy as written.” Second, “if the language of the policy is subject to different interpretations, [the court] will construe it in favor of coverage.” Third, the insurer’s “obligation to defend arises whenever the complaint against the insured alleges facts and circumstances, some of which, if proved, would fall within the risk covered by the policy.” The St. Paul policy at issue included a coverage provision stating that St. Paul would “pay amounts [AOL] is legally required to pay as damages for covered bodily injury, property damage, or premises damage.” The policy defined property damage as “physical damage to tangible property of others, including all resulting loss of use of that property . . . or loss of use of tangible property of others that isn’t physically damaged.” In addition, the St. Paul policy excluded certain events or harms from coverage. Among these exclusions was a provision stating that St. Paul would not cover “property damage to impaired property, or to property which isn’t physically damaged, that results from [AOL’s] faulty or dangerous products or completed work [or from] a delay or failure in fulfilling the terms of a contract or agreement.” The policy defined impaired property as “tangible property, other than [AOL’s] products or completed work, that can be restored to use by nothing more than . . . an adjustment, repair, replacement, or removal of [AOL’s] products or completed work which forms a part of it, [or AOL’s] fulfilling the terms of a contract or agreement.” Proceeding to interpret the St. Paul policy in light of the rules noted earlier, the court paid careful attention to the types of damages sought by the AOL customers. The court reasoned that claims

seeking damages from AOL for harm to or loss of use of computer systems or computer software or data were not covered claims because systems, software, and data are not “tangible” because they are not “‘capable of being touched [and] able to be perceived as materially existent . . . by the sense of touch’” [quoting definition of “tangible” in Webster’s New Third International Dictionary of the English Language (1993)]. Systems, software, and data thus would not appear to be “tangible property” for purposes of St. Paul’s policy. The Fourth Circuit also noted that computer systems, software, and data are customarily classified by courts as intangible property. In view of the St. Paul policy’s property damage definition (quoted above) and its references to “tangible property,” the court held that any harm to or loss of use of computer data, software, and systems would not be covered by the policy. The claims brought against AOL, however, also alleged loss of use of the customers’ computers. The court concluded that the computers themselves would be tangible property under the definition set forth above and that the claims alleging loss of use of computers might therefore appear, at first glance, to be covered by the policy. However, the Fourth Circuit noted, the AOL customers were not actually alleging that their computers were physically harmed. Instead, the AOL customers were contending that AOL 5.0 interfered with the proper operation of their computers and that loss of use of the computers resulted. The claimants’ allegations that their computers crashed were substantively allegations of system failure rather than of physical harm to the computers themselves. The absence of a claim of physical damage to the computers meant that harm consisting of loss of use would not be covered by the portion of the property damage definition that referred to “physical damage to tangible property of others, including all resulting loss of use of that property.” Still potentially applicable, though again at first glance only, was the portion of the property damage definition that appeared to cover “loss of use of tangible property of others that isn’t physically damaged.” That possible avenue to coverage was blocked, according to the court, by the St. Paul policy’s “impaired property” exclusion. The plaintiffs, after all, premised their claim on the notion that AOL 5.0 was defective and that as a result, their computers were rendered inoperable. The court observed that “the straightforward meaning of [the impaired property] exclusion bars coverage for loss of use of tangible property of others that is not physically damaged by the insured’s defective product.” The Fourth Circuit stressed that even though AOL 5.0 allegedly “caused damage to other software, including operating systems[, . . . ] there has been no demonstration or claim that the physical or tangible components of any computer were damaged. In the absence of property that is physically dam­ aged, AOL’s arguments for covering loss of use must be rejected.” Having concluded that none of the customers’ claims against AOL came within the terms of the St. Paul policy, the Fourth Circuit affirmed the district court’s grant of summary judgment to St. Paul and held that the insurer owed AOL no duty to defend it against those claims.



Chapter Twenty-Seven Insurance Law

Is the insurer also obligated to pay any punitive damages assessed against the insured as a result of a covered claim? As a general rule, the insurer will have no such obligation, either because of an insurance contract provision to that effect or because of judicial decisions holding that notions of public policy forbid arrangements by which one could transfer his punitive damages liability to an insurer. Not all courts facing this issue have so held, however, meaning that in occasional instances the insured’s punitive damages liability may also be covered if the insurance policy’s terms specifically contemplate such a result. The liability insurer need not wait until litigation has been concluded to attempt to dispose of a liability claim made against the insured. Insurance policy provisions, consistent with our legal system’s tendency to encourage voluntary settlements of claims, allow insurers to negotiate settlements with third parties who have made liability claims against the insured. These settlements involve payment of an agreed sum of money to the third party, in exchange for the third party’s giving up her legal right to proceed with litigation against the insured. Settlements may occur regardless of whether litigation has been formally instituted by the third party or whether the claim against the insured consists of the third party’s prelitigation demand for payment by the insured. If settlements are reached—and they are reached much more often than not—the substantial costs involved in taking a case all the way to trial may be avoided. The same is also true, from the insurer’s perspective, of the damages that might have been assessed against the insured if the case had been tried. Note, however, that even if the defendant (the insured) wins a suit that does proceed to trial, the costs to the insurer are still substantial even though there is no award of damages to pay. Those costs include a considerable amount for attorney fees for the insured (the insurer’s obligation regardless of the outcome of the case) as well as other substantial expenses associated with protracted litigation. Accordingly, even when the insurer thinks that the insured probably would prevail if the case went to trial, the insurer may be interested in pursuing a settlement with the third-party claimant if a reasonable amount—an amount less than what it would cost the insurer to defend the case—can be agreed upon.

Is There a Liability Insurance Crisis? In

recent decades, the necessary premiums for liability insurance policies of various types (particularly business and professional liability policies) have risen considerably. Sometimes, the premiums charged by liability insurers have become so substantial that would-be insureds have concluded that they cannot afford liability insurance and

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therefore must go without it despite its importance. In addition, some insurers have ceased offering certain types of liability policies and/or have become much more restrictive in their decisions about which persons or firms to insure. Insurance companies tend to blame the above state of affairs on what they see as a tort law regime under which plaintiffs win lawsuits too frequently and recover very large damage awards too often. As a result, insurers have been among the most outspoken parties calling for tort reform, a subject discussed in earlier chapters in this book. Plaintiffs’ attorneys and critics of the insurance industry blame rising liability insurance premiums on, primarily, another alleged cause: questionable investment practices and other unsound business practices supposedly engaged in by insurance companies. The parties making these assertions thus oppose tort reform efforts as being unnecessary and unwise. Liability insurance premiums in general may not be increasing as rapidly today as they once did, but they remain substantial in amount. So long as liability insurance remains unaffordable or otherwise difficult to obtain, there is a “crisis,” given the adverse financial consequences that could beset an uninsured person. This is so regardless of which of the competing explanations set forth above bears greater legitimacy.

Bad-Faith Breach of Insurance Contract LO27-12

Describe the types of circumstances in which an insurer may face bad-faith liability.

Earlier in this chapter, we discussed the liability that an insurer will face if it breaches its policy obligations by means of a good-faith but erroneous denial of coverage. That liability is for compensatory damages—damages designed to compensate the insured for the losses stemming from the insurer’s breach—just as in breach of contract cases outside the insurance setting. Punitive damages are not available, however, when the insurer’s wrongful failure or refusal to perform stemmed from a good-faith (though erroneous) coverage denial. What if the insurer’s failure or refusal to perform exhibited a lack of good faith? In this section, we examine the recent judicial tendency to go beyond the conventional remedy of compensatory damages and to assess punitive damages against the insurer when the insurer’s refusal to perform its policy obligations amounted to the tort of bad-faith breach of contract. The special nature of the insurer–insured relationship tends to involve a “we’ll take care of you” message

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Part Five Property

Ethics and Compliance in Action With the costs of medical treatment, hospitalization, and medications having increased dramatically in recent years, health insurance has become a critical means by which insured persons minimize the adverse financial consequences associated with illness and injury. The costs of serious illness or injury may be financially crippling unless insurance coverage exists for a person or family—and sometimes even when it does exist. As noted in Figure 27.1, which appears earlier in the chapter, coverage for health care expenses often comes in the form of a group policy that is made available to employees of a certain company or to persons affiliated with a particular organization. Subject to certain exclusions and other contractual restrictions, group policies tend to cover a significant portion of the costs of obtaining medical services. Although a very large percentage of the U.S. population has some form of health insurance, many millions of U.S. residents do not. Public policy questions regarding health insurance availability and costs have been debated extensively in political arenas during recent decades. Until very recently, Congress opted for measures that were important but limited in effect. For example, the Health Insurance Portability and Accountability Act of 1996 allows most employees who had health insurance in connection with their employment to change jobs without fear of losing health coverage. That statute followed the lead of the earlier COBRA statute, under which persons who end an employment status that had entitled them to group

that insurers communicate to insureds—at least at the outset of the relationship. Recognizing this, courts have displayed little tolerance in recent years for insurers’ unjustifiable refusals to take care of insureds when taking care of them is clearly called for by the relevant policy’s terms. When an insurer refuses to perform obvious policy obligations without a plausible, legitimate explanation for the refusal, the insurer risks more than being held liable for compensatory damages. If the facts and circumstances indicate that the insurer’s refusal to perform stemmed not from a reasonable argument over coverage but from an intent to “stonewall,” deny or unreasonably delay paying a meritorious claim, or otherwise create hardship for the insured, the insurer’s breach may be of the bad-faith variety. Because bad-faith breach is considered an independent tort of a flagrantly wrongful nature, punitive damages—in addition to compensatory damages—have been held to be appropriate. The purposes of punitive damages in this context are the same as in other types of cases that call for punitive damages: to punish the flagrant wrongdoer and to deter the

policy coverage may continue that coverage for a limited time. In 2010, however, Congress changed course and enacted the far-more-sweeping Affordable Care Act (ACA). Figure 27.1 contains discussion of that legislation and of the 2017 legislative efforts of ACA opponents to replace the law with a significantly different statutory approach. There is an ethical flavor to much of the debate over whether health insurance “reform” is desirable and over what form it should take. For instance, consider the questions set forth below. In doing so, you may wish to employ ethical theories discussed in Chapter 4.

• Is there a “right,” in an ethical sense, to health insurance coverage? If so, why? If not, why not?

• Do employers have an ethical obligation to make group health insurance available to their employees? If so, why? If so, does this obligation always exist, or does it exist only under certain circumstances? If employers do not have such an obligation, why don’t they? • Would Congress be acting ethically if it enacted a law requiring all employers in the United States to make health insurance available to their employees? Be prepared to justify your position. • Does the U.S. government have an ethical duty to furnish health coverage to all U.S. residents? Be prepared to justify your position.

wrongdoer (as well as other potential wrongdoers) from repeating such an action. The past 30-some years have witnessed bad-faith cases in which many millions of dollars in punitive damages have been assessed against insurers. The types of situations in which bad-faith liability has been found have included a liability insurer’s unjustifiable refusal to defend its insured and/or pay damages awarded against the insured in litigation that clearly triggered the policy obligations. Various cases involving very large punitive damages assessments for bad-faith liability have stemmed from property insurers’ refusals to pay for the insured’s destroyed property when the cause was clearly a covered peril and the insurer had no plausible rationale for denying coverage. Still other badfaith cases in which liability was held to exist have included malpractice or other liability insurers’ refusals to settle certain meritorious claims against the insured within the policy limits. Bad-faith liability in these cases tends to involve a situation in which the insured is held legally liable to a plaintiff for an amount well in excess of the dollar limits of the liability policy (meaning that the insured would be



Chapter Twenty-Seven Insurance Law

personally responsible for the amount of the judgment in excess of the policy limits), after the liability insurer, without reasonable justification, refused the plaintiff’s offer to settle the case for an amount less than or equal to the policy limits.

Problems and Problem Cases 1. Prior to the September 11, 2001, attacks that destroyed the World Trade Center (WTC) towers, 22 insurance companies had issued property insurance binders covering the WTC complex. These binders were issued to Silverstein Properties, the holder of a 99-year lease of the WTC complex under an agreement with the Port Authority of New York and New Jersey. A binder is a temporary contract of insurance that is in force until a formal insurance policy is issued by the insurer. The 22 insurers intended to issue formal insurance policies to Silverstein, but very few had done so as of 9/11. Therefore, the binders established and limited their obligations to pay Silverstein after the destruction of the WTC complex. Property insurance binders and policies often provide that the insurer’s obligation to pay is triggered when a covered “occurrence” results in damage to or destruction of the relevant real estate. Binders and policies also have policy limits, which are both the amount of insurance coverage purchased and the maximum sum that the insurer can be obligated to pay for a covered claim. The policy limits in a property insurance binder or policy typically apply on a per-occurrence basis. For example, if the policy limits are $200,000, the insurer may become obligated to pay up to a maximum of $200,000 for losses resulting from one occurrence and up to another $200,000 on losses stemming from a separate occurrence. Various ones of the 22 insurers that had issued binders regarding the WTC complex prior to 9/11 became involved in litigation with Silverstein over the amounts they were obligated to pay after the events of 9/11. Three of the insurers that were parties to the litigation—Hartford Fire Insurance Company, Royal Indemnity Company, and St. Paul Fire and Marine Insurance Company— had issued binders whose combined policy limits totaled approximately $112 million, out of a total of approximately $3.5 billion in insurance coverage contemplated by the binders and policies issued by all 22 insurers. Another party to the litigation was Travelers Indemnity Co., which also promised

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Whether bad-faith liability exists in a given case depends, of course, on all of the relevant facts and circumstances. Although bad-faith liability is not established in every case in which insureds allege it, cases raising a bad-faith claim are of particular concern to insurers.

millions of dollars of coverage under a binder that differed in a key respect from the Hartford, Royal, and St. Paul binders. The estimated cost of rebuilding the complex was $5 billion or more. In the litigation referred to above, a federal court agreed with an argument made by Hartford, Royal, and St. Paul: that their binders should be interpreted as containing the terms set forth in a form binder known as the “WilProp form,” which had been circulated among many of the various insurers. The WilProp form made the insurance coverage applicable on a peroccurrence basis and contained a specific definition of occurrence. (The form defined occurrence as “all losses or damages that are attributable directly or indirectly to one cause or to one series of similar causes,” and went on to state that “[a]ll such losses will be added together and the total amount of such losses will be treated as one occurrence.”) The court then addressed the critical issue: whether, for purposes of the binders at issue, the two plane attacks that destroyed the WTC towers on 9/11 were one occurrence or, instead, two occurrences. If, as argued by Hartford, Royal, and St. Paul, the two plane attacks were one occurrence, those three insurers would be obligated to pay Silverstein a total of $112 million. If, as argued by Silverstein, the two plane attacks were two occurrences, the three insurers would be obligated to pay Silverstein a total of $224 million. Although most of the remaining insurers were not parties to the case, a determination of the extent of their liabilities to Silverstein was likely to be heavily influenced by the court’s decision because it seemed reasonably likely that various ones of the other insurers would be viewed as having agreed to the same form binder terms to which Hartford, Royal, and St. Paul had agreed. Thus, although the actual amount in controversy under the Hartford, Royal, and St. Paul binders ranged from a minimum of $112 million to a maximum of $224 million, the practical economic stakes appeared to be much higher. Ruling on a motion for partial summary judgment filed by Hartford, Royal, and St. Paul, the district court held that in view of the WilProp form’s definition of

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Part Five Property

occurrence, the two plane attacks on the WTC were one occurrence for purposes of those companies’ binders. Travelers, however, had issued a binder that differed from the form binder employed by Hartford, Royal, and St. Paul. The Travelers binder called for coverage on a per-occurrence basis but did not contain a definition of occurrence. Silverstein moved for partial summary judgment, asking the court to rule that under the Travelers binder, the two plane attacks constituted two occurrences. Concluding that there were genuine issues of material fact to be resolved by a jury in regard to the plane attacks on the WTC, the district court denied Silverstein’s motion. Appealing to the U.S. Court of Appeals for the Second Circuit, Silverstein asked the appellate court to overturn the district court’s grant of partial summary judgment to Hartford, Royal, and St. Paul. Silverstein also appealed the district court’s denial of its (Silverstein’s) motion for partial summary judgment against Travelers. Should the court affirm the grant of summary judgment for Hartford, Royal, and St. Paul and should it affirm the denial of Silverstein’s motion for summary judgment against Travelers? 2. Don Davis owned a lumber mill that was subject to a $248,000 mortgage held by Diversified Financial Systems. Early in 1995, Aaron Harber became interested in forming a partnership with Davis for ownership and operation of the mill. Harber and Davis orally agreed upon the terms of a partnership. Harber contended that these terms included a purchase by Harber of Diversified’s interest in the mortgage on the mill. Davis later informed Harber that he (Davis) would not proceed with the partnership. Nevertheless, Harber purchased Diversified’s mortgage interest in April 1995. Harber did this in reliance on the oral partnership agreement with Davis—an agreement Harber intended to enforce despite Davis’s refusal to proceed. During Harber’s negotiations with Davis concerning their supposed partnership and with Diversified for purchase of its mortgage interest, Harber discovered that the mill was not covered by property insurance. Harber therefore purchased a policy from Underwriters at Lloyd’s of London (Lloyd’s). The policy, whose one-year term began in late May 1995, named Harber and U.S.A. Properties, a corporation set up and wholly owned by Harber, as insureds. In mid-June 1995, one of the buildings at the mill was destroyed by fire. Approximately two weeks later, in an effort to prompt negotiations in the dispute with

Davis over whether a partnership existed or would be pursued, Harber filed suit to foreclose the Diversified mortgage. The mortgage was in default at that time. Harber and Davis soon entered into a settlement agreement that provided in part for the transfer of the mill property to Harber, in exchange for Harber’s giving up all of his claims against Davis. The agreement also conveyed, to Harber, whatever interest Davis had in insurance proceeds related to the building that had been destroyed by fire. Harber and U.S.A. Properties submitted a claim to Lloyd’s concerning the destroyed building. After Lloyd’s denied the claim, Harber and U.S.A. Properties sued Lloyd’s for payment according to the terms of the policy. A federal district court held that the plaintiffs lacked an insurable interest and that Lloyd’s was therefore entitled to summary judgment. Harber and U.S.A. Properties appealed. Was the district court’s holding correct? 3. Property Owners Insurance Co. (POI) was the insurer and Thomas Cope was the insured under a liability policy that excluded liability except in cases of liability “with respect to the conduct of a business” owned by Cope. Cope’s business was a roofing company. While the policy was in force, Cope traveled to Montana with Edward Urbanski, a person with whom Cope did significant business. While on the trip, Cope snowmobiled with a group of persons that included Gregory Johnson, who died in a snowmobiling accident. Johnson’s estate brought a wrongful death lawsuit against Cope. After Cope notified POI of the case brought against him, POI filed a declaratory judgment action against Cope and Johnson’s estate. In the declaratory judgment action, POI sought a judicial determination that it had no obligations to Cope and Johnson’s estate under the liability policy. POI took the position that Cope’s trip to Montana was a personal trip for recreation purposes and that it therefore was not a trip “with respect to the conduct of [Cope’s] business.” Cope maintained that even if the trip was largely recreational, it was at least incidental to his business because Urbanski, who also was on the trip, was a business associate of Cope’s. POI moved for summary judgment. Was POI entitled to summary judgment? 4. In a class action suit against Aamco Transmissions, consumers Joseph R. Tracy and Joseph P. Tracy claimed that Aamco and its network of franchisees used deceptive advertising that inaccurately described Aamco’s services and lured many consumer purchasers of transmission services into



Chapter Twenty-Seven Insurance Law

paying excessively and for unnecessary repairs. The Tracys asserted that Aamco was liable under the Pennsylvania Unfair Trade Practices and Consumer Protection Law. Aamco was the insured under a comprehensive general liability insurance policy issued by Granite State Insurance Co. This policy provided liability coverage to Aamco “for personal injury or advertising injury . . . arising out of the conduct of ” Aamco’s business. The policy defined advertising injury as “injury arising . . . in the course of [Aamco’s] advertising activities, if such injury arises out of libel, slander, defamation, violation of right of privacy, piracy, unfair competition, or infringement of copyright, title or slogan.” Contending that it had coverage under the “unfair competition” category of the advertising injury coverage, Aamco demanded that Granite defend and indemnify it in connection with the consumer class action case described above. When Granite declined to do so, Aamco settled the case on its own. Granite then brought a declaratory judgment action against Aamco in federal district court. Granite sought a ruling that it was not obligated to provide coverage for Aamco in the class action case brought by the Tracys. A federal district court concluded that the unfair competition term in the policy contemplated coverage only for common law–based claims against Aamco, not for any claims based on a state or federal statute. Because the Tracys’ class action case was based on a supposed violation of a Pennsylvania statute, the district court held that Granite’s policy did not furnish coverage to Aamco. In addition, the court held that the term unfair competition was not ambiguous and that Aamco could not have had a reasonable expectation that consumers’ claims against it would be covered. Aamco appealed. Did Aamco win its appeal? 5. Shelter Mutual Insurance Co. brought a declaratory judgment action against Tommy and Bessie Maples (referred to collectively as “Maples”) in the U.S. District Court for the Western District of Arkansas. Shelter asked the court to declare that Shelter had no obligation to pay a claim made by Maples under a homeowner’s insurance policy issued by Shelter. The facts set forth here were as stipulated (i.e., as agreed to) by the parties. While residing in Saudi Arabia, Maples contracted for the construction of a single-­ family retirement home in Arkansas. Maples purchased homeowner’s insurance from Shelter, whose policy, issued in November 2000, was in full effect at

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all times relevant to the case. The two-story residence, which had a wooden frame and a basement made of concrete, was largely complete as of November 2000. Maples, who remained in Saudi Arabia, took reasonable precautions for winter weather by leaving a key with the contractor and asking him to winterize the residence. At some unknown time, a water pipe froze and burst. As a result, between four and six inches of water stood continuously in the basement until the contractor discovered the problem in April 2001. The standing water caused only minimal structural damage to the basement, but the humidity from the standing water caused mold to form on all of the interior surfaces of the residence. As a result of the mold, the residence became uninhabitable and had to be demolished. Maples reported the loss to Shelter, which instituted the declaratory judgment action referred to above. After the federal district court granted summary judgment in favor of Shelter, Maples appealed to the U.S. Court of Appeals for the Eighth Circuit. Should the district court’s grant of summary judgment in favor of Shelter be reversed? 6. Brandy Harvey, age 16, and Toby Gearheart, age 19, were at a Wabash River boat ramp one evening. When a disagreement arose, Brandy moved toward Gearheart and pushed him toward the water more than once. When she again approached Gearheart, he put his hands on her shoulders and pushed her. Brandy lost her balance and fell off the boat ramp, down a rocky embankment, and into the river, where she drowned. In a criminal proceeding concerning the incident, Gearheart pleaded guilty to involuntary manslaughter. Acting as co-personal representatives of Brandy’s estate, her parents, Jon Harvey and Misty Johnson, filed a wrongful death action against Gearheart in an Indiana trial court. They contended in their complaint that Gearheart’s “negligence and recklessness” had caused Brandy’s death. Harvey and Johnson also named Auto-Owners Insurance Co. as a defendant on the theory that because of the liability insurance portion of a homeowners’ insurance policy issued to Gearheart’s parents, Auto-Owners would be obligated to pay any judgment entered against Gearheart (who still lived in his parents’ home and was therefore an insured person under the policy). The insurance policy at issue stated that Auto-Owners “will pay all sums any insured becomes legally obligated to pay as damages because of or arising out of bodily injury or property damage caused by an occurrence to which this coverage applies.” The policy also defined

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Part Five Property

“occurrence” to mean “an accident that results in bodily injury or property damage and includes, as one occurrence, all continuous or repeated exposure to substantially the same generally harmful conditions.” The word “accident” was not defined in the policy. In addition, an exclusion set forth in the policy indicated that there was no coverage for “bodily injury or property damage reasonably expected or intended by the insured.” Auto-Owners moved for summary judgment, asserting that in view of the facts and the above-quoted provisions, the policy furnished no coverage in regard to Gearheart’s actions. The trial court denied AutoOwners’ motion, but the Court of Appeals of Indiana reversed. Harvey and Johnson appealed to the Supreme Court of Indiana. Should the appellate court’s decision be reversed? 7. In August 1982, a hog confinement building owned by Charles Ridenour collapsed and was rendered a total loss. Some of Ridenour’s hogs were killed as a further result of the collapse. Ridenour made a claim for these losses with his property insurer, Farm Bureau Insurance Company, whose Country Squire policy had been issued on Ridenour’s property in July 1977 and had been renewed on a yearly basis after that. Farm Bureau denied the claim because the policy did not provide coverage for the collapse of farm buildings such as the hog confinement structure. Moreover, though the policy provided coverage for hog deaths resulting from certain designated causes, collapse of a building was not among the causes listed. Asserting that the parties’ insurance contract was to have covered the peril of building collapse notwithstanding the terms of the written policy, Ridenour sued Farm Bureau. He asked the court to order reformation of the written policy so that it would conform to the parties’ supposed agreement regarding coverage. At trial, Ridenour testified about a February 1982 meeting in which he, his wife, and their son discussed insurance coverage with Farm Bureau agent Tim Moomey. Ridenour testified that he wanted to be certain there was insurance coverage if the hog confinement building collapsed because he had heard about the collapse of a similar structure owned by someone else. Therefore, he asked Moomey whether the Country Squire policy then in force provided such coverage. According to Ridenour, Moomey said that it did. Ridenour’s wife, Thelma, testified that she asked Moomey (during the same meeting) whether there would be coverage if the floor slats of the hog confinement building collapsed and caused hogs to fall into the pit below the building. According

to her testimony, Moomey responded affirmatively. The Ridenours’ son, Tom, testified to the same effect. Mr. and Mrs. Ridenour both testified that they had not completely read the Country Squire policy and that because they did not understand the wording, they relied on Moomey to interpret the policy for them. Moomey, who had ended his relationship with Farm Bureau by the time the case came to trial, testified that at no time did the Ridenours request that the hogs and the confinement building be insured so as to provide coverage for losses resulting from collapse of the building. Moomey knew that collapse coverage was not available from Farm Bureau for hog confinement buildings. In addition, Moomey testified that he met with Ridenour in April 1982 and conducted a “farm review” in which he discussed a coverage checklist and the Country Squire policy’s declarations pages (which set forth the policy limits). This checklist, which Ridenour signed after Moomey reviewed it with him, made no reference to coverage for collapse losses. (Ridenour admitted in his testimony that he had signed the checklist after Moomey read off the listed items to him.) When Moomey was contacted by the Ridenours on the day the building collapsed, he had his secretary prepare a notice of loss report for submission to Farm Bureau. He also assigned an adjuster to inspect the property. Moomey and the adjuster discussed the fact that the Country Squire policy did not provide coverage for Ridenour’s losses. Ridenour further testified that the day after the collapse occurred, Moomey told him he was sorry but that Farm Bureau’s home office had said there was no coverage. The trial court granted reformation, as Ridenour had requested. Farm Bureau appealed. Was the trial court’s decision correct? 8. Enterprise Financial Group provided financing and credit life insurance to consumers who bought automobiles from a certain Oklahoma dealership. If purchased by a car buyer, the credit life insurance would pay off the customer’s car loan in the event of his death. In March 1992, Milford Vining (Milford) purchased a Jeep from the dealership. An Enterprise employee whose office was at the dealership sold a credit life insurance policy to Milford when he purchased the jeep. In late May 1993, Milford suffered a fatal heart attack. His surviving spouse, Billie Vining (Vining), filed a claim with Enterprise for death benefits of approximately $10,000 under Milford’s credit life policy. Enterprise refused to pay the claim and rescinded the policy on the supposed ground that Milford had misrepresented his health history in his



Chapter Twenty-Seven Insurance Law

application for the credit life policy. After unsuccessfully contesting the rescission, Vining sued Enterprise for breach of contract and for rescinding the policy in bad faith. In defense, Enterprise maintained that it had a legitimate basis for contesting the claim and that Milford had made material misrepresentations in his application for the credit life policy. The evidence adduced at trial showed that in 1983, Milford suffered from coronary artery disease and underwent a triple bypass operation. After the surgery and follow-up tests, Milford began taking heart maintenance medication to prevent the occurrence of angina. From the time immediately following the 1983 surgery until the time of his death, Milford led an active life. He did not complain of chest pain or related symptoms. In February 1992, Milford visited Dr. Michael Sullivan. This visit took place because Milford, who had recently moved, wanted to find a doctor closer to home. Milford’s visit to Dr. Sullivan was not brought on by illness or physical symptoms. At the general time of this visit, Milford suffered from little, if any, angina. Dr. Sullivan continued Milford on his heart maintenance medications as a preventive measure. When Milford applied for the credit life policy in March 1992, he signed an application that contained the following statement: I hereby certify that I am in good health as of the effective date above. I further certify that I do not presently have, nor have I ever had, nor have I been told I have, nor have I been treated within the preceding 12 months for, any of the following: any heart disease, or other cardiovascular diseases. The parties to the case agreed that Milford did not intend to misstate any facts when he signed the application. At trial, Vining presented evidence designed to show that Enterprise routinely rescinded credit life policies after insureds’ deaths and that the rescission of Milford’s policy fit into this pattern. If Vining were to win the case, what sorts of damages would she be entitled to receive? Should Vining win the case? 9. Jeffrey Lane was employed by Memtek (a corporation) at its Arby’s Restaurant. He was being trained as a cook. After 11:00 one evening, Lane finished work and clocked out. He remained in the restaurant’s lobby, however, because he was waiting for the manager to complete her duties. As Lane waited, friends of other restaurant employees came to a door of the restaurant. Lane and the other employees became involved in a conversation with these persons, who

27-31

included John Taylor. Lane told Taylor that he could not enter the restaurant because it was closed. Taylor did not attempt to force his way into the restaurant. Instead, he “dared” Lane to come outside. Lane left the restaurant “of [his] own will” (according to Lane’s deposition) for what he assumed would be a fight with Taylor. In the fight that transpired, Lane broke Taylor’s nose and knocked out three of his teeth. Lane later pleaded guilty to a criminal battery charge. Taylor filed a civil suit against Lane and Memtek in an effort to collect damages stemming from the altercation with Lane. American Family Mutual Insurance Company provided liability insurance for Memtek in connection with its restaurant. The policy stated that for purposes of American Family’s duties to defend and indemnify, “the insured” included not only Memtek but also Memtek’s “employees, . . . but only for acts within the scope of their employment.” American Family filed a declaratory judgment action in which it asked the court to determine that it owed Lane neither a duty to defend nor a duty to indemnify in connection with the incident giving rise to Taylor’s lawsuit. American Family’s theory was that for purposes of that incident, Lane was not an insured within the above-quoted policy provision. Was American Family correct? 10. Earl and Vonette Crowell owned a farm in Minnesota. In 1980, they mortgaged the farm to Farm Credit Services and purchased a property insurance policy on the farm (including the farmhouse) from Delafield Farmers Mutual Insurance Co. Fire was among the perils covered by this policy, which ran from October 1985 to October 1988. When the Crowells fell behind on their mortgage payments, Farm Credit began foreclosure proceedings. Upon foreclosure, mortgagors such as the Crowells have a right of redemption for a specified time. The right of redemption allows the defaulting mortgagors to buy back their property after it has been sold to someone else in the foreclosure proceedings. In November 1987, the Crowells’ right of redemption expired. Minnesota law provides, however, that farmers who lose their farms to corporate lenders are given an additional opportunity to repurchase their farms under a “right of first refusal.” This right meant that Farm Credit was forbidden to sell the farm to anyone else before offering it to the Crowells at a price no higher than the highest price offered by a third party. Farm Credit allowed the Crowells to remain on the farm while they attempted to secure financing to buy the property under their right of first refusal. In November 1987, a fire substantially damaged the

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Part Five Property

farmhouse. The Crowells filed a claim for the loss with Delafield. Although Delafield paid the claim concerning the Crowells’ personal effects that were located inside the farmhouse and were destroyed in the fire, it denied the claim on the farmhouse itself. Delafield took the position that because the time period for the

Crowells’ right of redemption had expired, they no longer had an insurable interest in the farmhouse. The Crowells therefore sued Delafield. Concluding that the Crowells had an insurable interest in the farmhouse, the trial court granted summary judgment in their favor. Was the trial court correct?

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Chapter 28

Introduction to Credit and Secured Transactions

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Credit

Chapter 29

Security Interests in Personal Property

Chapter 30

Bankruptcy

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CHAPTER 28

Introduction to Credit and Secured Transactions

E

ric Richards decided to go into the commercial laundry and dry-cleaning business. He began by agreeing to buy the land, building, and equipment of a small dry cleaner. Richards agreed to pay the owner $300,000 in cash and “to assume” a $150,000 existing mortgage on the property. He next entered into a contract with a local contractor to build, within five months, an addition to the building for $250,000 with $40,000 payable with the signing of the contract and the balance to be paid in periodic installments as the construction progressed. Because Richards had heard some horror stories from friends in the local Chamber of Commerce about contractors who walked away from jobs without completing them, he asked the contractor to post a security bond or provide a surety to ensure the contract would be completed in a timely manner. Richards also had some of the existing dry-cleaning equipment picked up for repair and refurbishment. When the work was completed, the repairman refused to redeliver it until Richards paid in full for the work, claiming he had a lien on the equipment until he was paid. Among the questions that will be addressed in this chapter are: • What legal rights and obligations accompany the “assumption” of a mortgage? • Would Richards risk losing any of his rights to recover against the surety if he granted the contractor additional time to complete the construction? • If the contractor does not pay subcontractors or companies who provide construction material for the job, would they be able to assert a lien against the property until they are paid? • Would the person who repaired and refurbished the dry-cleaning equipment be able to assert a lien until Richards paid for it? Would it make a difference if the repair work had been done on site? • Would it be ethical for a person who has sold a parcel of real property on a land contract to declare a default of the contract when there is a minor default in making the payments called for in the contract and to reclaim possession of the property with the purchaser losing all the equity he might have built up in the property?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 28-1 Explain the difference between unsecured credit and secured credit. 28-2 Recall the definition of a surety, relate how the principal and surety relationship is created, and explain the defenses that may be available to a

surety as well as the duties that a creditor owes to a surety. 28-3 Describe common law liens and how they are created and recall the rights that they provide to artisans and others who hold such a lien.

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Part Six Credit

28-4 Compare and contrast mortgages, deeds of trust, and land contracts as mechanisms for holding a security interest in real property. 28-5 List the formalities necessary for the creation of a legally enforceable mortgage and explain

IN THE UNITED STATES, a substantial portion of business transactions involves the extension of credit. The term credit has many meanings. In this chapter, it will be used to mean transactions in which goods are sold, services are rendered, or money is loaned in exchange for a promise to repay the debt at some future date. In some of these transactions, a creditor is willing to rely on the debtor’s promise to pay at a later time; in others, the creditor wants some further assurance or security that the debtor will make good on her promise to pay. This chapter will discuss the differences between secured and unsecured credit and will detail various mechanisms that are available to the creditor who wants to obtain security. These mechanisms include obtaining liens or security interests in personal or real property, sureties, and guarantors. Security interests in real property, sureties and guarantors, and common law liens on personal property will be covered in this chapter, and the Uniform Commercial Code (UCC) rules concerning security interests in personal property will be covered in Chapter 29, Security Interests in Personal Property. The last chapter in Part 6 deals with bankruptcy law, which may come into play when a debtor is unable to fulfill his obligation to pay his debts when they are due.

Credit LO28-1

Explain the difference between unsecured credit and secured credit.

Unsecured Credit Many

common transactions are based on unsecured credit. For example, a person may have a charge account at a department store or a MasterCard account. If the person buys a sweater and charges it to his charge account or MasterCard account, unsecured credit has been extended to him. He has received goods in return for his promise to pay for them later. Similarly, if a person goes to a dentist to have a cavity in a tooth filled and the dentist sends her a bill payable by the end

what is meant by foreclosure and the right of redemption. 28-6 Describe mechanic’s and materialman’s liens created by state law and explain how they are obtained and what rights they give the lienholder.

of the month, services have been rendered on the basis of unsecured credit. Consumers are not the only people who use unsecured credit. Many transactions between businesspeople utilize it; for example, a retailer buys merchandise or a manufacturer buys raw materials, promising to pay for the merchandise or materials within 30 days after receipt. Unsecured credit transactions involve a maximum of risk to the creditor—the person who extends the credit. When goods are delivered, services are rendered, or money is loaned on unsecured credit, the creditor gives up all rights in the goods, services, or money. In return, the creditor gets a promise by the debtor to pay or to perform the promised act. If the debtor does not pay or keep the promise, the creditor’s options are more limited than if he had obtained security to ensure the debtor’s performance. One course of action is to bring a lawsuit against the debtor and obtain a judgment. The creditor might then have the sheriff execute the judgment on any property owned by the debtor that is subject to execution. The creditor might also try to garnish the wages or other moneys to which the debtor is entitled. However, the debtor might be judgment-proof; that is, the debtor may not have any property subject to execution or may not have a steady job. Under these circumstances, execution or garnishment would be of little aid to the creditor in collecting the judgment. A businessperson may obtain credit insurance to stabilize the credit risk of doing business on an unsecured credit basis. However, he passes the costs of the insurance to the business, or of the unsecured credit losses that the business sustains, on to the consumer. The consumer pays a higher price for goods or services purchased, or a higher interest rate on any money borrowed, from a business that has high credit losses.

Secured Credit To minimize his credit risk, a creditor may contract for security. The creditor may require the debtor to convey to the creditor a security interest or lien on the debtor’s property. Suppose a person borrows $3,000 from a credit union. The credit union might require her to put up her car as security for the loan or might ask that



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

some other person agree to be liable if she defaults. For example, if a student who does not have a regular job goes to a bank to borrow money, the bank might ask that the student’s father or mother cosign the note for the loan. When the creditor has security for the credit he extends and the debtor defaults, the creditor can go against the security to collect the obligation. Assume that a person borrows $18,000 from a bank to buy a new car and that the bank takes a security interest (lien) on the car. If the person fails to make his monthly payments, the bank has the right to repossess the car and have it sold so that it can recover its money. Similarly, if the borrower’s father cosigned for the car loan and the borrower defaults, the bank can sue the father to collect the balance due on the loan.

Development of Security Various types of se-

curity devices have been developed as social and economic need for them has arisen. The rights and liabilities of the parties to a secured transaction depend on the nature of the security—that is, on whether (1) the security pledged is the promise of another person to pay if the debtor does not or (2) a security interest in goods, intangibles, or real estate is conveyed as security for the payment of a debt or obligation. If personal credit is pledged, the other person may guarantee the payment of the debt—that is, become a ­guarantor—or the other person may join the debtor in the debtor’s promise to pay, in which case the other person would become surety for the debt. The oldest and simplest security device was the pledge. To have a pledge valid against third persons with an interest in the goods, such as subsequent purchasers or creditors, it was necessary that the property used as security be delivered to the pledgee or a pledge holder. Upon default by the pledger, the pledgee had the right to sell the property and apply the proceeds to the payment of the debt. Situations arose in which it was desirable to leave the property used as security in the possession of the debtor. To accomplish this objective, the debtor would give the creditor a bill of sale to the property, thus passing title to the creditor. The bill of sale would provide that if the debtor performed his promise, the bill of sale would become null and void, thus revesting title to the property in the debtor. A secret lien on the goods was created by this device, and the early courts held that such a transaction was a fraud on third-party claimants and void as to them. An undisclosed or secret lien is unfair to creditors who might extend credit to the debtor on the strength of property that they see in the debtor’s possession but that in fact is subject to the prior claim of another creditor. Statutes were enacted providing for the recording or filing of the bill of sale, which

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was later designated as a chattel mortgage. These statutes were not uniform in their provisions. Most of them set up formal requirements for the execution of the chattel mortgage and also stated the effect of recording or filing on the rights of third-party claimants. To avoid the requirements for the execution and filing of the chattel mortgage, sellers of goods would sell the goods on a “conditional sales contract” under which the seller retained title to the goods until their purchase price had been paid in full. Upon default by the buyer, the seller could (1) repossess the goods or (2) pass title and recover a judgment for the unpaid balance of the purchase price. Abuses of this security device gave rise to some regulatory statutes. About one-half of the states enacted statutes providing that the conditional sales contract was void as to third parties unless it was filed or recorded. No satisfactory device was developed whereby inventory could be used as security. The inherent difficulty is that inventory is intended to be sold and turned into cash and the creditor is interested in protecting his interest in the cash rather than in maintaining a lien on the sold goods. Field warehousing was used under the pledge, and an after-acquired property clause in a chattel mortgage on a stock of goods held for resale partially fulfilled this need. One of the devices used was the trust receipt. This short-term marketing security arrangement had its origin in the export–import trade. It was later used extensively as a means of financing retailers of consumer goods having a high unit value.

Security Interests in Personal Property Chapter 29, Security Interests in Personal Property, will discuss how a creditor can obtain a security interest in the personal property or fixtures of a debtor. It will also explain the rights to the debtor’s property of the creditor, the debtor, and other creditors of the debtor. These security interests are covered by Article 9 of the Uniform Commercial Code, which sets out a comprehensive scheme for regulating security interests in personal property and fixtures. The Code abolishes the old formal distinctions between different types of security devices used to create security interests in personal property.

Security Interests in Real Property Three

types of contractual security devices have been developed by which real estate may be used as security: (1) the real estate mortgage, (2) the trust deed, and (3) the land contract. In addition to these contract security devices, all of the states have enacted statutes granting the right to mechanic’s liens on real estate. Security interests in real property are covered later in this chapter.

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Part Six Credit

Suretyship and Guaranty Recall the definition of a surety, relate how the principal and surety relationship is created, and explain the LO28-2 defenses that may be available to a surety as well as the duties that a creditor owes to a surety.

Sureties and Guarantors As

a condition of making a loan, granting credit, or employing someone (particularly as a fiduciary), a creditor may demand that the debtor, contractor, or employee provide as security for his performance the liability of a third person as surety or guarantor. The purpose of the contract of suretyship or guaranty is to provide the creditor with additional protection against loss in the event of default by the debtor, contractor, or employee. A surety is a person who is liable for the payment of another person’s debt or for the performance of another person’s duty. The surety joins with the person primarily liable in promising to make the payment or to perform the duty. For example, Kathleen Kelly, who is 17 years old, buys a used car on credit from Harry’s Used Cars. She signs a promissory note, agreeing to pay $200 a month on the note until the note is paid in full. Harry’s has Kathleen’s father cosign the note; thus, her father is a surety. Similarly, the city of Chicago hires the B&B Construction Company to build a new sewage treatment plant. The city will probably require B&B to have a surety agree to be liable for B&B’s performance of its contract. There are insurance companies that,

for a fee, will agree to be a surety on the contract of a company such as B&B. The surety is primarily liable for the debtor’s obligation, and the debtor can demand performance from the surety at the time the debt is due. The creditor does not need to establish a default by the debtor or proceed first against the debtor on his obligation. A guaranty contract is similar to a suretyship contract in that the promisor agrees to answer for the obligation of another. However, a guarantor does not join the principal in making a promise; rather, a guarantor makes a separate promise and agrees to be liable upon the happening of a certain event. For example, a father tells a merchant, “I will guarantee payment of my daughter Rachel’s debt to you if she does not pay it,” or “If Rachel becomes bankrupt, I will guarantee payment of her debt to you.” While a surety is primarily liable, a guarantor is secondarily liable and can be held to his guarantee only after the principal defaults and cannot be held to his promise or payment. Generally, a guarantor’s promise must be made in writing to be enforceable under the statute of frauds. Most commercial contracts and promissory notes today that are to be signed by multiple parties provide for the parties to be “jointly and severally” liable, thus making the surety relationship the predominate one. In the case that follows, Columbia Realty Ventures v. Dang, the court concluded that a document that purported to establish the signator as a guarantor actually created a suretyship and held that under the circumstances of the case, it would be unconscionable to enforce the guaranty.

Columbia Realty Ventures v. Dang    2011 Va. Cir. LEXIS 115 (Aug. 16, 2011)

Dong Dang and his wife, Hao Dang, attended a settlement with Columbia Realty for Mr. Dang to execute a commercial lease agreement in Mr. Dang’s sole name for a nail salon in the District of Columbia. During the course of the settlement, Mrs. Dang was handed a document titled “Guaranty” and told that she had to sign the document or her husband would not be able to obtain the lease. While both Mr. Dang and Columbia Realty’s representative urged Mrs. Dang to sign the document, no explanation was given as to the document’s contents, no explanation was given as to the terms of the underlying commercial lease, and at no time was she advised that she was signing a document that made her individually liable to a greater degree than Mr. Dang would be on the commercial lease. Mr. Dang was in default on the lease, and Columbia Realty brought suit against the Dangs and, among other things, sought to hold Mrs. Dang liable on the Guaranty she had signed. At the trial, Mrs. Dang raised concerns about the validity of the Guaranty due to its failure to name the property involved and the person whose obligation it required Mrs. Dang to guarantee. At the conclusion of the evidence, Mrs. Dang moved to strike the claims against her based on her contention that the Guaranty was invalid and unenforceable against her. In essence, she contended that the contract of guarantee was unenforceable against her because it was unconscionable.



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

Nordlund, Judge A guaranty is a collateral undertaking by one person to be answerable for the payment of some debt or the performance of some duty if another person defaults on his payment or performance. A guaranty must be in writing and supported by adequate consideration. The law deems a guaranty absolute unless its terms import some condition precedent to the liability of the guarantor. If a guaranty is conditional, however, the creditor must satisfy those conditions before proceeding against the guarantor. In Virginia, the distinction between guaranty and suretyship is that guaranty is a secondary obligation while suretyship is a primary one. The Supreme Court of Virginia elaborated on this distinction, stating: The contract of the guarantor is his own separate undertaking, in which the principal does not join. The guarantor contracts to pay, if, by the use of due diligence, the debt cannot be made out of the principal debtor, while the surety undertakes directly for the payment, and so is responsible at once if the principal debtor makes default; or, in other words, guaranty is an undertaking that the debtor shall pay; suretyship, that the debt shall be paid. The document at issue in this case states in pertinent part: Guarantors further covenant that (1) the liability of the Guarantors is primary, shall not be subject to deduction for any claim of offset, counterclaim or defense which Tenant or Guarantors may have against Landlord, and Landlord may proceed against Guarantors separately or jointly, before, after or simultaneously with any proceeding against Tenant for default . . . (4) this Guaranty shall be absolute and unconditional . . . Even Columbia’s counsel had to acknowledge, during the June 30, 2011 hearing, that the “Guaranty” in this case did indeed operate as a suretyship and not a guaranty, making Mrs. Dang primarily obligated to Columbia should the current tenant default on his contractual duties to Columbia. Consistent with the above stated principles, the Court finds that Mrs. Dang signed what amounts to a primary obligation and an absolute guaranty, which is therefore a suretyship, not a guaranty. When construing a suretyship contract, the Court must apply the same rules as it would to the construction of any other contract, the relevant inquiry being: “What was the intention of the parties as disclosed by the instrument in the light of the surrounding circumstances?” Virginia law has several well settled principles regarding the liability of sureties. At its most basic level, a surety’s liability to the creditor is the same as that of the principal. Accordingly, the creditor’s right of recovery against the surety does not extend beyond that against the principal, nor will a surety be liable where the creditor could not assert that liability against the principal.

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Moreover, a creditor must demonstrate that he has performed his obligations under the contract before he can recover against the debtor’s surety. If the creditor demonstrates a prima facie case for liability against the principal, the surety may assert the same defenses as the principal because the surety and principal are in privity. A surety who receives no payment for his contract is a favored debtor under Virginia law because she receives no benefit for her obligation. In the case, the “Guaranty” contains no explicit statement about consideration, nor could the Court reasonably imply one from its terms. Therefore, Mrs. Dang is a gratuitous surety. In Southern Cross Coal Corp., the Supreme Court described the obligation of a gratuitous, or accommodation surety, as follows: “Accommodation sureties are entitled to the benefit of the strictissimi juris rule: they are discharged by any change in the obligation.” Strictissimi juris is usually defined as “most strictly according to the law.” Additionally, if a creditor and a principal debtor make a positive contract to extend the time of the debtor’s obligation without the surety’s consent, the surety is thereby discharged. Despite these well settled principles, the “Guaranty” in this case requires Mrs. Dang to forfeit multiple rights she otherwise would have as a gratuitous surety. Specifically, the Guarantor covenants that: (1) the liability of the Guarantors [sic] is primary, shall not be subject to deduction for any claim of offset, counterclaim or defense which Tenant . . . may have against Landlord; (2) this Guaranty shall not be terminated or impaired in any manner whatsoever by reason of the assertion by Landlord against Tenant of any of the rights or remedies reserved to Landlord pursuant to the provisions of such Lease, by reason of summary or other proceedings against Tenant . . . or by reason of any extension of time or indulgence granted by Landlord to Tenant or any other defense available to guarantors or sureties. . . . (4) the Guaranty shall be absolute and unconditional and shall remain and continue in full force and effect as to any renewal, extension, amendment, additions, assignments, sublease, transfer or other modification of the Lease, whether or not currently expressed in the Lease and whether or not the Guarantors have notice thereof; (emphasis added). These sections of the “Guaranty” stand in direct opposition to Mrs. Dang’s rights to bring any defenses that her husband might have against the landlord, be discharged because of an extension of time or modification of the underlying obligation without her notice, and “any other defense available to guarantors or sureties.” Because the “Guaranty” essentially requires Mrs. Dang to give up all rights she would normally be entitled to under Virginia law, the Court finds it necessary to

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Part Six Credit

determine whether this forfeiture makes the “Guaranty” unconscionable and unenforceable against Mrs. Dang. Virginia law sets a high burden for declaring a contract unconscionable. While the jurisdiction undoubtedly exists in the courts to avoid a contract on the ground that it makes an unconscionable bargain, nevertheless an inequitable and unconscionable bargain has been defined to be “one that no man in his senses and not under a delusion would make, on the one hand and as no fair man would accept, on the other.” The inequality must be so gross as to shock the conscience. Applying the law to the evidence from the trial in this case, it appears that a corporate party told an individual that she needed to sign the Guaranty or her husband would not be allowed to lease the property. The evidence from trial therefore indicates that no bargaining over the terms of the “Guaranty” took place. Even Columbia admits that Mr. Dang simply instructed Mrs. Dang to sign the “Guaranty” so that Columbia would lease him the property, without offering her the opportunity to discuss or negotiate the terms of either document. Looking then to the substance of the “Guaranty,” it appears to convert Mrs. Dang from a guarantor, with a conditional and secondary obligation, to a gratuitous surety with a primary obligation. In addition, the terms of the “Guaranty” then attempt to take away many of the rights Mrs. Dang would otherwise have as a gratuitous surety under Virginia law. Even putting many of them aside, Mrs. Dang’s signature on the “Guaranty” made her primarily liable for the obligation of the Tenant, regardless of whether the Tenant continued to be her husband or not, and regardless of how much Columbia and the Tenant decided to change the underlying obligation, all without ever notifying Mrs. Dang. Additionally, despite any modifications to that underlying obligation, Mrs. Dang would be liable and utterly defenseless in a trial for the collection of that obligation and could potentially be forced to pay Columbia more than a Tenant owed. Columbia has argued that the Court should not find the “Guaranty” unconscionable because it chose not to enforce the

Creation of Principal and Surety Relation The relationship of principal and surety, or that of prin-

cipal and guarantor, is created by contract. The basic rules of contract law apply in determining the existence and nature of the relationship as well as the rights and duties of the parties.

Defenses of a Surety Suppose Jeffrey’s mother agrees to be a surety for Jeffrey on his purchase of a

more problematic terms against Mrs. Dang during the trial of this case. Specifically, Columbia notes that it allowed Mrs. Dang to present defenses at trial, including defenses available to the Tenant. But it is well settled in this Commonwealth, that when the terms of a contract are clear and unambiguous, as they are here, the contract needs no interpretation, and the intention of the parties must be determined only from the terms themselves. The Court finds the terms of the “Guaranty” in this case clear and unambiguous. Therefore, the Court cannot and will not interpret the “Guaranty” based upon Columbia’s representation that it did not enforce certain terms at the trial and perhaps never intended to enforce them. The Court further finds that Mrs. Dang was given no opportunity to review or understand the “Guaranty” or to negotiate over its terms, and thereby had unequal bargaining power with Columbia at the time of her signature. Additionally, the Court finds that Mrs. Dang was a gratuitous surety, as she primarily obligated herself to Columbia under the Lease, for no consideration, and therefore is a favored debtor. In addition, despite that the laws governing suretyships allow a surety to assert the same defense as the principal, the “Guaranty” purports to waive and deny Mrs. Dang the right to assert any rights or defenses the Tenant would have under the Lease, (including any right of setoff), regardless of how severely Columbia and the Tenant may have modified the Lease from its form at the time of her signature. Most importantly, by definition, a surety is only liable for the underlying obligation of the primary debtor, and by waiving Mrs. Dang’s right to assert the same defenses as the Tenant, the “Guaranty” opens her up to potentially be liable for more than the underlying obligation. For the reasons stated herein, the Court concludes that the circumstances surrounding Mrs. Dang’s execution of the “Guaranty,” combined with the terms of the “Guaranty” itself, constitute an inequality “so gross as to shock the conscience.” Accordingly, the Court finds that the “Guaranty” is unconscionable and unenforceable against Mrs. Dang, and hereby grants her Motion to Strike the claims against her.

motorcycle. If the motorcycle was defectively made and Jeffrey refuses to make further payments on it, the dealer might try to collect the balance due from Jeffrey’s mother. As a surety, Jeffrey’s mother can use any defenses against the dealer that Jeffrey has if they go to the merits of the primary contract. Thus, if Jeffrey has a valid defense of breach of warranty against the dealer, his mother can use it as a basis for not paying the dealer.



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

Other defenses that go to the merits include (1) lack or failure of consideration, (2) inducement of the contract by fraud or duress, and (3) breach of contract by the other party. Certain defenses of the principal cannot be used by the surety. These defenses include lack of capacity, such as minority or insanity, and bankruptcy. Thus, if Jeffrey is only 17 years old, the fact that he is a minor cannot be used by Jeffrey’s mother to defend against the dealer. This defense of Jeffrey’s lack of capacity to contract does not go to the merits of the contract between Jeffrey and the dealer and cannot be used by Jeffrey’s mother. A surety contracts to be responsible for the performance of the principal’s obligation. If the principal and the creditor change that obligation by agreement, the surety is relieved of responsibility unless the surety agrees to the change. This is because the surety’s obligation cannot be changed without his consent. For example, Fredericks cosigns a note for his friend Kato, which she has given to Credit Union to secure a loan. Suppose the note was originally for $2,500 and payable in 12 months with interest at 11 percent a year. Credit Union and Kato later agree that Kato will have 24 months to repay the note but that the interest will be 13 percent per year. Unless Fredericks consents to this change, he is discharged from his responsibility as surety. The obligation he agreed to assume was altered by the changes in the repayment period and the interest rate. The most common kind of change affecting a surety is an extension of time to perform the contract. If the creditor merely allows the principal more time without the surety’s consent, this does not relieve the surety of responsibility. The surety’s consent is required only where there is an actual binding agreement between the creditor and the principal as to the extension of time. In addition, the courts usually make a distinction between accommodation sureties and compensated sureties. An accommodation surety is a person who acts as a surety without compensation, such as a friend who cosigns a note as a favor. A compensated surety is a person, usually a professional such as a bonding company, who is paid for serving as a surety. The courts are more protective of accommodation sureties than of compensated sureties. Accommodation sureties are relieved of liability unless they consent to an extension of time. Compensated sureties, on the other hand, must show that they will be harmed by an extension of time before they are relieved of responsibility because of a binding extension without their consent. A compensated surety must show that a change in the contract was both material and prejudicial to him if he is to be relieved of his obligation as surety.

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Creditor’s Duties to Surety The creditor is re-

quired to disclose any material facts about the risk involved to the surety. If he does not do so, the surety is relieved of liability. For example, a bank (creditor) knows that an employee, Arthur, has been guilty of criminal conduct in the past. If the bank applies to a bonding company to obtain a bond on Arthur, the bank must disclose this information about Arthur. Similarly, suppose the bank has an employee, Alison, covered by a bond and discovers that Alison is embezzling money. If the bank agrees to give Alison another chance but does not report her actions to the bonding company, the bonding company is relieved of responsibility for further wrongful acts by Alison. If the debtor posts security for the performance of an obligation, the creditor must not surrender the security without the consent of the surety. If the creditor does so, the surety is relieved of liability to the extent of the value surrendered.

Subrogation, Reimbursement, and Contribution If the surety has to perform or pay the prin-

cipal’s obligation, then the surety acquires all of the rights that the creditor had against the principal. This is known as the surety’s right of subrogation. The rights acquired could include the right to any collateral in the possession of the creditor, any judgment right the creditor had against the principal on the obligation, and the rights of a creditor in bankruptcy proceedings. If the surety performs or pays the principal’s obligation, she is entitled to recover her costs from the principal; this is known as the surety’s right to reimbursement. For example, Amado cosigns a promissory note for $2,500 at the credit union for her friend Anders. Anders defaults on the note, and the credit union collects $2,500 from Amado on her suretyship obligation. Amado then not only gets the credit union’s rights against Anders under the right of subrogation, but also the right to collect $2,500 from Anders under the right of reimbursement. Suppose several persons (Tom, Dick, and Harry) are cosureties of their friend Sam. When Sam defaults, Tom pays the whole obligation. Tom is entitled to collect onethird from both Dick and Harry because he paid more than his prorated share. This is known as the cosurety’s right to contribution. The relative shares of cosureties, as well as any limitations on their liability, are normally set out in the contract of suretyship. A surety also has what is known as a right of exoneration, which is the right of the surety or guarantor to require the debtor to make good on his commitment to the creditor when he (1) is able to do so and (2) does not have a valid defense against payment. The right is exercised when

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Part Six Credit

the creditor is pursuing the surety or guarantor to make good on their liability. The surety or guarantor then sues the debtor to force him to pay the creditor, automatically staying the creditor’s action against the surety or guarantor. The surety or guarantor uses this right to prevent its having to pay the creditor (which may require liquidation of some of the surety’s or guarantor’s assets) and then having to sue the debtor under the right of subrogation or reimbursement.

Liens on Personal Property LO28-3

Describe common law liens and how they are created and recall the rights that they provide to artisans and others who hold such a lien.

Security Interests in Personal Property and Fixtures under the Uniform Commercial Code Chapter 29 will discuss how a creditor

can obtain a security interest in the personal property or fixtures of a debtor. It will also explain the rights of the creditor, the debtor, and other creditors of the debtors to the property. These security interests are covered by Article 9 of the Uniform Commercial Code, which sets out a comprehensive scheme for regulating security interests in personal property and fixtures. Article 9 does not deal with the liens that landlords, artisans, and materialmen are given by statute or with security interests in real estate. These security interests will be covered in this chapter.

Common Law Liens Under

the common—or judge-made—law, artisans, innkeepers, and common carriers (such as airlines and trucking companies) were entitled to liens to secure the reasonable value of the services they performed. An artisan such as a furniture upholsterer or an auto mechanic uses his labor or materials to improve

personal property that belongs to someone else. The improvement becomes part of the property and belongs to the owner of the property. Therefore, the artisan who made the improvement is given a lien on the property until he is paid. For example, the upholsterer who recovers a sofa for a customer is entitled to a lien on the sofa. The innkeeper and common carrier are in business to serve the public and are required by law to do so. Under the common law, the innkeeper, to secure payment for his reasonable charges for food and lodging, was allowed to claim a lien on the property that the guest brought to the hotel or inn. Similarly, the common carrier, such as a trucking company, was allowed to claim a lien on the goods carried for the reasonable charges for the service. The justification for such liens was that the innkeeper and common carrier were entitled to the protection of a lien because they were required by law to provide the service to anyone seeking it.

Statutory Liens While common law liens are still

generally recognized today, many states have incorporated this concept into statutes. Some of the state statutes have created additional liens, while others have modified the common law liens to some extent. The statutes commonly provide a procedure for foreclosing the lien. Foreclosure is the method by which the rights of the property owner are cut off so that the lienholder can realize her security interest. Typically, the statutes provide for a court to authorize the sale of the personal property subject to the lien so that the creditor can obtain the money to which she is entitled. Carriers’ liens and warehousemen’s liens are provided for in Article 7, Documents of Title, of the Uniform Commercial Code. They are covered in Chapter 23, Personal Property and Bailments.

Characteristics of Liens The

common law lien and most of the statutory liens are known as possessory liens. They give the artisan or other lienholder the right to keep possession of the debtor’s property until the

Ethics and Compliance in Action What Is the Ethical Thing to Do? Suppose you own and operate a small loan business. A young man applies for a $1,000 loan. When you run a credit check on him, you find that he has had difficulty holding a job and has a terrible credit record. You conclude that he is a poor credit risk and inform him that you are willing to make the requested loan only if he can find

someone who has a good credit rating to cosign a promissory note with him. The next day he comes by the office with a young woman who meets your criteria for a good credit rating and who indicates she is willing to cosign the note. Do you have any ethical obligation to share with the young woman the information you have about the young man’s employment and credit history?



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

reasonable charges for services have been paid. For the lien to come into play, possession of the goods must have been entrusted to the artisan. Suppose a person takes a chair to an upholsterer to have it repaired. The upholsterer can keep possession of the chair until the person pays the reasonable value of the repair work. However, if the upholsterer comes to the person’s home to make the repair, the upholsterer would not have a lien on the chair as the person did not give up possession of it. The two essential elements of the lien are (1) possession by the improver or the provider of services and (2) a debt created by the improvement or the provision of services concerning the goods. If the artisan or other lienholder gives up the goods voluntarily, he loses the lien. For example, if a person has a new engine put in his car and the mechanic gives the car back to him before he pays for the engine, the mechanic loses the lien on the car to secure the person’s payment for the work and materials. However, if

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the person uses a spare set of keys to regain possession, or does so by fraud or another illegal act, the lien is not lost. Once the debt has been paid, the lien is terminated and the artisan or other lienholder no longer has the right to retain the goods. If the artisan keeps the goods after the debt has been paid, or keeps the goods without the right to a lien, he is liable for conversion or unlawful detention of goods. Another important aspect of common law liens is that the work or service must have been performed at the request of the owner of the property. If the work or service is performed without the consent of the owner, no lien is created. In the case that follows, Allstate Lien & Recovery Corporation v. Stansbury, the court concluded that a lienholder had sought to include charges within its lien that it was not authorized under the statute to include and awarded damages to the owner of a vehicle that was sold at auction to satisfy the unlawful lien.

Allstate Lien & Recovery Corporation v. Stansbury    101 A.3d 520 (Md. Ct. Spec. App. 2014)

In December 2010, Cedric Stansbury brought his two-year-old vehicle to Russel Auto Imports for an oil change. Although the vehicle had been running great before the oil change, a week after the oil change, the engine cut off in the middle of the street during rush hour traffic and he could not get it started again. As the car sat in the middle of the roadway, in the snow, another car ran into the back of his car. Stansbury had it towed to Russel Auto. On May 18, 2011, Russel contacted Stansbury to tell him his vehicle was ready to be picked up. The same day, at approximately 5:30 P.M, Stansbury went to Russel, and he was told that he owed $6,330.67. He began to write a check for that amount, but was told he would have to return the next day to talk to Jeremy Martin. Stansbury did not have $6,330.37 in his account when he wrote the check, but he stated that he intended to immediately deposit the funds into the account after leaving Russel Auto. The following day, Stansbury called Martin to tell him he would try to get to Russel Auto to pick up his vehicle, but by the time he arrived after work, the shop was closed. He made three or four attempts to get to Russel before it closed, but was unable to do so. In the beginning of June, Stansbury received a Lien Notice stating that there was a lien on his vehicle in the amount of $7,630.37. The Lien Notice stated that Allstate Lien & Recovery would sell Stansbury’s vehicle at public auction on June 23 unless he paid “repair costs” of $6,630.37 plus “costs of the process” of $1,000 in full within 10 days. The “repair cost“ figure included $300 that Allstate had suggested Russel Auto include as “storage charges,” even though Stansbury had never agreed to pay any storage charges. He called Martin and asked why there was a lien on his car. Martin responded that Stansbury did not pay for the repairs “in time,” and that he would have to contact Allstate Lien & Recovery to ask the company not to put the car up for auction. Stansbury attempted to call Allstate, but his calls were not answered. During the week of June 8, Stansbury went to Allstate where the office manager was “nasty” and not “very agreeable or cooperative.” She told him his car would be put up for auction. She said the vehicle was not his and that if he wanted it, he would have to bid for it at auction. Between June 8 and June 23, Stansbury repeatedly tried calling Allstate, but no one would answer or return his vehicle. At that point, Stansbury had $6,300 to recover his vehicle, but did not have $7,600. The car was sold at auction for $7,730. Of that amount, Russel Auto received $6,630 plus $522 that it had paid to Allstate to process the lien. Allstate kept the balance of the $1,000 processing fee, and Stansbury was entitled to receive $99.60. At the time of the auction, Stansbury believed that it was worth at least $25,000. He had paid more than $31,000 for it two years prior to the time it was auctioned for sale.

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Part Six Credit

Maryland law provides: (a) Motor vehicle lien (1) any person who, with the consent of the owner, has custody of a motor vehicle and who, at the request of the owner, provides a service to or materials for the motor vehicle, has a lien on the motor vehicle for any charge incurred for any: i. Repair or rebuilding; ii. Storage; or iii. Tires or other parts or accessories. (2) A lien is created under this subsection when any charges set out under paragraph (1) of this subsection giving rise to the lien are incurred. While the lien statute does provide that the “costs of process” may be recovered from the proceeds of the sale, it does not include them within the lien itself. Stansbury brought suit against Russel Auto, Martin (its owner), and Allstate Lien & Recovery, alleging that they violated Maryland’s Consumer Protection Act and Consumer Debt Collection Act by, among other things, including a “processing fee” of $1,000 as part of the lien that Stansbury was required to pay to redeem his vehicle. The trial court ruled as a matter of law that the processing fee was not part of a garageman’s lien, and a jury found that there had been violations of the Maryland Consumer Protection Act and the Debt Collection Act by enforcing a right that did not exist. The jury awarded Stansbury $16,500 in compensatory damages plus attorneys’s fees. The defendants appealed the court’s ruling.

Graeff, Justice This case involves a garageman’s lien, a lien created on behalf of someone who conducted work on a vehicle but was not paid for the service by the owner of the vehicle. Appellants contend that the circuit court erred in its interpretation of CL section 16-202, the garageman’s lien statute. The issue presented is what is encompassed in the lien created when a person requests repairs to be done to a motor vehicle and then does not pay for those repairs. Appellants argue that the court erred in determining and instructing the jury that the $1,000 processing fee “was not an appropriate part of the lien, that it should not have been an upfront cost added to the lien in advance.” It is well settled in Maryland that the goal of statutory interpretation is to ascertain and implement, to the extent possible, the legislative intent. In doing so, we look first to the statute’s plain language, giving words their natural and ordinary meaning. If the language is clear and unambiguous on its face, our inquiry ends. If the language of the statute is ambiguous, the courts consider not only the literal or usual meaning of the words, but their meaning and effect in light of the setting, the objectives and purposes of the enactment under consideration. Appellants acknowledge that the plain language of the statute does not include processing fees as part of the lien on the motor vehicle. They argue, however, that a review of the statutory scheme as a whole shows that an illogical result would occur if the processing fees are not included in the amount necessary to redeem the vehicle. Mr. Stansbury argues that a plain reading of the statute prohibits front loading the $1,000 cost of process and making it part of the lien. He asserts that the statutory scheme as a whole

provides that “costs of process” be recovered from the proceeds of the sale, not made part of the lien itself. He further argues that, even if processing costs could be deemed part of the lien, the costs here were improper because they were not actual costs incurred by Russel. The plain language of CL section 16-202 is clear and unambiguous. A person who provides a service to, or materials for, a vehicle has a “motor vehicle lien” only for those charges incurred for repair or rebuilding, storage, or tires or other parts or accessories. A processing fee is not included as part of the lien. A review of the statutory scheme as a whole does not, as appellants argue, suggest a different conclusion. Although processing fees may be recovered if the vehicle is sold or if judicial proceedings are instituted, the statutory scheme does not suggest that processing fees constitute a part of the lien that may be included as a part of the amount the consumer must pay to redeem the vehicle. Having determined that the inclusion of the “processing fees” in the lien amount was improper, the next issue presented by appellants is whether its action in doing so, violated the Maryland Consumer Debt Collection Act (MCDCA) which provides that a debt collector may not “claim, attempt, or threaten to enforce a right with knowledge that the right does not exist.” Although appellants are correct that they had the right to enforce the garageman’s lien, as we have explained, the plain language of the statute makes clear that “costs of process” are not part of the lien amount. In requiring Mr. Stansbury to pay the $1,000 “costs of process” to redeem the vehicle, appellants were attempting to enforce a right they did not have. Accordingly, the jury properly found the appellants were liable for a violation of the MCDCA. Judgment affirmed for Stansbury.



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

Foreclosure of Lien The right of a lienholder to

possess goods does not automatically give the lienholder the right to sell the goods or to claim ownership if his charges are not paid. Commonly, there is a procedure provided by statute for selling property once it has been held for a certain period of time. The lienholder is required to give notice to the debtor and to advertise the proposed sale by posting or publishing notices. If there is no statutory procedure, the lienholder must first bring a lawsuit against the debtor. After obtaining a judgment for his charges, the lienholder can have the sheriff seize the property and have it sold at a judicial sale.

Security Interests in Real Property LO28-4

Compare and contrast mortgages, deeds of trust, and land contracts as mechanisms for holding a security interest in real property.

There are three basic contract devices for using real estate as security for an obligation: (1) the real estate mortgage, (2) the deed of trust, and (3) the land contract. In addition, the states have enacted statutes giving mechanics, such as carpenters and plumbers, and materialmen, such as lumberyards, a right to a lien on real property into which their labor or materials have been incorporated.

Historical Developments of Mortgages A

mortgage is a security interest in real property or a deed to real property that is given by the owner (the mortgagor) as security for a debt owed to the creditor (the mortgagee). The real estate mortgage was used as a form of security in England as early as the middle of the 12th century, but our present-day mortgage law developed from the common law mortgage of the 15th century. The common law mortgage was a deed that conveyed the land to the mortgagee, with the title to the land to return to the mortgagor upon payment of the debt secured by the mortgage. If the mortgagor defaulted on the debt, the mortgagee’s title to the land became absolute. The land was forfeited as a penalty, but the forfeiture did not discharge the debt. In addition to keeping the land, the mortgagee could sue on the debt, recover a judgment, and seek to collect the debt. The early equity courts did not favor the imposition of penalties and would relieve mortgagors from such forfeitures, provided that the mortgagor’s default was minor and was due to causes beyond his control. Gradually, the courts became more lenient in permitting redemptions and

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allowed the mortgagor to redeem (reclaim his property) if he tendered performance without unreasonable delay. Finally, the courts of equity recognized the mortgagor’s right to redeem as an absolute right that would continue until the mortgagee asked the court of equity to decree that the mortgagor’s right to redeem be foreclosed and cut off. Our present law regarding the foreclosure of mortgages developed from this practice. Today, the mortgage is generally viewed as a lien on land rather than a conveyance of title to the land. There are still some states where the mortgagor goes through the process of giving the mortgagee some sort of legal title to the property. Even in these states, however, the mortgagee’s title is minimal, and the real ownership of the property remains in the mortgagor.

LO28-5

List the formalities necessary for the creation of a legally enforceable mortgage and explain what is meant by foreclosure and the right of redemption.

Form, Execution, and Recording Because

the real estate mortgage conveys an interest in real property, it must be executed with the same formality as a deed. As a general rule, the mortgage must contain the name of the secured party, the legal description of the property, and the terms and conditions of the security interest in the property—and it must be signed by the debtor/owner of record of the property. In addition, most states require a mortgage to be notarized—that is, acknowledged by the debtor/owner before a notary public or other authorized officer. Unless it is executed with the required formalities, it will not be eligible for recording in the local land records. Recordation of the mortgage does not affect its validity as between the mortgagor and the mortgagee. However, if it is not recorded, it will not be effective against subsequent purchasers of the property or creditors, including other mortgagees, who have no notice of the earlier mortgage. It is important to the mortgagee that the mortgage be recorded so that the world will be on notice of the mortgagee’s interest in the property.

Rights and Liabilities The

owner (mortgagor) of property subject to a mortgage can sell the interest in the property without the consent of the mortgagee. However, the sale does not affect the mortgagee’s interest in the property or the mortgagee’s claim against the mortgagor. In some cases, the mortgage may provide that if the property is sold, then any remaining balance becomes immediately due and payable. This is known as a “due on sale” clause.

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Part Six Credit

Suppose Erica Smith owns a lot on a lake. She wants to build a cottage on the land, so she borrows $155,000 from First National Bank. She signs a note for $155,000 and gives the bank a $155,000 mortgage on the land and cottage as security for her repayment of the loan. Several years later, Smith sells her land and cottage to Melinda Mason. The mortgage she gave First National might make the unpaid balance due on the mortgage payable on sale. If it does not, Smith can sell the property with the mortgage on it. If Mason defaults on making the mortgage payments, the bank can foreclose on the mortgage. If at the foreclosure sale the property does not bring enough money to cover the costs, interest, and balance due on the mortgage, First National is entitled to a deficiency judgment against Smith. However, some courts are reluctant to give deficiency judgments where real property is used as security for a debt. If on foreclosure the property sells for more than the debt, Mason is entitled to the surplus. A purchaser of mortgaged property may buy it subject to the mortgage or may assume the mortgage. If she buys subject to the mortgage and there is a default and foreclosure, the purchaser is not personally liable for any deficiency. The property is liable for the mortgage debt and can be sold to satisfy it in case of default; in addition, the original mortgagor remains liable for its payment. If the buyer assumes the mortgage, then she becomes personally liable for the debt and for any deficiency on default and foreclosure. The creditor (mortgagee) may assign his interest in the mortgaged property. To do this, the mortgagee must assign the mortgage as well as the debt for which the mortgage is security. In most jurisdictions, the negotiation of the note carries with it the right to the security and the holder of the note is entitled to the benefits of the mortgage.

Foreclosure Foreclosure is the process by which any

rights of the mortgagor or the current property owner are cut off. Foreclosure proceedings are regulated by statute in the state in which the property is located. In many states, two or more alternative methods of foreclosure are available to the mortgagee or his assignee. The methods in common use today are (1) strict foreclosure, (2) action and sale, and (3) power of sale. A small number of states permit what is called strict foreclosure. The creditor keeps the property in satisfaction of the debt, and the owner’s rights are cut off. This means that the creditor has no right to a deficiency and the debtor has no right to any surplus. Strict foreclosure is normally limited to situations where the amount of the debt exceeds the value of the property. Foreclosure by action and sale is permitted in all states, and it is the only method of foreclosure permitted in some

states. Although the state statutes are not uniform, they are alike in their basic requirements. In a foreclosure by action and sale, suit is brought in a court having jurisdiction. Any party having a property interest that would be cut off by the foreclosure must be made a defendant, and if any such party has a defense, he must enter his appearance and set up his defense. After the case is tried, a judgment is entered and a sale of the property ordered. The proceeds of the sale are applied to the payment of the mortgage debt, and any surplus is paid over to the mortgagor. If there is a deficiency, a deficiency judgment is, as a general rule, entered against the mortgagor and such other persons as are liable on the debt. Deficiency judgments are generally not permitted where the property sold is the residence of the debtor. The right to foreclose under a power of sale must be expressly conferred on the mortgagee by the terms of the mortgage. If the procedure for the exercise of the power is set out in the mortgage, that procedure must be followed. Several states have enacted statutes that set out the procedure to be followed in the exercise of a power of sale. No court action is required. As a general rule, notice of the default and sale must be given to the mortgagor. After the statutory period, the sale may be held. The sale must be advertised, and it must be at auction. The sale must be conducted fairly, and an effort must be made to sell the property at the highest price obtainable. The proceeds of the sale are applied to the payment of costs, interest, and the principal of the debt. Any surplus must be paid to the mortgagor. If there is a deficiency and the mortgagee wishes to recover a judgment for the deficiency, she must bring suit on the debt.

Right of Redemption At common law and under

existing statutes, the mortgagor or an assignee of the mortgagor has what is called an equity of redemption in the mortgaged real estate. This means that he has the absolute right to discharge the mortgage when due and to have title to the mortgaged property restored free and clear of the mortgage debt. Under the statutes of all states, the mortgagor or any party having an interest in the mortgaged property that will be cut off by the foreclosure may ­redeem the property after default and before the mortgagee forecloses the mortgage. In several states, the mortgagor or any other party in interest is given by statute what is known as a redemption period (usually six months or one year, beginning either after the foreclosure proceedings are started or after a foreclosure sale of the mortgaged property has been made) in which to pay the mortgaged debt, costs, and interest and to redeem the property. As a general rule, if a party in interest wishes to ­redeem, he must, if the redemption period runs after the foreclosure



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

sale, pay to the purchaser at the foreclosure sale the amount that the purchaser has paid plus interest up to the time of redemption. If the redemption period runs before the sale, the party in interest must pay the amount of the debt plus the costs and interest. The person who wishes to redeem from a mortgage foreclosure sale must redeem the entire mortgage interest; he cannot redeem a partial interest by paying a proportionate amount of the debt or by paying a proportionate amount of the price bid at the foreclosure sale.

Recent Development Concerning Foreclosures As the subprime lending crisis unfolded

during 2007, the number of defaults and foreclosure actions on both subprime and conventional mortgages increased significantly, and the trend continued into 2008 and beyond. In 2010, there were 3.8 million foreclosure filings in the country, an increase of about 800,000 over the number filed the previous year. Historically, mortgage lenders were local banks that lent money to a homeowner who then paid the money back to the bank. If the loan was in difficulty, the borrower and his local lender would work through the matter directly. Over time, local lenders began to resell or assign the loans they originated to others. And the practice of bundling loans together as mortgage-backed securities became commonplace. Securitization takes the role of the lender and breaks it down into different components. The loan is sold to a third

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party, the issuer, that bundles the loan into a security and then sells it to investors who are entitled to a share of the cash paid by the borrowers on their mortgages. Another party—the trustee—is created to represent the interests of the investors. And, another party—the servicer—collects the payments, distributes them to the issuer, and also deals with any delinquencies on the part of borrowers. Thus, these arrangements involving bundles of hundreds or thousands of mortgages are much more complex than the simple assignment of a single mortgage, and concomitantly, the paperwork involved is much more complicated— and the documentation sometimes incomplete when there was/is pressure to get deals done. As some of the collateralized loans fell into default and the owners of the securities—often large banks—brought foreclosure actions, judges began to scrutinize the cases to make sure that the parties bringing the foreclosure actions actually were the legal holders of the mortgage obligation and to dismiss the cases where that showing had not been made. The opinion that follows by Judge Boyko in In re Foreclosure Cases generated a lot of attention in the media and in the financial and legal communities when it was issued in October 2007 and served as a warning to would-be foreclosers that they needed to have their paperwork in order before they sought to put a homeowner out of his house. These same issues continue to arise in cases in the decade beginning in 2010 and continuing today.

In re Foreclosure Cases   2007 U.S. Dist. LEXIS 84011 (N.D. Ohio 2007) Boyko, U.S. District Judge On October 10, 2007, this court issued an Order requiring Plaintiff-Lenders in a number of pending foreclosure cases to file a copy of the executed Assignment demonstrating Plaintiff was the holder and owner of the Note and Mortgage as of the date the Complaint was filed, or the Court would order a dismissal. After considering the submissions along with all the documents filed of record, the Court dismisses the captioned cases without prejudice. To satisfy the requirements of Article III of the United States Constitution, the plaintiff must show he has personally suffered some actual injury as a result of the illegal conduct of the defendant. In each of the . . . Complaints, the named Plaintiff alleges that it is the holder and owner of the Note and Mortgage. However, the attached Note and Mortgage identify the mortgagee and promisee as the original lending institution—one other than the named Plaintiff. Further the Preliminary Judicial Report

attached as an exhibit to the complaint makes no reference to the named Plaintiff in the recorded chain of title/interest. The Court’s Amended General Order requires Plaintiff to submit an affidavit along with the complaint, which identifies Plaintiff either as the original mortgage holder, or as an assignee, trustee, or successorin-interest. Once again, the affidavits submitted in all these cases recite the averment that Plaintiff is the owner of the Note and Mortgage, without any mention of an assignment or trust or successor interest. Consequently, the very filings and submissions of the Plaintiff create a conflict. In every instance, then, Plaintiff has not satisfied its burden of demonstrating standing at the time of the filing of the Complaint. Understandably, the Court requested clarification by requiring each Plaintiff to submit a copy of the Assignment of the Note and Mortgage, executed as of the date of the Foreclosure Complaint. In the above-captioned cases, none of the Assignments show the named Plaintiff to be the owner of the rights, title, and interest under the Mortgage at issue as of the date of the Foreclosure

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Part Six Credit

Complaint. The Assignments, in every instance, express a present intent to convey all rights, title and interest in the Mortgage and the accompanying Note to the Plaintiff named in the Foreclosure Complaint upon receipt of sufficient consideration on the date the Assignment was signed and notarized. Those proferred documents belie Plaintiffs’ assertion they own the Note and Mortgage by means of a purchase which pre-dated the Complaint by days, months or years. This Court is obligated to carefully scrutinize all filings and pleadings in foreclosure actions, since the unique nature of real property requires contracts and transactions concerning real property to be in writing. Ohio law holds that when a mortgage is assigned, moreover, the assignment is subject to the recording requirements. “Thus, with regards to real property, before an entity assigned an interest in that property would be entitled to receive a distribution from the sale of the property, their interest therein must have been recorded in accordance with Ohio law.” This Court acknowledges the right of banks, holding valid mortgages, to receive timely payments. And, if they do not receive timely payments, banks have the right to properly file actions on the defaulted notes—seeking foreclosure on the property securing the notes. Yet, this Court possesses the independent obligations to preserve the judicial integrity of the federal court and to jealously guard federal jurisdiction. Neither the fluidity of the secondary mortgage market, nor monetary or economic considerations of the parties, nor the convenience of the litigants supersede those obligations. Despite Plaintiffs’ counsel’s belief that “there appears to be some level of disagreement and/or misunderstanding amongst professionals, borrowers, attorneys and members of the judiciary,” the Court does not require instruction and is not operating under any misapprehension. Plaintiff’s, “Judge, you just don’t understand how things work,” argument reveals a condescending mindset and quasi-­ monopolistic system where financial institutions have traditionally controlled, and still control, the foreclosure process. Typically, the homeowner who finds himself/herself in financial straits, fails to make the required mortgage payments and faces

Deed of Trust States typically use either the mort-

gage or the deed of trust as the primary mechanism for holding a security interest in real property. There are three parties to a deed of trust: (1) the owner of the property who borrows the money (the debtor), (2) the trustee who holds legal title to the property put up as security, and (3) the lender who is the beneficiary of the trust. The trustee serves as a fiduciary for both the creditor and the debtor. The purpose of the deed of trust is to make it easy

a foreclosure suit, is not interested in testing state or federal jurisdictional requirements, either pro se or through counsel. Their focus is either, “how do I save my home,” or “if I have to give it up, I’ll simply leave and find somewhere else to live.” In the meantime, the financial institutions or successors/­ assignees rush to foreclose, obtain a default judgment and then sit on the deed, avoiding responsibility for maintaining the property while reaping the financial benefits of interest running on a judgment. The financial institutions know the law charges the one with title (still the homeowner) with maintaining the property. There is no doubt every decision made by a financial institution in the foreclosure process is driven by money. And the legal work which flows from winning the financial institution’s favor is highly lucrative. There is nothing improper or wrong with financial institutions or law firms making a profit—to the contrary, they should be rewarded for sound business and legal practices. However, unchallenged by underfinanced opponents, the institutions worry less about jurisdictional requirements and more about maximizing returns. Unlike the focus of financial institutions, the federal courts must act as gatekeepers, assuring that only those who meet diversity and standing requirements are allowed to pass through. Counsel for the institutions are not without legal argument to support their position, but their arguments fall woefully short of justifying their premature filings, and utterly fail to satisfy their standing and jurisdictional burdens. The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test, their weak legal arguments compel the Court to stop them at the gate. The Court will illustrate in simple terms its decision: “Fluidity of the market”—“X” dollars, “contractual arrangements between institutions and counsel”—“X” dollars, “purchasing mortgages in bulk and securitizing”—“X” dollars, “rush to file, slow to record after judgment”—“X” dollars, “the jurisdictional integrity of United States District Court”—“Priceless.” For all the foregoing reasons, the above-captioned Foreclosure Complaints are dismissed without prejudice.

for the security to be liquidated. However, most states treat the deed of trust like a mortgage in giving the borrower a relatively long period of time to redeem the property, thereby defeating this rationale for the arrangement. In a deed of trust transaction, the borrower deeds to the trustee the property that is to be put up as security. The trust agreement usually gives the trustee the right to foreclose or sell the property if the debtor fails to make a required payment on the debt. Normally, the trustee does not



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

sell the property until the lender notifies him that the borrower is in default and demands that the property be sold. The trustee must notify the debtor that he is in default and that the land will be sold. The trustee advertises the property for sale. After the statutory period, the trustee will sell the property at a public or private sale. The proceeds are applied to the costs of the foreclosure, interest, and debt. If there is a surplus, it is paid to the borrower. If there is a

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deficiency, the lender has to sue the borrower on the debt and recover a judgment.

Land Contracts The

land contract is a device for securing the balance due the seller on the purchase price of real estate. Essentially, it is an installment contract for the purchase of land. The buyer agrees to pay the purchase price over a period of time. The seller agrees to convey

Ethics and Compliance in Action Who Was Ethical? During the first half of the decade beginning in 2000, housing prices in many areas of the country escalated, creating a bubble in the housing market. At the same time, lenders began relaxing their standards for making loans to prospective homebuyers. In prior years, a purchaser would have to make a significant down payment on a house, putting up 10 or 20 percent of the purchase price. As banks and other mortgage originators increasingly sold the mortgages in packages to investors, they became less demanding about down payments and were willing to accept 5 percent or even nothing down. They also made loans that appeared very ­attractive to borrowers, with low interest rates and required monthly

payments for the first few years of the loan—but then provided that both interest rates and monthly payments could escalate dramatically in a few years. Some borrowers entered into the loan agreements knowing they were a stretch but counting on prices continuing to rise, and they assumed they could always refinance into a more viable arrangement. Others experienced a change in their employment circumstances and no longer had the ability to make their payments. And others may not have understood the financial ramifications of what they had agreed to do or entered into the mortgage arrangements after making fraudulent statements about their financial circumstances and income. Do you find any of these actions to be unethical? Why?

CONCEPT REVIEW Security Interests in Real Property Type of Security Instrument

Parties

Features

Mortgage

1. Mortgagor (property owner/debtor) 2. Mortgagee (creditor)

1. Mortgagee holds a security interest (and in some states, title) in real property as security for a debt. 2. If mortgagor defaults on her obligation, mortgagee must foreclose on property to realize his security interest. 3. Mortgagor has a limited time after foreclosure to redeem her interest.

Deed of Trust

1. Owner/debtor 2. Lender/creditor 3. Trustee

1. Trustee holds legal title to the real property put up as security. 2. If debt is satisfied, the trustee conveys property back to owner/debtor. 3. If debt is not paid as agreed, creditor notifies trustee to sell the property. 4. While intended to make foreclosure easier, most states treat it like a mortgage for purposes of foreclosure.

Land Contract

1. Buyer 2. Seller

1. Seller agrees to convey title when full price is paid. 2. Buyer usually takes possession, pays property taxes and insurance, and maintains the property. 3. If buyer defaults, seller may declare a forfeiture and retake possession (most states) after buyer has limited time to redeem; some states require foreclosure

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title to the property to the buyer when the full price is paid. Usually, the buyer takes possession of the property, pays the taxes, insures the property, and assumes the other ­obligations of an owner. However, the seller keeps legal title and does not turn over the deed until the purchase price is paid. If the buyer defaults, the seller usually has the right to declare a forfeiture and take over possession of the property. The buyer’s rights to the property are cut off at that point. Most states give the buyer on a land contract a limited period of time to redeem his interest. Moreover, some states require the seller to go through a foreclosure proceeding. Generally, the procedure for declaring a forfeiture and recovering property sold on a land contract is simpler and less time-consuming than foreclosure of a mortgage. In most states, the procedure in case of default is set out by statute. If the buyer, after default, voluntarily surrenders possession to the seller, no court procedure is necessary; the seller’s title will become absolute, and the buyer’s equity will be cut off. Purchases of farm property are commonly financed through the use of land contracts. As an interest in real estate, a land contract should be in writing and recorded in the local land records so as to protect the interests of both parties. However, some courts have invoked the equitable doctrine against forfeitures and have required that the seller on a land contract must foreclose on the property in order to avoid injustice to a defaulting buyer.

Mechanic’s and Materialman’s Liens LO28-6

Describe mechanic’s and materialman’s liens and explain how they are obtained and what rights they give the lienholder.

Each state has a statute that permits persons who contract to furnish labor or materials to improve real estate to claim a lien on the property until they are paid. There are many differences among states as to exactly who can claim such a lien and the requirements that must be met to do so.

Rights of Subcontractors and Materialmen A general contractor is a person who has con-

tracted with the owner to build, remodel, or improve real property. A subcontractor is a person who has contracted with the general contractor to perform a stipulated portion of the general contract. A materialman is a person who has

contracted to furnish certain materials needed to perform a designated general contract. Two distinct systems—the New York system and the Pennsylvania system—are followed by the states in allowing mechanic’s liens on real estate to subcontractors and materialmen. The New York system is based on the theory of subrogation, and the subcontractors or materialmen cannot recover more than is owed to the contractor at the time they file a lien or give notice of a lien to the owner. Under the Pennsylvania system, the subcontractors or materialmen have direct liens and are entitled to liens for the value of labor and materials furnished, irrespective of the amount due from the owner to the contractor. Under the New York system, the general contractor’s failure to perform his contract or his abandonment of the work has a direct effect on the lien rights of subcontractors and materialmen, whereas under the Pennsylvania system, such breach or abandonment by the general contractor does not directly affect the lien rights of subcontractors and materialmen.

Basis for Mechanic’s or Materialman’s Lien Some state statutes provide that no lien shall be claimed unless the contract for the improvement is in writing and embodies a statement of the materials to be furnished and a description of the land on which the improvement is to take place and of the work to be done. Other states permit the contract to be oral, but in no state is a licensee or volunteer entitled to a lien. No lien can be claimed unless the work is done or the materials are furnished in the performance of a contract to improve specific real property. A sale of materials without reference to the improvement of specific real property does not entitle the person furnishing the materials to a lien on real property that is, in fact, improved by the use of the materials at some time after the sale. Unless the state statute specifically includes submaterialmen, they are not entitled to a lien. For example, if a lumber dealer contracts to furnish the lumber for the erection of a specific building and orders from a sawmill a carload of lumber that is needed to fulfill the contract, the sawmill will not be entitled to a lien on the building in which the lumber is used unless the state statute expressly provides that submaterialmen are entitled to a lien. At times, the question has arisen as to whether materials have been furnished. Some courts have held that the materialman must prove that the material furnished was actually incorporated into the structure. Under this ruling, if material delivered on the job is diverted by the general contractor or others and not incorporated into the structure, the materialman will not be entitled to a lien. Other courts have held that the materialman is entitled to a lien if



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

he can provide proof that the material was delivered on the job under a contract to furnish the material.

Requirements for Obtaining a Lien The

requirements for obtaining a mechanic’s or materialman’s lien must be complied with strictly. Although there is no uniformity in the statutes as to the requirements for obtaining a lien, the statutes generally require the filing of a notice of lien with a county official such as the register of deeds or the county clerk, which notice sets forth the amount claimed, the name of the owner, the names of the contractor and the claimant, and a description of the property. Frequently, the notice of lien must be verified by an affidavit of the claimant. In some states, a copy of the notice must be served on the owner or be posted on the property. The notice of lien must be filed within a stipulated time. The time varies from 30 to 90 days, but the favored time is 60 days after the last work performed or after the last materials furnished. Some statutes distinguish among labor claims, materialmen’s claims, and claims of general contractors as to time of filing. The lien, when filed, must be foreclosed within a specified time, which generally varies from six months to two years.

Priorities and Foreclosure The provisions for

priorities vary widely, but most of the statutes provide that a mechanic’s lien has priority over all liens attaching after the first work is performed or after the first materials are furnished. This statutory provision creates a hidden lien on the property, in that a mechanic’s lien, filed within the allotted period of time after completion of the work, attaches as of the time the first work is done or the first material is furnished, but no notice of lien need be filed during this period. And if no notice of lien is filed during this period, third persons would have no means of knowing of the existence of a lien. There are no priorities among lien claimants under the majority of the statutes.

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The case that follows, Trump Endeavor 12 LLC v. Fernich, Inc. d/b/a The Paint Spot, illustrates a situation where a subcontractor was able to enforce a lien on property to which it had provided materials but had not been paid by the owner of the property. The procedure followed in the foreclosure of a ­mechanic’s lien on real estate follows closely the procedure followed in a court foreclosure of a real estate mortgage. The rights acquired by the filing of a lien and the extent of the property covered by the lien are set out in some of the mechanic’s lien statutes. In general, the lien attaches only to the interest that the person has in the property that has been improved at the time the notice is filed. Some statutes provide that the lien attaches to the building and to the city lot on which the building stands, or if the improvement is to farm property, the lien attaches to a specified amount of land.

Waiver of Lien The question often arises as to the

effect of an express provision in a contract for the improvement of real estate that no lien shall attach to the property for the cost of the improvement. In some states, there is a statute requiring the recording or filing of the contract and making such a provision ineffective if the statute is not complied with. In other states, courts have held that such a provision is effective against everyone; in other states, courts have held that the provision is ineffective against everyone except the contractor; and in still other states, courts have held that such a provision is ineffective as to subcontractors, materialmen, and laborers. Whether the parties to the contract have notice of the waiver of lien provision plays an important part in several states in determining their right to a lien. It is common practice that before a person who is having improvements made to his property makes final payment, he requires the contractor to sign an affidavit that all materialmen and subcontractors have been paid and to supply him with a release of lien signed by the subcontractors and materialmen.

Trump Endeavor 12 LLC v. Fernich, Inc. d/b/a The Paint Spot    216 So. 3d 704 (Fla. Dist. Ct. App. 2017)

On October 21, 2014, The Paint Spot (Paint Spot) recorded a claim of lien against the Trump National Doral Miami owned by Trump Endeavor 12 (Trump). When Trump failed to pay $32,535.87 owed to Paint Spot for paint and related materials, Paint Spot filed a complaint to foreclose its claim of lien. Trump asserted that the claim of lien was invalid because it identified the wrong contractor on the project and did not comply with the Florida Construction Lien Law. The trial court entered final judgment of foreclosure of the lien, as well as an award of attorney fees and costs, to Paint Spot. Trump appealed.

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The project at the Trump National Doral Miami consisted of two parts: renovations to the property’s 10 lodges (the Lodge Project) and renovations to the clubhouse (the Clubhouse Project). Both the Lodge Project and the Clubhouse Project share the same property address: 4400 NW 87 Avenue, Miami, Florida. Trump hired a different general contractor for each of the two projects: Straticon, LLC for the Lodge Project and T & G Constructors for the Clubhouse Project. Straticon hired M&P Reynolds (M&P) to furnish paint and labor for the Lodge Project, which in turn contracted with the Paint Spot to supply paint and related materials. Paint Spot negotiated pricing with M&P, which M&P submitted to Straticon. Trump approved M&P’s price quotations. Trump recorded multiple notices of commencement (NOC) for the Lodge Project, and later recorded an NOC naming T&G as the general contractor for the Clubhouse Project. All the NOCs disclosed the same address for both projects: 4400 NW 87 Avenue, Miami, Florida. Prior to supplying materials to the Lodge Project, the Paint Spot’s president visited the project site for the purpose of obtaining a copy of the NOC so that Paint Spot could prepare its statutory NTO. He made it a habit to obtain the NOC from the owner of the project, rather than the general contractor, to ensure his NTO contained the correct information. When he asked for the NOC from Trump’s Director of Construction, Frank Sanzo, Sanzo mistakenly gave him the T&G NOC instead of the Straticon NOC. At this point, Paint Spot’s president was unaware that there was a different general contractor for each of the two projects. Using the T&G NOC, Paint Spot prepared and timely served its NTO on Trump and T&G by certified mail in November 2013 and began supplying materials to the Lodge Project that month. Later that month, Straticon learned that the Paint Spot had listed T&G in error on the NTO; however, it also knew that Paint Spot was supplying paint materials to the Lodge Project and knew that Paint Spot was M&P’s only paint supplier for the project. Paint Spot attended meetings with Straticon regarding the Lodge Project, and Paint Spot signed partial waivers of lien to M&P as a precondition to receiving payment for the paint materials. Straticon would not pay M&P without M&P submitting partial waivers from its suppliers. Paint Spot continued supplying materials to the Lodge Project through September of 2014, at which time M&P stopped working on the project because it was not being paid by Straticon. At the time M&P left the Lodge Project, $32,535.87 worth of paint and supplies delivered by Paint Spot that had not been paid for remained at the Lodge Project. Trump used those materials to finish the painting work, but Paint Spot was never paid for those items, resulting it filing the action to foreclose the lien.

Emas, Judge. Chapter 713 of the Florida Statutes, entitled “Construction Lien Law,” establishes a statutory framework for establishment and enforcement of construction liens by subcontractors, laborers and materialmen. The fundamental purpose of the Construction Lien Law is to protect those who have provided labor and materials for the improvement of real property. It is to be construed favorably so as to give laborers and suppliers the greatest protection compatible with justice and equity. The mechanics lien law was enacted to protect the interests of subcontractors and materialmen who remain unpaid while the owner pays the contractor directly. Section 713.06(2)(a) provides [in pertinent part]: All liens under this section, except laborers, as a prerequisite to perfecting a lien under this chapter and recording a claim of lien, must serve a notice on the owner setting forth the lienor’s name and address, a description sufficient for identification of the real property and the nature of the services or materials furnished, or to be furnished. A sub- subcontractor or a materialman to a subcontractor must serve a copy of the notice on the contractor as a prerequisite to perfecting a lien under this chapter and recording a claim of lien. *** The notice must be served before commencing, or not later than 45 days after commencing, to furnish his or her labor, services, or materials . . . . (Emphasis added.)

Under section 713.06(2)(f): If a lienor has substantially complied with the provisions of paragraphs (a), (b), and (c), errors and omissions do not prevent the enforcement of a claim against a person who has not been adversely affected by such omission or error. However, a lienor must strictly comply with the time requirements of paragraph (a). In the instant case, Trump and Straticon had actual, express and timely notice that: Paint Spot mistakenly named the wrong contractor in its NTO; M&P (whose name was properly listed on the NTO) was Straticon’s own subcontractor for the Lodge Project; Paint Spot was supplying materials to the Lodge Project under M&P; and Paint Spot intended to lien the property if payment was not timely made. Further, the evidence established that Straticon treated Paint Spot as a potential lienor for the duration of the Lodge Project. For example, Paint Spot attended meetings with Straticon, and Straticon received partial lien waivers from M&P, which included partial lien waivers from Paint Spot for materials provided for the Lodge Project. Straticon even attempted to assist Paint Spot in obtaining payment from Trump for the remaining Paint Spot materials left at the Lodge Project, which materials were later used to complete M&P’s work.



Chapter Twenty-Eight Introduction to Credit and Secured Transactions

Trump has failed to carry its burden of demonstrating that it was adversely affected by Paint Spot’s erroneous listing of T&G as the contractor. Notably, there is no evidence that, as a result of this error, Trump paid T&G for the paint supplies, and was thus at risk of paying twice for the same materials. Rather, the evidence at trial established that the painting subcontractor (who replaced M&P when it left the job) used Paint Spot’s materials to finish the Lodge Project, and that Paint Spot was never fully paid for those materials. At trial, Straticon’s project manager admitted the reason for not paying Paint Spot the amounts due: [T]he decision not to pay Paint Spot had nothing to do with a defective Notice to Owner. . . . They weren’t paid because Mr. Trump had already paid M&P a decent amount of money

Problems and Problem Cases 1. Rusty Jones, a used car dealer, applied to First ­Financial Federal Savings and Loan Association for a $50,000 line of credit to purchase an inventory of used cars. First Financial refused to make the loan to Jones alone but agreed to do so if Worth Camp, an attorney and friend of Jones, would cosign the note. Camp agreed to cosign as an accommodation maker or surety. The expectation of the parties was that the loans cosigned by Camp would be repaid from the proceeds of the car inventory. The original note for $25,000 was signed on August 2, 1994; renewals were executed on January 25, 1995, September 11, 1995, and March 15, 1996; and the amount was eventually increased to $50,000. In August 1995, as Camp was considering whether to sign the September renewal note, he was advised by First Financial’s loan officer that the interest on the loan had not been paid. In fact, interest payments were four months delinquent. In addition, unknown to Camp, as the $50,000 credit limit was approached, First Financial began making side, or personal, loans to Jones totaling about $25,000, which were also payable out of the used car inventory. Camp knew nothing of these loans and thought that Jones’s used car business was making payments only on the loans he had cosigned. Jones defaulted on the $50,000 note cosigned by Camp, and First Financial brought suit against Camp on his obligation as surety on the note. Was Camp relieved of his obligation as surety by First Financial’s failure to disclose material facts to him?

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of the contract . . . and there was still a lot of work that needed to be completed, so we used the money, M&P’s remaining balance, plus additional funds to get the work done. “The purpose of the NTO is to protect an owner from the possibility of paying over to his contractor sums which ought to go to a subcontractor who remains unpaid.” Accordingly, we hold that the trial court correctly determined that Paint Spot substantially complied with the time requirements of subsection (2)(a). We also hold that Trump failed to establish that it was adversely affected by the error contained in the NTO. We also affirm the final judgment awarding attorney’s fees. Affirmed.

2. Mr. and Mrs. Marshall went to Beneficial Finance to borrow money but were deemed by Beneficial’s office manager, Puckett, to be bad credit risks. The Marshalls stated that their friend Garren would be willing to cosign a note for them if necessary. Puckett advised Garren not to cosign because the Marshalls were bad credit risks. This did not dissuade Garren from cosigning a note for $480, but it prompted him to ask Beneficial to take a lien or security interest in Mr. Marshall’s custom-built Harley-Davidson motorcycle, then worth more than $1,000. Beneficial took and perfected a security interest in the motorcycle. Marshall defaulted on the first payment. Beneficial gave notice of the default to Garren and advised him that it was looking to him for payment. Garren then discovered that Beneficial and Marshall had reached an agreement whereby Marshall would sell his motorcycle for $700; he was to receive $345 immediately, which was to be applied to the loan, and he promised to pay the balance of the loan from his pocket. Marshall paid Beneficial $89.50 and left town without giving the proceeds of the sale to Beneficial. Because Beneficial was unable to get the proceeds from Marshall, it brought suit against Garren on his obligation as surety. When Beneficial released the security for the loan (the motorcycle) without Garren’s consent, was Garren relieved of his obligation as surety for ­repayment of the loan? 3. Krista Babcock cosigned an automobile loan agreement that enabled her friend, Horne, to obtain a $5,000 loan to acquire an automobile from a third party. Horne defaulted on the loan after making a number of payments, and Babcock paid $2,000 to the

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lending institution to pay off the remaining balance on the loan. Babcock then brought suit against Horne to recover the $2,000. Is she entitled to recover the $2,000? 4. Wieslaw Wik was the owner of a truck tractor on which Navistar Financial Corporation held a lien to secure a purchase loan agreement. On February 21, Wik was driving his truck tractor and pulling a trailer owned by the V. Seng Teaming Company. The tractor/ trailer unit overturned in a ditch. Allen’s Corner Garage and Towing Service was called by the Illinois State Police. Its crew removed the cargo from the trailer and hoisted the tractor and trailer out of the ditch and onto the highway. They then took the truck, trailer, and cargo to Allen’s garage for storage. The uprighting and towing of semitrailer trucks is an intricate process and involves a good deal of specialized equipment. Allen’s was licensed by the Interstate Commerce Commission and the Illinois Commerce Commission as a common carrier and owned more than 50 specialized trucks and trailers for such operations. Wik defaulted on his loan agreement with Navistar and the right to possession passed to Navistar. One of its employees contacted Allen’s and offered to pay the towing plus storage charges on the truck in exchange for possession of it. Allen’s refused, saying it would not release the truck unless the charges for the truck, trailer, and cargo were all paid. Navistar then brought suit against Allen’s to recover possession of the truck.  Subsequently, V. Seng Teaming Company paid $13,000 in towing and storage charges on the trailer and cargo and took possession of them. Navistar then reiterated its willingness to pay the towing charges but refused to pay any storage charges accruing after its initial offer. Was Allen’s entitled to a common law lien for its towing and storage charges? 5. Philip and Edith Beh purchased some property from Alfred M. Gromer and his wife. Sometime earlier, the Gromers had borrowed money from City Mortgage. They had signed a note and had given City Mortgage a second deed of trust on the property. There was also a first deed of trust on the property at the time the Behs purchased it. In the contract of sale between the Behs and the Gromers, the Behs promised to “assume” the second deed of trust of approximately $5,000 at 6 percent interest. The Behs later defaulted on the first deed of trust. Foreclosure was held on the first deed of trust, but the proceeds of the sale left nothing for City Mortgage on its second deed of trust. City Mortgage then brought a lawsuit against

the Behs to collect the balance due on the second deed of trust. When the Behs “assumed” the second deed of trust, did they become personally liable for it? 6. Pope agreed to sell certain land to Pelz and retained a mortgage on the property to secure payment of the purchase price. The mortgage contained a clause providing that if Pelz defaulted, Pope had the “right to enter upon the above-described premises and sell the same at public sale” to pay the balance of the purchase price, accounting to Pelz for any surplus realized on the sale. What type of foreclosure does this provision contemplate: (1) strict foreclosure, (2) action and sale, or (3) private power of sale? 7. In October 1992, Verda Miller sold her 107-acre farm for $30,000 to Donald Kimball, who was acting on behalf of his own closely held corporation, American Wonderlands. Under the agreement, Miller retained title, and Kimball was given possession pending full payment of all installments of the purchase price. The contract provided that Kimball was to pay all real ­estate taxes. If he did not pay them, Miller could discharge them and either add the amounts to the unpaid principal or demand immediate payment of the delinquencies plus interest. Miller also had the right to ­declare a forfeiture of the contract and regain possession if the terms of the agreement were not met. In 1995, Miller had to pay the real estate taxes on the property in the amount of $672.78. She demanded payment of this amount plus interest from Kimball. She also served a notice of forfeiture on him that he had 30 days to pay. Kimball paid the taxes but refused to pay interest of $10.48. Miller made continued ­demands on Kimball for 2 months, then filed notice of forfeiture with the county recorder in August 1995. She also advised Kimball of this. Was Miller justified in declaring a forfeiture and taking back possession of the land? 8. Bowen-Rodgers Hardware Company was engaged in the business of furnishing materials for the construction of buildings. It delivered a quantity of materials to property owned by Ronald and Carol Collins. The materials were for the use of a contractor who was building a home for the Collinses as well as several other houses in the area. The hardware company was not paid for the materials by the contractor, and it sought to obtain a mechanic’s lien against the Collinses’ property. The Collinses claimed that even though the materials were delivered to their home, they were actually used to build other houses in the area. Was the Collinses’ property subject to a mechanic’s lien because payment had not been made for materials delivered to it?

CHAPTER 29

Security Interests in Personal Property

E

mily Morales purchased a used Honda Civic from her local Honda dealer. She paid $500 down, and the dealer helped her arrange financing of the $4,500 balance through a local bank that placed a lien on the car to secure the loan. She fell behind in her payments when she was temporarily laid off from her job. Then the car was damaged by vandals one night while parked in the parking lot of the apartment complex where she rented an apartment. She took it to an automobile repair shop to have the damaged windshield and broken mirrors and headlamps replaced and portions of it repainted. When she went to pick it up, the repair shop refused to release it to her until she paid $950 cash for the repairs. Emily borrowed the money from her mother and was able to reclaim the car. However, several weeks later, she awoke one evening to see a flashing yellow light outside her apartment. She looked out the window and saw a tow truck was in the process of picking up her car by its rear end. She raced outside and confronted the driver as to what he was doing with her car. A loud shouting match ensued, during which the driver indicated he had been instructed by the bank to repossess the car because she was behind on her payments. Eventually, the truck driver got in his truck and drove away with the car towed behind, leaving Emily and a number of her neighbors, who had gathered to see what the commotion was about, cursing at the driver. Among the issues posed by this hypothetical are these: • What did the bank have to do to protect its interest in the Honda until Emily paid off the loan? • If the bank had learned that the car was at the repair shop and sought to repossess it then, would the bank’s lien or the repair shop’s artisan’s lien have the first priority? • Was the bank within its rights in repossessing the car in the manner it did? If it was not, does Emily have any recourse?

LO

LEARNING OBJECTIVES After studying this chapter, you should be able to: 29-1

29-2 29-3

 ecognize and describe the different classes or R types of collateral that can be used as collateral to secure a security interest under Article 9 of the Uniform Commercial Code (UCC). List and explain the three requirements for creating a security interest in a debtor’s property that will be enforceable against a debtor. Explain why it is important that the creditor perfect his security interest and list the three main ways of perfecting a security interest.

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 ecall the general priority rules that the R UCC sets out for determining which of any conflicting security interests take precedence over other security interests or liens. 29-5 Explain what is meant by a purchase money security interest and discuss why the UCC accords it preferential treatment. 29-6 Describe the steps a creditor can take when there is a default on the part of the debtor.

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IN MANY CREDIT TRANSACTIONS, the creditor, in order to protect his right to payment or performance of the underlying obligation, takes a security interest, or lien, in personal property belonging to the debtor. The law covering security interests in personal property is set forth in Article 9 of the Uniform Commercial Code. Article 9, titled Secured Transactions, applies to situations that consumers and businesspeople commonly face; for example, the financing of an automobile, the purchase of a refrigerator on a time-payment plan, or the financing of business inventory.

Article 9 If a creditor wants to obtain a security interest in the personal property of the debtor, he also wants to be sure that his interest is superior to the claims of other creditors. To do so, the creditor must carefully comply with Article 9. In Part 4 of this text, Sales, we pointed out that businesspersons sometimes leave out important terms in a contract or insert vague terms to be worked out later. Such looseness is a luxury that is not permitted in secured transactions. If a debtor gets into financial difficulties and cannot meet her obligations, even a minor noncompliance with Article 9 may cause the creditor to lose his preferred claim to the personal property of the debtor. A creditor who loses his secured interest is only a general creditor if the debtor is declared bankrupt. As a general creditor in bankruptcy proceedings, he may have little chance of recovering the money owed by the debtor because of the relatively low priority of such claims. Chapter 30, Bankruptcy, covers this in detail. In 1998, the National Conference on Uniform State Laws adopted a “Revised Article 9” that has now been adopted by all 50 states with effective dates ranging from 2001 to 2002. Then in 2010, additional amendments to Article 9 were drafted to respond to filing issues and other matters that have arisen in practice following a decade of experience with the 1998 revision. The 2010 amendments were designed to go into effect simultaneously on July 1, 2013. Because Article 9 has not been adopted in exactly the same form in every state, the law must be examined very carefully to determine the procedure in a particular state for obtaining a security interest and for ascertaining the rights of the creditors and debtors. However, the general concepts are the same in each state and will be the basis of our discussion in this chapter.

Security Interests under the Code Security Interests Basic

to a discussion of secured consumer and commercial transactions is the term security interest. A security interest is an interest in personal property or fixtures a creditor obtains from a

debtor to secure payment or performance of an obligation [1-201(37)].1 For example, when a person borrows money from a